Can the 4% Rule Be Salvaged?

My colleague Catherine Brock recently made a compelling case for why the traditional 4% rule for retirement savings may be at risk because of the craziness that 2020 has brought us. The challenge presented by that article, however, is that the most straightforward solution -- save more -- is easier said than done.

Shifting to a 3% or 3.5% rule may make a person's retirement portfolio more sustainable, but it comes with two very big risks. First, hitting that target is harder than hitting one based on the 4% rule. Second, stretching for the bigger nest eggs those numbers require puts you at a greater risk of saving too much, spending too little, and not enjoying the money you worked your career to save. Those risks raise a key question: Can the 4% rule be salvaged?

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What is the 4% rule anyway?

The 4% rule is a retirement planning guideline that helps people plan for and budget during retirement. Based on its principles, you can spend 4% of the value of your retirement portfolio in the first year of your retirement and adjust your withdrawals for inflation every year after that. The back testing behind that rule indicates that you have a very strong chance of seeing your money last at least as long as a 30-year retirement. 

It has been a great guideline not just because of its relative simplicity, but also because it recommends a target that's within reach for many people. Withdrawing 4% of your initial balance means you'll need 25 times your first year's expenses socked away. So if you need your portfolio to cover $3,000 per month ($36,000 per year), you'd need to retire with a $900,000 nest egg. That takes a long time to reach, but it is generally achievable for those that start early and save consistently.

What's wrong with it?

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The key challenge with the 4% rule in the modern world, however, is that it requires you to start with and maintain a balanced 50% stock, 50% bond portfolio. With interest rates near all-time lows, bond funds provide nearly no return and may be at risk of serious declines as rates rise. In addition, as investors have shifted into stocks to try to get any chance of positive returns today, that puts pressure on future stock returns as shares have generally risen faster than earnings.

It's that backdrop of a potential world where both stocks and bonds underperform their historic rates of return that make very smart people question whether the 4% rule still makes sense today. The problem becomes that shifting from a 4% rule to a 3% rule shifts that $900,000 nest egg to $1,200,000  to cover the same $36,000 in first year expenses. That adds years and/or lots of extra money to the amount you need to work and save to retire, putting it that much farther out of reach.

What else can you adjust?

Aside from saving more money, a different adjustment you can make is to own a portfolio with a higher potential rate of return than the 50% stocks, 50% bonds one designed into the original 4% rule. That means owning a higher proportion of stock, which means more volatility, but a better chance of getting a high enough portfolio return to make the plan work overall.

To give that plan a shot of working, though, you still need to protect yourself against the market dropping in the near term. One way to attempt that is to keep at least five years' worth of the expenses you need to cover in cash and an investment grade bond ladder. That will give you higher certainty of having the money you need in the near term when you need it, while giving the rest of your money more opportunity to grow more for the long run in stocks.

Assuming you are planning for your first day of retirement to be Jan. 1, 2021, your initial retirement portfolio might look something like this:

Table by Author.

This structure gives you five years' worth of expected spending in cash and bonds, while building in 4% per year for anticipated inflation. That's higher than inflation has been in a long time,  and pre-planning for it gives you some buffer in case inflation does come roaring back.

Each year, you'd spend your cash, which gets replenished by your maturing bonds. To attempt to make the structure sustainable, you'd plan to collect your interest and dividends and put them in bonds to start making up the next year's rung. On top of that, if the market performed around as you expect, you'd convert some of your stocks into bonds until you topped off the next year's rung.

Of course, since the stock market is volatile, it won't always perform exactly as you expect. If the stock market drastically over-performs, you would add another year (or more) to your bond ladder. If, on the other hand, the stock market drastically under-performs, you'd let the bond ladder shrink until the market showed signs of recovery.

If you continue to project 4% inflation, you'd need the 2026 rung on your bond ladder to be $44,000. Assuming 1% interest on both your bonds and a similar yield your stocks, you'd get around $8,600 in portfolio income in your first year. That would leave a gap of $35,400 you'd have to close by selling stocks. That would require your stocks to grow a little above 5%. That's below the market's historic long-run growth rate, which makes it a reasonable long-term target to consider.

Does this save the 4% rule?

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Managing your retirement money like that would give you a fighting chance of being able to keep your targeted nest egg to a level the 4% rule would support, but it certainly isn't risk free.

Key among the risks is that it uses around a 75% initial allocation to stocks, which is higher than most traditional guidance recommends.  Although the five year cash and bond ladder gives you a good opportunity to be patient and let the stock market recover from a crash, it may not be enough time to recover from a really bad one. You can extend your initial ladder to give you more breathing room, but that comes at the expense of needing your stocks to perform better to replenish your bond ladder as your holdings mature.

In addition, since you are pre-projecting an inflation rate in this model, if inflation comes in significantly ahead of what you've planned for, you can find yourself coming up short. Some of that can be managed by spending some of the dividends and interest you receive, but that also comes with the trade-off of needing faster growth from your stocks to replenish your maturing bond ladder.

Despite those risks, there's good reason to believe this adjustment could work. Chief among them is that the original paper that sparked the 4% rule suggests that a 75% stock allocation also has a strong chance of success over a 30-year time horizon.

Choose your trade-offs and build your plan

In today's environment, it's very clear that there are no certainties when it comes to investing for your retirement. The best you can do is recognize the risks, understand the trade-offs between time, money, potential returns, and allocation options, and make an educated choice while you're planning for it.

As you get closer to your actual retirement date, what you'll likely find is that you appreciate the flexibility that having a decently sized nest egg gives you. That way, when you're close in both age and finances to where you want to be, you can make a game-time decision based on what matters most to you then. When all is said and done, that flexibility may very well become the part of your retirement plan you appreciate the most.