Podcast Summary
The 4% Rule: A Retirement Planning Foundation: The 4% rule, based on historical data, allows retirees to safely withdraw a consistent amount each year for 30 years without depleting their savings, but personal circumstances should be considered in retirement planning.
The 4% rule, a foundational theory in retirement planning introduced by Bill Bengen in 1994, posits that retirees can safely withdraw 4% of their portfolio value in their first year and adjust for inflation annually for 30 years without depleting their money. This rule, which has become an article of faith in financial planning circles, was revolutionary because it was the first known attempt to gauge safe withdrawals based on historical data, not averages. The 4% rule worked in 96 out of 100 30-year historical periods studied by Bengen, providing a deeper level of certainty for retirees seeking to determine how much money they need to retire. However, it's important to note that individual circumstances, such as personal inflation rates, can impact the applicability of the 4% rule. Therefore, thorough financial planning and consideration of personal circumstances are crucial when relying on this rule for retirement planning.
The 4% Rule for Retirement Planning: The 4% rule is a widely used guideline for determining how much wealth is needed for retirement based on annual spending, which is calculated by multiplying annual spending by 25. Critics question its relevance during high inflation, but researchers like Bill Bengen continue to support it with historical data.
The 4% rule in retirement planning, which states that a portfolio can typically support 4% annual withdrawals without running out of money, equates to having enough wealth to cover annual spending. This is calculated by multiplying annual spending by 25. For instance, if an individual spends $40,000 per year, their portfolio would need to be worth $1,000,000. The 4% rule has been influential in accounting for both market volatility and high inflation. Critics may question its relevance during periods of high inflation, but researchers like Bill Bengen have accounted for this factor. Bengen, who popularized the 4% rule, still performs his analyses manually using historical data. Despite debates about its longevity due to inflation and low bond yields, Bengen uses a more conservative 4.8% as a worst-case scenario. This episode explores the 4% rule and Bengen's insights on its applicability during unprecedented times.
Impact of bad market conditions and inflation on retirees' portfolios: Retirees should consider a lower withdrawal rate due to current high inflation and uncertain economic climate, as historical conditions of high inflation and bear markets have led to portfolio depletion.
The sequence of bad market conditions and high inflation in retirement can significantly impact the longevity of a retiree's portfolio. The individual mentioned in the discussion retired in 1968 due to running out of money, which was a result of experiencing two terrible market conditions in a row and dealing with years of inflation that forced them to raise their withdrawals. Historically, the timing of a bad bear market and inflation rate are two factors that have contributed to the depletion of portfolios. With the current economic climate, featuring a high PE ratio and inflation approaching 8%, these conditions have not occurred together before in US history. The outcome will depend on how quickly inflation is tamed. It's recommended that retirees start with a withdrawal rate lower than the traditional 4% rule in this environment to ensure safety. Another important factor to consider is the impact of large fixed costs on the 4% rule. In the analysis conducted by Bagan, the retiree's spending was increased each year by that year's actual inflation rate, not the average. The original research used a 4.15% withdrawal rate, which generated a 100% success rate historically. However, conditions may change going forward, and it's important to remember that the "safe" withdrawal rate is not a guarantee.
Considering Fixed Costs in Retirement Planning: 36% of retirement spending can be fixed, which can help mitigate the impact of inflation on retirement savings
A significant portion of your retirement spending may be fixed and not subject to inflation. For example, mortgage payments and car payments often make up a large percentage of total expenses. These fixed costs can represent around 36% of your annual spending. Therefore, when planning for retirement and using the 4% rule, it's essential to consider the impact of inflation on variable expenses while acknowledging that a substantial portion of your spending remains constant. This fixed spending can help mitigate the impact of inflation on your retirement savings, allowing for more flexibility in your retirement lifestyle.
Sticking with Stocks During Market Downturns Can Lead to Significant Long-Term Gains: Despite our instincts to sell during market crashes, staying invested in stocks could lead to substantial retirement savings over time.
An 8% increase on a smaller number results in a smaller overall gain over time. This concept, known as the "black holes" theory, was highlighted in Bill Bengen's 1994 paper, where he found that the best course of action for retirees during market crashes would have been to increase, not decrease, their stock holdings. For example, someone retiring in 1929 with $500,000 would have seen their balance dwindle to less than $200,000 by 1932. However, if they had switched to 100% stocks and held until 1992, their balance would have grown to $42 million. This pattern held true for other market crashes as well. The key lesson is that our instincts to sell during market downturns may be misguided, and sticking with stocks could lead to significant long-term gains. Retirees have two things they can control: their spending and their portfolio setup. It's essential to take measures to protect your retirement nest egg, such as actively managing your portfolio and potentially seeking help from a third-party service to reduce emotional decision-making.
Fixed expenses help manage retirement budgets: Keeping some expenses fixed can reduce total withdrawals by $312k over 20 years compared to all inflation-adjusted spending
Maintaining some fixed expenses in retirement, such as property taxes, car insurance, and maintenance, can help bolster the success of your withdrawal rate over time. This is because these expenses remain relatively stable while other expenses increase with inflation. For example, if you have $100,000 in retirement savings and spend 64% of it on inflation-adjusted expenses while keeping 36% fixed, your total withdrawals over 20 years could be $312,000 less than if all your spending was inflation-adjusted ($431,000). This concept, known as "inflation-protected spending," can help retirees manage their budgets and ensure they don't run out of money. However, it's important to note that historical data cannot be perfectly extrapolated forward, and retirement planning should also consider factors like housing costs and individual circumstances. Additionally, having a mortgage or renting may still be viable options as long as the total housing costs are within your means. Homeownership can also serve as a valuable store of value in retirement, especially if you find yourself in a fixed income situation. However, it's important to budget for home maintenance costs, which can be significant and should be factored into retirement planning.
Expanding retirement portfolio asset classes for increased returns: Adding more asset classes to retirement portfolios can lead to increased potential returns, but the gains may level off as more classes are included, and returns may vary based on country-specific investment opportunities and historical data.
The original research on retirement portfolio performance, which started with just two asset classes (intermediate term US Treasury bonds and US large cap stocks), was expanded over the years to include more asset classes in order to better represent the diversity of most people's portfolios. Additions included small cap stocks, international stocks, and US Treasury bills, which led to a significant increase in potential returns. However, as more asset classes were added, the increase in returns began to level off, suggesting that there may be diminishing returns as more asset classes are included. The research, which was conducted primarily for American clients with access to US-based investments, may not be applicable to those in other countries with different investment opportunities and historical return rates. The researcher expressed confidence in the continued growth of the US stock market, despite some theories suggesting a shift in global economic power towards China.
Investing in the US economy despite uncertainty: Consider long-term US investment despite economic cycles, adjust for personal inflation, and allocate to safer options based on current market conditions.
Despite the uncertainty of economic cycles and market fluctuations, the speaker believes that the US economy and markets, with their regulation, openness, size, and flexibility, are still a good place to invest in the long term. However, with current low stock market returns and higher interest rates on safe investments like CDs and Treasury bills, some investors might prefer to allocate a larger portion of their portfolio to these safer options. The speaker also emphasizes the importance of understanding personal inflation rates and adjusting investment strategies accordingly. Ultimately, while no one can predict the future with certainty, it's essential for investors to consider their unique circumstances and make informed decisions based on their risk tolerance and financial goals.
Considering the economic climate for retirement planning: In uncertain economic times, a more conservative retirement withdrawal strategy might be necessary to preserve capital.
While the amount of money you withdraw from your retirement assets is something you can control, it's important to consider the current economic climate when making retirement plans. Historically, a safe withdrawal rate for a diversified portfolio has been around 4.8% per year. However, we're currently in unprecedented economic times, and the Fed getting inflation under control could impact new retirees. A more conservative approach might be necessary to preserve capital during the next few years. In summary, while you can control how much you withdraw, it's crucial to consider the current economic landscape when making retirement decisions.
