The 4% Rule: Is It Still Valid?
My recently written book, “How to Make a Fortune During Future Stock Market Crashes With Strategic Stock Accumulation,” is about a system that describes how to make money by playing the long game in the stock and bond markets. But what about finally spending the money in retirement? This subject is simply too important to ignore. With this in mind, let’s look at the often quoted “4% Rule.” The 4% Rule was first devised by a financial planner by the name of William Benjen about twenty years ago. He proposed drawing down 4.5% from a total retirement fund in the first year of retirement. This initial total percentage to be withdrawn would then be adjusted annually for inflation, while otherwise remaining the same throughout the retirement years.
Benjen’s model was set up to generate 30 years of retirement income, and he constructed the model portfolio to be balanced at about a 50/50 representation of stocks and bonds. The asset allocation that he proposed in 1994 was composed of 35% U.S. large-cap stocks, 18% U.S. small-cap stocks, and 47% intermediate-term U.S. government bonds. This portfolio would then be rebalanced annually.
Is the 4% Rule still valid? Will a retirement portfolio with the above parameters still last 30 years without being totally depleted before its endpoint is reached? This thesis is being questioned more often today in light of lower future stock and bond returns being projected by some analysts. These lower market projections are based largely on the premise that the stock market is overvalued at the present time, and that reversion to the mean requires lower future stock prices for a period of time that will possibly last 5 to 10 years. Such projections also assume that today’s lower interest rates will continue close to that same time duration.
As explained in my book (“How to Make a Fortune during Future Stock Market Crashes with Strategic Stock Accumulation”) the Federal Reserve (“Fed”) is presently engaged in a policy of socalled “financial repression,” and this action by the Fed has been totally responsible for the low interest rates that the U.S. has experienced over the last six years. But the Fed doesn’t operate in a vacuum. Economic conditions must be such so as to allow it to act with monetary impunity, without igniting inflation or causing another recession resulting from an expansive or restrictive policy (i.e., lower or higher interest rates).
Regardless of what the Fed does or doesn’t do, is the U.S. economy (and therefore the stock market) looking at a state of low near-future growth? And if so, what bearing would this have, if any, on the future validity of the 4% Rule? The Congressional Budget Office (CBO), Capitol Hill’s non-partisan budget agency, cites the following factors as reasons why this will indeed occur: (1) an aging U.S. population, (2) reduced working age immigration, and (3) an economic situation of growing income inequality. All three of these factors limit economic growth by limiting consumer spending and productivity. At this point in time, over 50% of the adult population does not work. Does this point to a loss of the vaunted U.S. work ethic? I don’t think so. Let’s be fair. A significant part of the adult population consists of retired people who are not expected to be in the workforce anyway.
At the same time, the above statistic does point to a loss in the percentage of adults who are reasonably expected to be able and willing to work. The CBO has downgraded U.S. economic growth from a 3% average since the turn of the century (2000) to 2%, mainly because of the three factors discussed above. There are valid arguments against the CBO’s projections. The most important of these, I believe, is the steadily declining unemployment rate over the last several months. The second argument, although not frequently made, is that the present decrease in the price of energy puts a lot of extra money into the hands of most American consumers. This tends to seriously impair the thesis of overall reduced consumer spending as being the limiting factor of economic growth.
Having discussed all of the above, if we assume that the CBO is correct in their assumptions, does this mean that the 4% rule is dead? Would a lower stock market return resulting from a low growth economy over the next three to five years mean that taking four and a half percent annually from an initial portfolio value is too high of a percentage for the portfolio to last for 30 years? First of all, there is a definite link between performance of the economy and that of the stock market. However, the link is not directly time-related. In other words, the stock market can remain overvalued (or undervalued) for a relatively long period of time before it reestablishes its true relationship with present or future economic growth.
The concept of “reversion to the mean” (also discussed in my book), is the process that takes place while this relationship (between price and true value) reestablishes itself. If the stock market is too high in relation to its overall earnings (a measure of the economy’s growth rate), then it must revert in value to an average level reflecting the economy’s performance. In order to reach this true valuation, it must undershoot its true value for some time to compensate for the time in which it was overvalued.
This overvaluation added to undervaluation over time leads to ‘true’ valuation. That is why if the stock market enters so-called “bubble” territory, and stays there unsupported by economic fundamentals for a considerable time, then it must become, and stay, undervalued for a comparable time period. When I say, “comparable time period,” this counter effect (on the downside) can be altered by the extent of the correction or “crash,” if you will. This period of time could be shortened somewhat by a higher percentage drop in the market as compared to the level of the previous increase on the upside into bubble territory.
The bottom line is that these overshootings and undershootings of the stock market must average out to a fair value over time. This is the main reason investors need to realize that the stock market “always comes back” after a crash or correction. And, likewise, it always corrects on the low side of valuation (to ultimately reach fair valuation) after the market has been in overvaluation mode for a time. The opposite is also true. After a considerable time in undervaluation, the stock market must adjust into overvaluation for a time to ultimately reach fair valuation. This fair valuation itself will then morph into either undervaluation or overvaluation at some point, depending on a number of economic factors, not the least of which is so-called
“animal spirits” or investor greed and/or overconfidence leading to overvaluation.
Investor fear, on the other side, will help lead the stock market into undervaluation. To further add to the confusion, present economic conditions will also usually have some effect on investor attitudes. This non-linear time relationship between economic fundamentals and stock market performance is what makes the market so difficult to predict in the short-term. As Keynes said in the early 20th century, “In the short-term, the stock market is a voting machine. In the long run, it is a weighing machine.”
Now, how does all of this affect the 4% Rule? Well, if we take Benjen’s research at face value, in which he ran an analysis using actual 30-year retirement periods beginning as early as 1926 along with their actual returns and corresponding inflation rates, the approximately 50/50 stock/bond portfolio never ran out of money over all those 30 year periods when 4 ½ percent was initially withdrawn and adjusted only for inflation annually thereafter. Even more significant, in over 95% of those 30 year periods, the retirees ended up with at least the same amount of money that they started out with. The closest the portfolio came to being prematurely depleted was in the 30-year period beginning in 1969, a period that included very high inflation rates.
It turns out that the greatest risk to a retiree’s nest egg is inflation rather than low interest rates. A “this time it’s different” argument is made against use of the 4% Rule by present and future retirees based on low future interest rate projections. However, there was a period after the Second World War when the Fed kept interest rates low for a longer period of time than its present ‘financial repression’ actions. The 4½% Rule stayed valid throughout the late 1940s and 1950s, in spite of that extended period of low interest rates, never becoming depleted over any of those related 30-year periods.
My personal belief is that the 4% Rule (actually 4½%) is still valid with a very high confidence level. It is frequently claimed that whether the money lasts 30 years or not is dependent on how the stock market performs over the first years of retirement. If the stock market performs poorly during the first 5 to 10 years of retirement, then the retiree is at great risk of portfolio depletion before completion of his 30-year period. And yet, Benjen showed that this was not the case. Regardless of the timing of market performance, the portfolio was never depleted during all of those 30-year periods.
The only adjustment that I would make is to allow for expense ratios and transaction costs. This is another reason that the use of low cost index funds is so important. If rock-bottom low cost index funds make up the investor’s portfolio, then I would simply drop down to 4%, from 4½%, to take all costs into consideration. If a retired investor finds it psychologically difficult to watch his portfolio drop temporarily while continuing to withdraw an initial inflation adjusted 4% per year, then for this reason only, reduce the percentage. Certainly, reducing the percentage to somewhere between 3% and 3½% would increase the portfolio’s 30-year survival confidence level to close to 100%, assuming a balanced 50/50 stock/bond ratio and low expense ratios.
So, how does a retiree consider a valid use of the 4% Rule (assuming that he believes it to be valid) within the Strategic Stock Accumulation Strategy? After all, even a 35/65 stock/bond-cash ratio will exceed the stock portion of the 50/50 ratio used in Benjen’s research, when a stock market crash dictates that the SSA investor start buying more stock, possibly using all of his bond-cash position to buy stock “on sale” during a severe crash. My advice, as I state in my book, is for all retirees to have at least 8 to10 years (10 years should be the goal) of retirement funds totally in Treasury Inflation Protected Securities (TIPS) before investing in any stock market strategy.
Retirees could then simply withdraw a smaller percentage, let’s say 3 to 3 ½%, from their TIPS fund, and when adding social security payments to this withdrawal amount, both would equal close to 4½% value of their TIPS account. Since the average bear market lasts about 18 months, most typical market declines will revert to fair value and above well before the 8 to 10 year period is over. This “reversion to the mean” subsequent to a crash will result in very significant profits at that time, if the SSA System is followed accurately. Money could then be withdrawn annually from the SSA portfolio if needed for living expenses beyond the 8 to 10 year TIPS account kept outside the SSA portfolio. The SSA portfolio would then be readjusted to reflect whatever the stock/bond-cash ratio was before any funds were withdrawn.
Retirees can feel a sense of security in knowing that they have close to 10 years of totally safe, inflation-adjusted living expenses in TIPS outside the SSA portfolio. As this time period comes
to a close, money could then be withdrawn from the bond-cash portion of the SSA portfolio, one year at a time to replenish the TIPS fund. Then the SSA portfolio stock/bond-cash ratio would be reestablished at the same ratio as was existing before the money was withdrawn. This would, of course, necessitate selling some stock, contrary to the Sell Rules of SSA. We may refer to this as the “retiree exception.”