The 4% Rule is the creation of an advisor named Bill Bengen, You can read more here.
Basically, the rule was established to help those considering retirement and wondering how much of their nest egg they could take out each year for spending.
“I have $500,000. Sounds like a lot, but is it enough?”
Many of us have wondered. We plug in our net worth and we’re asking the same question.
What is the 4% Rule?
Bengen did some analysis and came up with what has now become a standard. He says we can take 4% out in the first year of retirement, adjust our withdrawal up by the rate of inflation in each subsequent year, and we should have enough to last 30 years.
I heard Bill Bengen on the Motley Fool Podcast and he got me thinking. The podcast is worth a listen. It covers a lot of ground and helps put the rule into perspective.
Bengen also says that 4.7% may be a more realistic number. Yay!
Rules are Made to be Broken
Rules are a good starting point.
I like the 4% rule because it’s a simple rule that helps us start planning. And Bengen did all the hard work so we just have to multiply 4% times our net worth. Thanks Bill!
But if I’m making a decision that could cause me to run out of money in my 90’s, I want to be a bit more sure. Imagine updating our resume and starting a job search then.
What Else Can I Do?
I’m glad you asked.
4% is a good start. Save that number.
Now let’s look at what is really going to happen in retirement.
Don’t get your golf clubs out yet. We have some work to do.
Asset Allocation
I’ve written a couple of posts on asset allocation. Here’s the first. And then I wrote one about my Mom’s story with Asset Allocation.
For the purposes of today’s discussion, we’ll talk about asset allocation as the % of our net worth that is in cash v, fixed income, v. equity.
And quick refresher:
- Cash is checking, savings, high yield savings, CDs and cash under the mattress
- Fixed income is bonds or bond mutual funds and ETFs. More on bonds here, but essentially, bonds pay regular interest and we get our original investment back at maturity. Bond funds and ETFs buy a basked of bonds and pay us regular interest but may not have a lot in the way of capital appreciation.
- Equity is stocks. We’re taking an ownership stake in a business with the expectation that we will see significant capital appreciation. We may get dividend payments as well. We can buy equity mutual funds and ETFs as well as individual stocks.
Equity is the most volatile of the 3. Cash is the least and fixed income is somewhere in the middle.
How Do We Decide?
There are a few golden rules of asset allocation for me. Here we go.
Most importantly, money that we need in the next 5 years should ideally be in cash, but could be cash and fixed income, but not in equities. The reason is because equities are volatile, and while a nice basket of equities like a low-cost S&P 500 fund has a solid track record of gains over long periods, it is not uncommon to see massive pullbacks.
If we need money to pay the rent or mortgage or to pay for food, this shouldn’t be in equities.
Secondly, while equity has proven to be a better performer than cash and fixed income in the long run, its volatility can test our courage. Having 100% in equity when the market is down 6% in a day can be painful and can cause us to make rash decisions. Having some cash and fixed income can make this less painful.
And finally, asset allocation is very fluid. It needs to be reviewed every year. We grow older, our situation changes, and we need to account for this in our allocation.
Equity
The S&P 500 has gained 10% per year on average with dividends reinvested over the last 100 years or so. I feel like I’ve said his before. But it’s important.
It’s also been a wild ride. Up 30% some years and down 30% others.
I don’t want to be in a position where the money I need to buy groceries is in an S&P 500 fund when the market is down 30%. I’ll need to sell shares to get the cash and I’ll be doing that at a multi-year low. Years of patient gains go out the window.
But equity is the growth engine in my portfolio. I’m 62, but I’m planning for living past 90. Who knows if I’ll make it, but I want to be sure my money will. That’s 30 years away. It makes good sense to have a big chunk of money in equities that will continue to grow over the next 30 years.
As I get older and closer to 90, I’ll start moving to cash and fixed income. That’s the part about evaluating annually.
Fixed Income
As a retiree, I love fixed income. I get a monthly social security check, but I need to supplement that to maintain my standard of living.
My treasury bills, bonds and notes, along with my bond funds and ETFs provide regular income payments.
My bond funds pay an average of 5%. Most pay out interest at the end of the month, so I get a nice bump in my balance that supplements my social security.
And yes, the value of bond funds can go down. I’m less concerned about this because I’m in the fund for its monthly interest payment, but it’s something to be aware of.
Cash
It’s king for a reason.
The $20 tucked in my wallet was worth $20 yesterday, will be worth $20 tomorrow and next week as well. True that inflation will eat away at the value so that I may be able to buy fewer things with my $20, but I won’t look at CNBC this afternoon and see that my $20 is now worth $10.
And surprisingly, interest rates are still high, which means that I can get 4% on my CDs, high yield savings and brokerage cash accounts.
Income on cash won’t make me rich, but it’s nice to have.
If I’ve got $10,000 socked away to pay for my country club membership, I don’t want to be in a position where the stock or bond market drops and I only have $9,000. No golf for me.
If I need $10,000, it needs to be sitting in cash. Same for your rent check and grocery money.
Allocation Strategy
This is more art than science and it depends on the amount of money we have.
If I’ve got a large retirement nest egg, I can safely put a few month’s worth of expenses in cash, have a sizable bond fund portfolio to provide income and stability and still keep a good portion in equities for long term growth.
Our allocation strategy will be partly driven by the size of our nest egg.
Small Savings Balance
Without a large nest egg, I need to get creative. This could be another source of income, like a part-time job or owning rental property, it could mean saving more, or taking on more risk.
Taking on more risk doesn’t mean cashing out our 401k and heading to Vegas. But it does require taking more investment risk to potentially achieve the higher returns we need to fund our many years of retirement.
Here’s an example. A fairly safe bond fund would invest in short term high quality corporate bonds and treasury securities. Its value would be fairly stable. Little volatility. I’d get a reasonable annual income stream of about 4%-6% in today’s market.
Alternatively, I could take more risk and choose to put some of my fixed income assets in a high yield (which is a nice way of saying junk bond) fund. I could get 8%, 10%, even 14% annual interest. That’s a significant amount of income. But, junk bonds are much more likely to default. This will negatively impact the value of the fund and could put that high income at risk as well.
With a small savings balance, I might also take a portion of my equity allocation out of my nice low cost S&P 500 fund (which itself is volatile) and put it into a high growth fund. Or I may do my research and buy shares of a basket of growth companies.
This will guarantee me higher swings – both up and down. But it may be a way to accelerate my portfolio growth.
Moderate Savings Balance
With a moderate savings balance, I have more flexibility.
I’d have a good sized emergency fund sitting in cash. In addition, I’d have cash on hand for the next several months. I’d have a fixed income portfolio (possibly including muni bond funds to avoid taxes) that would pay me a regular income stream to supplement my social security.
I’d have a moderate equity portfolio, mostly in S&P 500 funds, that would provide long term income.
Adjustments
Each year, I’d ask myself, “what’s new?”
This year, I’m adding solar and taking a vacation. I’ll need more cash. I can’t afford to have that money in an S&P 500 fund. If the market is down, I’ll need to sell more shares than I’d hoped in order to raise the cash to pay for the vacation and the solar.
Don’t worry. You won’t always be right. Let’s say I sold shares of my S&P 500 fund in January to fund my solar and vacation. Today, the S&P 500 is 10% higher.
Yes, we’d have been better off if we’d stayed in equities, but what if the market had stayed down at its post liberation-day tariff low’s. Selling in January would have required us to sell fewer shares than we would have sold at the lower price. That leaves more shares for growth.
We won’t always be right, but it pays to be safe, especially with near-term expenses.
I may find out that I’ve spent less. I’m getting older and doing fewer things, so maybe I don’t need all the income today. I may want to move some fixed income to equity to save for medical expenses or long-term care for the future.
The adjustments, or the annual re-allocation requires a solid knowledge of our net worth and our spending. We’ll also need to project our spending for the coming year.
With this info, we can put together an appropriate asset allocation to best meet our needs.
Wrap Up
So, we didn’t talk much about the 4% rule, or 4.7%, or 3%, or whatever the rule is.
The point is that the 4% rule is a helpful piece of information when planning for retirement.
If my wife and I are 65and thinking about retiring, we know that we’ll get $1,500 per month each from social security, and we have $500,000 in combined savings, I can use the 4% rule to estimate that I can take (4% of 500,000, which is $20,000) per year or $1,600 per month.
My wife and I will have $3,000 in social security plus $1,600 from our savings (based on the 4% rule). Can we live on $4,600 per month?
This is where we need a good understanding of what we spend. When we add up utility bills, mortgage, insurance, credit card payments, pizza, coffee, golf, taxes, and everything else, will $4,600 cover it?
However, once we’re in retirement, I think we need to put the rule aside and get more granular.
That’s where asset allocation plays a big role. Whether we have a small, medium or large nest egg, we can manage our allocation across cash, fixed income and equity to optimize the potential for meeting our financial goals.
Which asset class we take the money from becomes important. Preserving some money for long-term growth in equities is important.