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When it comes to dealing with your finances, it's always tempting to go with a simple solution. But more often than not, the issue is more complicated than a simple rule can cover. That doesn't mean that the simple approach is always a mistake -- but you have to understand what you're getting into before you risk everything on a strategy that may not work out for the best.
Recently, William Sharpe, a finance professor and Nobel Prize winner from Stanford University, published an academic article discussing what's known as the 4% rule -- a simple rule that many people follow to figure out how much they can safely withdraw from their retirement portfolios. In the paper, Sharpe pointed out that despite the rule's popularity, there are flaws that make it a second-best option for retirees, and he points to some other ways to think about retirement saving and spending that may lead to better results.
The easiest rule to follow
The biggest virtue of the 4% rule is that it's incredibly easy to use. Here's how it works: When you retire, add up the total value of your retirement portfolio. When you multiply that figure by 4%, that gives you how much you're allowed to withdraw from your retirement savings during the first year. Every year after the first, the only thing you do is increase your withdrawal by the rate of inflation.
Notice the most important thing you don't do with the 4% rule: recalculate the 4% based on what happened to your retirement portfolio over the first year. Even in a year like 2008, in which the market tanked, the historical basis of the 4% rule argues that you'll be fine basing your spending on the initial calculation rather than reducing what you spend to take into account your smaller net worth.
What Sharpe's argument, however, boils down to is that the 4% rule rarely results in the best outcome. Often, you end up with a large pot of money when you die -- which means that you've arguably lived less well than you could have. Moreover, most retirees use investments that are more expensive than they need to be for the exposure they want.
Unfortunately, Sharpe's article is short on practical alternatives. But you can figure out what effects various moves can have on the safety of your retirement.
Go beyond the basics
Given how important financial stability is to retirees, the Fool's Rule Your Retirement often revisits the issue of safe withdrawals. There, Foolish retirement expert Robert Brokamp and his team have looked closely at the 4% rule and its implications.
One interesting question is how best to invest in order to follow the rule. Most researchers would have you invest 60% in stocks and 40% in bonds. So if you wanted to use ETFs, SPDR S&P 500 ETF (NYSE: SPY ) would be a good choice for low-cost stock exposure, and iShares Barclays Aggregate Bond (NYSE: AGG ) would give you similarly broad coverage for the bond market.
But that mix doesn't always produce the best return for the risk you're taking on. Instead, you want to make sure you have diversified exposure to a broad range of investments. Considering stocks, when Brokamp went beyond the S&P 500 to include investments that you can buy via the iShares MSCI EAFE ETF (NYSE: EFA ) , the Vanguard REIT Index ETF (NYSE: VNQ ) , and the iShares GSCI Commodity ETF (NYSE: GSG ) , he found much better returns than a pure S&P 500 stock portfolio -- and with much less risk.
The same goes for bond exposure. An aggregate bond approach may be simplest, but depending on your situation, working in other kinds of bonds in different proportions may be best. For instance, the aggregate bond index doesn't include municipal bonds -- but for certain taxpayers in high brackets, they can provide better after-tax returns. It also doesn't give much exposure to international bonds. Mixing an aggregate bond fund with the muni fund iShares S&P National Municipal Bond Fund (NYSE: MUB ) and the SPDR Barclay International Treasury Bond ETF (NYSE: BWX ) could give you better results.
There are other simple things you can do to address some of Sharpe's concerns. Raising your withdrawals in good times and cutting them in bad times can help insulate your portfolio from moving markets. Building cash cushions to shelter you from having to sell stocks during bear markets.
The key, though, is understanding that simple rules are made as guidelines rather than perfect strategies. Your best strategy depends on what's most important to you -- and no rule of thumb will perfectly match up with your priorities. The 4% rule, however, can still be a useful tool to give you a sense of whether you're on the right track.
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