“On Retirement Income” series:
- A 4% Rule Fable
- More to come…
Consider the following scenario…
At the start of 2022, Bob, a healthy 65-year-old man, decides he is ready to retire. To help him manage his finances in retirement, Bob hires Rule of Thumb Investment Advisors (a.k.a., “ROT IA”). He has $1 million to invest, so ROT builds him a portfolio that is 60% stocks and 40% bonds—the classic “60/40” portfolio. Per the famous “4% Rule,” ROT informs Bob that he can safely withdraw $40,000/year (4% of $1 million), adjusted annually for inflation.
A year later, compliments of unusually high inflation contributing to double-digit declines in both stocks and bonds, the value of the portfolio has declined to $796,000. ROT rebalances back to 60/40 and, noting the 6.5% inflation rate over the prior year, instructs Bob to withdraw $42,600 ($40k + 6.5%) the following year. At the same time, Bob’s identical twin brother Fred decides he too is ready to ride off into the sunset. By uncanny coincidence, Fred also has $796,000 available to invest. His brother convinces him to hire Rule of Thumb Investment Advisors as well. Following their formula, ROT IA builds a 60/40 portfolio and instructs Fred to withdraw $31,840 (4% of $796,000) plus inflation throughout retirement.
Here is summary of the situation at this juncture: Bob and Fred are the same age, have the same life expectancy (or at least the same genetics), and hold the same nest egg in the same basket of investments. Yet merely because one of them retired a year earlier, his projected “safe withdrawal rate” in retirement is 34% larger ($42,600 vs. $31,840). Does this make any sense?!
“On Retirement Income” Series Intro
In future articles in this series, we’ll attack this thought experiment from multiple directions, looking into why the 4% rule has held up as well as it has, contemplating whether its historical success makes it a sensible guideline for the future, and mulling alternative methodologies.
But for now, I’d like to offer the more high-level observation that a quality financial advisor should go far beyond rules of thumb, tailoring a financial plan to your specific needs and goals, and then tailoring your investment portfolio to your financial plan. And on the off chance your situation looks identical to that of another client (we have yet to encounter this, by the way), a reliable advisor should not offer the two of you wildly inconsistent advice!
 Here’s the math: First, Bob took out $40,000, leaving $960,000. Using the S&P 500 Index (2022 return = -18.11%) and the Bloomberg Aggregate Bond Index (2022 return = -13.01%) for stock and bond returns, respectively, the 60/40 portfolio returns -16.07%. Assuming another 1% for ROT’s fee means -17.07% return overall. $960,000 * (1 – 17.07%) = $796,128.
 Since both figures will be adjusted by the same inflation percentage each year, this means Bob’s income is projected to be 34% higher than Fred’s for the rest of their lives. Assuming inflation is generally positive, it also means the differential between their dollar incomes will grow even wider over time. But clearly it also means Bob is at much greater risk of running out of money in retirement, so-called “safe withdrawal rate” notwithstanding. Conversely, it also means Fred is much more likely to pass away with a huge hoard of assets he could have spent.
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