I’m warning you now: don’t jeopardize your retirement with this flawed (but popular) piece of financial advice. The 4% Rule that’s frequently espoused by financial planners and pundits can carry with it substantial risk.
The 4% Rule is a financial concept that states that as you enter into your retirement years, you should plan on deducting roughly 4% of your retirement portfolio’s value every year in order to meet your living expenses. The plan is that the structured withdrawals from your nest egg should provide financial support for at least a couple of decades, and possibly as high as 30 years depending on your investment returns and financial profile.
EXPOSING THE PROBLEMS
The challenge with the approach is that it only works in an ascending market or a market that’s trending horizontally. If you had tried the 4% Rule in late 2008 when the markets were getting clobbered, you would have been in a world of hurt. A declining market requires you to withdraw larger and larger percentages of the portfolio in order to meet your expenses.
For example, if your retirement nest egg is worth $100,000, the 4% Rule dictates that you may withdraw $4,000 to meet your expenses. However, what if the markets hit a rough patch and your portfolio is now only worth $80,000? Well, in order to extract the same $4,000 from the account in order to supplement your expenses, you now have to withdraw 5% of the portfolio ($4,000 / $80,000). Do you see the problem here? You’re now down to $75,000, and unless your portfolio increases in value, you’ll have to deduct an even larger percentage next year in order to meet that same $4,000 requirement. Subpar investment performance can severely hinder this approach. By the time the portfolio is down to $20,000, you’re having to deduct 25% of its value to meet your daily expenses. At that point, you’re hoping and praying that the markets start heading north to replenish all the capital you’ve withdrawn (note: hope and prayer are not investment strategies that I endorse).
And all this is assuming that your cost of living doesn’t increase too dramatically over the years. What if the US economy hits a period of aggressive inflation like we did during the Carter Administration in the 1970s? That could REALLY screw up the 4% Rule because now you’re having to extract substantially larger amounts every year.
As you can tell, this is a flawed approach that’s dependent on faulty assumptions – increasing portfolio values, no costly health challenges or emergencies, tepid inflation, etc.
Moreover, neither you nor I have any control over the direction of the markets, so it’s dangerous for us to depend on their mood swings. Selling off assets and portfolio holdings can work okay in rising market conditions, but that strategy can burn through capital at a rapid rate when markets are declining. As we demonstrated above with some numbers, when a portfolio is dropping in value, you have to keep extracting larger and larger percentages from it in order to meet your targets.
A MUCH BETTER APPROACH
The solution is to establish a portfolio that yields income without diminishing the asset base. Collecting significant inflows from productive assets in the form of rental income, stock dividends, interest income, option premiums, business profits, and the like, is the superior approach to harvesting profits from an investment portfolio. It’s the approach I’ve followed for years and it’s proven itself to be incredibly resilient when executed correctly.
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By collecting the income provided by your holdings instead of constantly reducing your asset base, you effectively convert the portfolio into a self-sustaining perpetuity that provides long-term cash flow (assuming the fundamentals remain sound). Cash flow is reliable; capital gains are transitory and subject to tremendous market risks.
Therefore, I would propose that in order to avoid running out of money in your retirement years, consider relying on the investment income provided by your portfolio instead of making systematic withdrawals and hoping that the markets are behaving favorably when you need to extract capital.
After all, why would you want to make a habit of selling something that’s putting money in your pocket on an ongoing basis? That seems like very short-term thinking. Besides, you’re supposed to be retired, right? Sitting in front of your computer trying to sell assets at a favorable price sounds like a lot of work.
I would encourage you to consult with your financial advisor and consider questioning the status quo on this piece of outdated, antiquated financial advice. The 4% Rule is popular, but inherently flawed – especially in this era of economic uncertainty and increased market volatility. Protect yourself by adopting an approach where you’re reliant on the income produced by your retirement account, not its ever-changing value. You’ll thank me when you’re comfortably enjoying your golden years on the back of a cruise ship rocking a stylish socks-with-sandals combo.
Those are my thoughts. Feel free to share some of yours below. Thanks for reading and as always, make it a great day.
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