What amount can an investor, Ian, withdraw safely each year from a portfolio 50% in stocks and 50% in bonds? Suppose that Ian wants to fix some dollar amount and bump it up by inflation each year, and wants a high probability of not outliving the money. According to a 1994 paper by William Bergen, the answer if Ian is between 60 and 65 years old is about 4% of his starting portfolio size. This has come to be called the 4% rule.
So, starting with $750,000, Ian should be able to withdraw $30,000 the first year, and then bump up the withdrawal amount by inflation each year. With reasonable probability, Ian won’t run out of money during his remaining lifetime, according to Bergen.
Patrick at A Loonie Saved noted a logical inconsistency with this 4% rule. Two investors in exactly the same situation might receive different advice. Let’s illustrate this with an example.
Suppose that in the first year of Ian’s retirement stocks performed very poorly. Between the $30,000 worth of withdrawals and the portfolio losses, Ian has $600,000 left today. Assuming inflation is 3%, Ian plans to continue with the 4% of starting portfolio rule and bump up his withdrawal amount to $30,900 for the upcoming year.
A second investor, Sam, is the same age as Ian, but is just retiring today. Sam’s portfolio is also worth $600,000. However, when Sam follows the 4% rule starting now, he will only withdraw $24,000 during the upcoming year. How can it make any sense that Ian and Sam are the same age and have the same amount of money, but should withdraw very different amounts during the upcoming year?
This inconsistency caused me to modify the 4% rule for my own use. When I get to full retirement, I plan to target withdrawing 4% of whatever my portfolio is worth each year. So, if my portfolio drops in value from one year to the next, my income for the next year will drop as well.
This kind of uncertainty may not be for everyone. I’m quite comfortable making lifestyle changes to increase or decrease spending. Many people can’t do this well. On the positive side, I won’t ever run out of money this way. If my portfolio happens to perform well, I will get to enjoy rising income.
The approach I plan to use may be forced upon some investors even if they planned to follow the original 4% rule. The poor performance of Ian’s portfolio in his first year of retirement greatly increases the risk that he will outlast his money if he doesn’t cut back on withdrawals. If he sticks to the original 4% rule for 5 or 10 years, it may become very obvious that he is running out of money fast.