Following the 4-per-cent rule is sure to lead to a happy retirement. That's how much an investor can extract from a balanced portfolio when they retire without having to worry about running out of cash before running out of time. At least, that's the theory.
The 4-per-cent rule was established by investment manager William P. Bengen in a 1994 paper called Determining Withdrawal Rates Using Historical Data. Mr. Bengen crunched the numbers on U.S. stocks and bonds using data spanning the period from 1926 through 1992.
While several different scenarios were examined, he started with a simple balanced portfolio composed of half stocks and half intermediate bonds that was rebalanced each year. He used a million-dollar portfolio, but his findings scale reasonably well for most portfolio sizes.
Investors who started their retirement using a 3-per-cent withdrawal rate, subsequently adjusted to account for inflation, managed to survive all manner of ups and downs.
For instance, even unlucky investors who retired in 1929 sailed through the crash and Great Depression. Every time, the balanced portfolio provided a steady stream of income for more than 40 years.
Those using a slightly more aggressive 4-per-cent initial withdrawal rate also fared well. Sure, there were occasions when the portfolio was consumed after about 35 years, but they were rare.
Launching retirement with a withdrawal rate north of 5 per cent was more problematic. Five per cent might not seem like much to live on, but it was enough to chew through a portfolio in only a couple of decades, or even less, all too often.
The best low-risk, high-income combination was provided by the 4-per-cent initial withdrawal rate, which was subsequently only adjusted for inflation.
Since 1994, Mr. Bengen's work has been updated, and extended, by many authors. But generally speaking, the 4-per-cent rule of thumb has held up reasonably well for U.S. investors so far.
It stumbled badly in other countries, on the other hand. That's because the U.S. has been one of the best-performing markets in the world over the last century or so. (Canada has also fared well.) Investors using the rule elsewhere ran the real risk of being dumped into the poor house.
International investors were hurt by the great wars of the 20th century, market collapses, and similar catastrophes. For instance, Japanese investors suffered mightily after their market crumbled in the 1990s. Some investors, like Fairfax Financial's Prem Watsa, worry that a similar fate is in store for other developed economies.
Generally speaking, it seems unwise to count on the U.S., or Canada, to always provide world-leading returns.
Practical factors can also trip up investors using the 4-per-cent rule. Taxes and fees make a big impact on returns, but they weren't included in the original study.
Consider the hapless investor who goes to a bank for financial advice. They're told they can rely on the 4-per-cent rule and are put into a balanced package of mutual funds that costs 2 per cent a year.
Problem is, only a few funds manage to outperform before fees and most trail badly once fees are taken into account. The 2-per-cent annual fee represents a huge portion of the initial withdrawal rate. Unless the fund makes it all back – and the bond portion of the portfolio would be particularly hard pressed to do so – the portfolio's life expectancy will suffer, as will the lifestyle of the retiree.
The impact of taxes varies from person to person, but they too can put a real crimp on returns and cause investors to run out of money sooner than expected.
To improve the odds of a happy retirement, it is important to reduce fees and taxes where possible.
At the end of the day, the 4-per-cent rule isn't quite the sure thing it's sometimes made out to be.