Many advisors tell their clients, as a rule of thumb, a client can withdraw about 4% of their portfolio each year, without it affecting the principal. We have been telling our clients this for years. In fact, this rule of thumb dates back a few decades and was determined after a lot of research.
And then a few weeks ago, an article written in the WSJ called into question the validity of the rule of thumb. Its premise is quite simple: if you retire and then your portfolio drops like it did in 2008, then a withdrawal rate of 4% of the original balance would most likely not be able to sustain you through retirement. You would then need to reduce your withdrawal rate. In the investment and financial community, this was quite a statement to make and has caused many individuals to question their current withdrawal rate.
It’s important to consider a few points that the article touches upon, but are overlooked:
1) The “4% Rule” is a rule of thumb, a guide, a rough figure to help investors determine how much they can withdraw from their portfolio in retirement.
2) A client should only take what they need from their portfolios. They should keep as much invested as possible, so their assets can continue to appreciate. An extra $1,000 sitting in a checking account earning next to nothing, should probably stay in invested where it can generate a decent return.
3) The “4% Rule” does account for some of the long tail risks. When this rule of thumb was calculated in the 90’s, it did use data points going back to the depression. Of course, there are scenarios where the “4% Rule” will not work, but these are the outlier scenarios. They are economic situations that happen every 75 years or so. Fortunately, we are recovering from one of them right now.
The most important point to take away from this post and the article is to remember that the “4% Rule” should be renamed “4% Rule of Thumb”. Maybe then investors will understand that withdrawals will have to fluctuate depending on market conditions and their needs.
If you’re interested in some additional information on this topic, Vanguard has a few interesting pieces on the topic.