The Dude Who Came Up With 4% Rule Tells Barron's It Might Not Work

by: Roger Nusbaum

Barron's had an article titled Revisiting the 4% Rule, which included comments by the recently retired William Bengen. Bengen is the guy who came up with the 4% rule, which is the amount you can safely withdraw from your portfolio without outliving your money. Probably. Bengen first published the idea in 1994 based on the idea of a person who retired in 1969. He assumed a 50/50 stock bonds mix. The reason it worked is because the average annual return in the period studied was 13.75% of which 6.5% (or a little under half) came from stock dividends and bond interest.

The big change is the low interest rates available in the bond market which is the source of Bengen's concern. If the SPX as a benchmark has yielded about 2% for the last 20 years, then bonds would need to kick off 4.5% and stocks return 7%-ish annually for it to be apples to apples to Bengen.

The equity portion of a portfolio could probably be skewed toward dividends such that it yielded 3% instead of just 2% from the benchmark, which would help-- of course-- at some point not too far above 3% you've gone from increasing the yield a little to taking on more risk. I don't think that the person who reads this and thinks I can get 4% in dividends no problem has a good grasp of the risk they would be taking.

While I generally like the concept of a 4% withdrawal rate (or less if you can live on it) I've had one bone of contention that I've written about repeatedly. Specifically Bengen starts with a dollar amount equal to 4% when you first retire and then anchors to that dollar amount forever, increasing it for inflation each year. So if your 4% dollar figure is $33,000 and inflation that first year is 2.0% then next year you would take $33,660.

If your 4% dollar figure is $33000 then your nest egg amount was $825,000. What if that first year the market went down and your nest egg was $713,000 at the end of the first year? Then what if that second year the market is flat and you take out your now $33,660 and only make $20,000 of it back from dividends and interest? Getting back to $825,000 is looking farther and farther away and then you need a new roof.

My thought all along has been to remove the inflation calculation and simply take no more than 4% of whatever you have. More precisely, take no more than 1% every three months (mathematically that works out to a hair over 4%). If the portfolio generally goes up in value then that addresses inflation. That will create volatility in your income, of course, but I think that is better than increasing the burden on your portfolio by taking 5 or 6% for a few years while your portfolio digs itself out of a bear market hole. This is easier to absorb if you are able to live below your means (maybe you don't have to take out the entire $33,000 and spend it).

The article also mentioned the idea of having a year's worth of expenses set aside as a buffer to supplement any portfolio shortfall. The buffer account could also serve as a source of funds for unbudgetable one off expenses that seem to come along every month (vet bill, tires, an adult child needs $10,000).

As a final note, hopefully it is easy to see the huge role that living below your means and increasing your savings rate plays in this discussion. They are far more in your control than returns from the capital markets.