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Andrew Hallam
23.01.2019

When The 4% Rule Could Fail Investors

Financial advisors and scuba diving instructors share similar responsibilities. They each guide clients into ever-changing waters. Scuba divers need to trust that their tanks are full. When retiring, clients need to know that they won’t run out of money.

A fee-based Certified Financial Planner (CFP) recently created a comprehensive financial plan for one of his clients. The client, whom I’ll call Jim, sent me the plan and asked for my opinion. The report included an assessment of Jim’s risk tolerance. It said Jim should have a low-cost, diversified portfolio. It also showed how much he should save each year to fund his retirement.

This all looked good. But what I read next gave me cold-water shivers. The advisor wrote:

“When you retire, you can withdraw an inflation-adjusted 4 percent per year, and your money should last until you’re 95 years old.”

The advisor inserted a bar graph. According to the report, if the portfolio averaged a compound annual return of 7 percent per year, and if inflation averaged 3 percent per year, and if Jim withdrew an inflation-adjusted 4 percent per year and if Jim didn’t live past his 95th birthday, then Jim wouldn’t run out of money. There were a lot of ifs in there. But something else worried me more.

Jim’s financial advisor abused the 4 percent rule. For example, Jim pays total investment fees of 1.7 percent per year. If Jim withdraws 4 percent and he pays investment fees of 1.7 percent, that’s 5.7 percent coming out of his portfolio during the first year of his retirement.

The 4 percent rule is part of financial planning lore. Plenty of studies have back-tested a variety of conditions for diversified portfolios. Such research says retirees should be able to withdraw an inflation-adjusted 4 percent from their portfolios every year. When doing so, their money should last at least 30 years. Such back-tests started in 1926. That means the 4 percent rule would have survived a 30-year period that included the crash of 1929-1930. It would have survived the stock market crash of 1973-74. It would have survived runaway inflation in the 1970s. It would have survived the Bear Markets of 2001-2002 and 2008.

But the 4 percent rule might have a single kryptonite: high investment fees.

First, let me explain how the 4 percent rule works. Assume a 60-year old man retired in 1973. He had $100,000 invested: 60 percent in U.S. stocks and 40 percent in Intermediate U.S. government bonds (*see endnote). During his first year of retirement, he withdrew 4 percent, or $4000. He then increased each annual withdrawal to cover the rising cost of living.

Annual Inflation-Adjusted Withdrawals On A $100,000 Portfolio

The First Ten Years Of Retirement

 1973-1983

 

Year

Annual Inflation

Amount Withdrawn

1973 8.71% $-4,348
1974 12.34% $-4,885
1975 6.94% $-5,224
1976 4.86% $-5,478
1977 6.70% $-5,845
1978 9.02% $-6,372
1979 13.29% $-7,219
1980 12.52% $-8,122
1981 8.92% $-8,847
1982 3.83% $-9,186
1983 3.79% $-9,534

In 1973, he would have withdrawn $4,348. This is based on 4 percent of his portfolio, plus an upward adjustment for that year’s inflation. In 1974, he would have withdrawn $4,885. That’s $537 more than the previous year. But it covered the 12.34 percent inflation rate in 1974. In 1975, the investor would have withdrawn $5,224. That covered the 6.94 percent inflation rate for 1975. By continuing to match withdrawals with inflation, the retiree ensures the same year-to-year purchasing power until he’s pushing daisies.

At this point you might wonder how long the money would last. The portfolio itself would gyrate with the market. Sometimes it would rise. Other years it would fall…sometimes a lot. But if the investor paid low annual investment fees, he would still have money left, even if he lived to be 105 years old.

You might not want to live until you’re 105. But if you pay 1.7 percent in annual investment fees, like my friend Jim, you might run out of money before running out of breathe. Note the yellow and the green lines on the chart below. Both lines represent $100,000 portfolios, comprising 60 percent U.S. stocks and 40 percent U.S. bonds.

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The yellow line represents an investor who paid 0.15 percent in annual fees. They would have withdrawn $640,671 from the original $100,000 portfolio between 1973 and 2018. By January 2018, they would also have $91,669 left.

Now note the green line. It represents an investor who pays total annual fees of 1.70 percent. The investor would have withdrawn $285,336… before running out of money. If he retired at 60 years of age, he would be broke at 87.

According to Social Security statistics, there’s about a 50 percent chance that a 65 year-old woman will live past her 85th birthday. The typical 65 year-old man is expected to see his early 80s. That’s why we shouldn’t gamble with longevity or high investment fees. If you’re paying total investment fees of more than 1 percent per year, don’t roll the dice with the 4 percent rule. Instead, withdraw an inflation-adjusted 3 percent or less.

Unfortunately, Jim’s financial advisor thinks he can take out more. The guy is testing fate–with somebody else’s money.

Year-By-Year Inflation Levels, Withdrawals and Balances

For 60% U.S. Stocks, 40% U.S. Bonds

January 1973- January 2018

 

Year

Annual Inflation

Calendar Year Inflation-Adjusted Withdrawals

End of Year Balances After Paying 0.15% In Annual Fees

End of Year Balances After Paying 1.70% In Annual Fees

1973

8.71%

 $4,348

 $86,382

 $84,832

1974

12.34%

 $4,885

 $68,920

 $66,281

1975

6.94%

 $5,224

 $81,263

 $76,924

1976

4.86%

 $5,478

 $93,038

 $86,585

1977

6.70%

 $5,845

 $85,565

 $77,883

1978

9.02%

 $6,372

 $83,796

 $74,493

1979

13.29%

 $7,219

 $90,437

 $78,441

1980

12.52%

 $8,122

 $101,216

 $85,497

1981

8.92%

 $8,847

 $93,503

 $76,283

1982

3.83%

 $9,186

 $107,318

 $84,680

1983

3.79%

 $9,534

 $114,461

 $86,993

1984

3.95%

 $9,911

 $112,757

 $81,970

1985

3.80%

 $10,287

 $133,490

 $92,963

1986

1.10%

 $10,400

 $142,633

 $94,732

1987

4.43%

 $10,861

 $134,682

 $84,335

1988

4.42%

 $11,341

 $139,960

 $82,094

1989

4.65%

 $11,868

 $159,625

 $87,449

1990

6.11%

 $12,593

 $147,016

 $73,492

1991

3.06%

 $12,979

 $171,776

 $78,239

1992

2.90%

 $13,355

 $172,902

 $70,267

1993

2.75%

 $13,722

 $177,854

 $63,045

1994

2.67%

 $14,089

 $160,243

 $46,730

1995

2.54%

 $14,447

 $193,068

 $45,344

1996

3.32%

 $14,927

 $203,607

 $35,695

1997

1.70%

 $15,181

 $233,280

 $27,825

1998

1.61%

 $15,426

 $259,961

 $16,990

1999

2.68%

 $15,840

 $277,214

 $3,049

2000

3.39%

 $16,377

 $258,398

 $0

2001

1.55%

 $16,631

 $232,180

 $0

2002

2.38%

 $17,026

 $198,739

 $0

2003

1.88%

 $17,346

 $220,366

 $0

2004

3.26%

 $17,911

 $221,671

 $0

2005

3.42%

 $18,522

 $212,813

 $0

2006

2.54%

 $18,993

 $215,974

 $0

2007

4.08%

 $19,768

 $211,627

 $0

2008

0.09%

 $19,786

 $155,780

 $0

2009

2.72%

 $20,325

 $160,987

 $0

2010

1.50%

 $20,629

 $161,367

 $0

2011

2.96%

 $21,240

 $147,130

 $0

2012

1.74%

 $21,610

 $141,219

 $0

2013

1.50%

 $21,934

 $145,580

 $0

2014

0.76%

 $22,100

 $136,626

 $0

2015

0.73%

 $22,261

 $115,225

 $0

2016

2.07%

 $22,723

 $101,548

 $0

2017

2.13%

 $23,202

 $91,669

 $0

 

 

 

 Total Withdrawn

Total Withdrawn

 

 

 

$640,671

$285,336

 

Sources: Combined asset class returns (60% U.S. stocks, 40% Intermediate Term U.S. government bonds) courtesy of portfoliovisualizer.com, minus annual fees of 0.15% versus annual fees of 1.7%, calculated annually using Excel)

*Endnote: The 4% rule works best for portfolios with at least 60 percent in stocks. If someone retired with a globally diversified portfolio in 1973, the investor would have run out of money earlier than the above examples show. That’s because the above examples didn’t include international stocks, and U.S. stocks beat international stocks during the measured time period above. As a result, international exposure would have decreased average returns. However, international stocks might beat U.S. stocks over the next 30 years, so it pays to be diversified, especially considering the current expensiveness of the U.S. stock market, when comparing relative cyclically adjusted price-to-earnings ratios. Never assume that low-inflation rates are here forever. And don’t assume that the stock market will perform splendidly in the future. These are unknowns. As such, it’s prudent to maintain conservative levels of withdrawals. They should be lower than 4% for those who pay high investment fees.

 Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and Millionaire Expat: How To Build Wealth Living Overseas


Internaxx Bank S.A. accepts no responsibility for the content of this report and makes no warranty as to its accuracy of completeness. This report is not intended to be financial advice, or a recommendation for any investment or investment strategy. The information is prepared for general information only, and as such, the specific needs, investment objectives or financial situation of any particular user have not been taken into consideration. Opinions expressed are those of the author, not Internaxx Bank and Internaxx Bank accepts no liability for any loss caused by the use of this information. This report contains information produced by a third party that has been remunerated by Internaxx Bank.

Please note the value of investments can go down as well as up, and you may not get back all the money that you invest. Past performance is no guarantee of future results.

 

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