Today’s question comes from Eric in Evanston, IL…
“I got a quick question for you all about the 4% Rule. It assumes you’re making a 7% return overall… 4% you get to spend, and 3% for inflation, which is totally fine.
Right now, my wife and I are 40 and almost all of our investment dollars are in stocks. But in retirement, we’re assuming to be more like a 30/70 split or a 60/40 split, you know, mostly stocks, but some bonds. What would our returns most likely be at that point?
So, say, if we’re getting a 5-6% overall return, with 3% going to inflation, does that mean we can only count on a 2 or 3% withdrawal rate?”
The short answer:
Yes, the 4% rule still applies if you have a heavy bond allocation. In fact, it was built with the assumption of 50/50 stock to bond mix!
The rule was, after all, built for people retiring in their 60’s and 70’s. And these folks traditionally had a mix of both stocks and bonds.
There’s a lot of confusion around the 4% rule and its assumptions. Let’s delve into where this helpful rule of thumb came from and the flexibility it has.
The 4% Rule Basics
The 4% safe withdrawal rule was born from one of multiple scenarios in The Trinity Study. This was published ~30 years ago.
The rule determines (fairly reliably) how much money a retiree can safely withdraw from their retirement savings each year without running out of funds.
For those new to this rule, here’s how it works:
- In the first year of retirement, you can withdraw 4% of your total retirement savings.
- For each subsequent year, you withdraw the same dollar amount as the first year, adjusted for inflation.
- This approach is designed to make your retirement savings last for about 30 years.
For example: Let’s say you have $1 million in retirement savings:
- In Year 1 of retirement: You withdraw 4% of $1 million, which is $40,000.
- Year 2: If inflation is 2%, you withdraw $40,800 ($40,000 + 2% inflation adjustment).
- This continues each year, with the withdrawal amount adjusted for inflation.
Now let’s talk about different mixes of stocks and bonds…
Asset Allocation
The Trinity Study analyzed a variety of different portfolio examples. It also cross referenced these with different withdrawal rates and retirement timelines.
Here’s a cool summary table included in the study! 👇👇👇
So does your allocation dictate whether the 4% rule works or not? Yes, it does!
When the 4% rule was devised it was looking at a balanced portfolio – half stocks & half bonds. As you can see in the table above, the 50/50 split has a 100% success rate over all timelines.
The reason mixing stocks and bonds is important is because you need to account for market gyrations over the years. Sometimes stocks will rip to all-time highs, buoying your balance, and other times bonds will be your saving grace as stocks encounter choppy waters.
A blended portfolio minimizes that volatility. It smoothes the ride so you can take out more consistent withdrawals without trepidation.
Btw – you can see that a withdrawal rate of 3% has a perfect track record, no matter the portfolio mix or investment timeline. If you are a pretty conservative person and want ultimate assurance in retirement, you might want to plan based on the 3% rule, not 4.
But, shifting your withdrawal rate down by 1% is actually a big deal. It either means you need to live on less or save a lot more. It’s not something we would recommend.
Remember, it’s a rule of thumb
It’s worth reiterating something we’ve said before, that the 4% rule is more like a rule of thumb. It’s not perfect!
It’s also based on historical performance, prior to 1995! The guy who invented the rule ~30 years ago has since revised his analysis and now thinks 4.5-5% is a reasonable withdrawal rate for most folks. That sounds incredibly reasonable to us.
Predicting future market performance is impossible. So it’s highly unlikely that you will perfectly plan the exact withdrawal rate. But being at least a little flexible with your withdrawals, particularly in down years for the market, can help your portfolio weather those storms.
If you withdraw too little there’s an overwhelming likelihood that you’ll die with lots of money left over. Not the worst thing in the world, but it’s also good to make a plan to enjoy it!
But if you listen to a big talker like Dave Ramsay who thinks 8% is a safe withdrawal rate, there’s a much higher chance you’re going to run out of money while you’re still alive!
All in all, a 4-5% withdrawal rate makes sense for most folks. Especially if you can build in flexibility to your withdrawal strategy.
Target Date Funds
As you know, we love index funds and keeping your portfolio super simple.
But another option that will slowly change your asset mix over time is Target Date Funds.
Investing inside a TDF will automatically change your asset allocation from stock heavy → bond heavy throughout your lifetime. Here’s a glance at what Vanguard TDFs look like:
One of the biggest problems we have with Target Date Funds (assuming they’re low cost) is that they’re probably too conservative for folks at the beginning of their investing journey.
If you’re in your 20’s and just starting to invest, going with a 100% stock route would typically be a better choice. Bonds and conservative investments will stunt your growth in those early years where you can afford to take more risk.
But as you get closer to the wealth preservation time in life (age ~50+) a TDF can make a whole lot of sense.
We like the approach that Paul Merriman suggested when we interviewed him on the pod. He recommends having most of your investment dollars in a Target Date Fund, but also having a portion in a small cap value fund.
This gives you added diversity and the potential for higher overall returns (based on historical performance, of course).
Whether you invest in Target Date Funds that slowly get more conservative, or choose your own index fund mix, the 4% rule of thumb will still work.
The Bottom Line:
Don’t overthink the 4% rule. It’s just a guideline made to cover several different portfolio mixes and timelines. Inflation is already accounted for, because you can add the current year’s inflation rate to the amount you’re taking out each year.
It’s natural that your portfolio mix will change over time, getting more conservative. But you can rest assured that even if you had a 50/50 stock to bond mix, the 4% rule of thumb will still apply.
Cheers for the question Eric. Keep on that good investing track!
For the full version of this discussion, check out Podcast Episode #823 (it’s the 2st question in the episode)
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This is such a great post, I love the detailed table. It’s so interesting how changing the draw down period can shift a strategy from 100% to like 50%.
What are the assumptions about *what* you are withdrawing? Does it assume that you take from stocks in a year stocks when up a lot, or that you sell to rebalance or what?
Hey Becca! Great question about which assets to withdraw… The study is vague in this regard. It also doesn’t specify which types of tax-advantaged accounts the money might sit in, annual dividends from bonds, which funds are held and their fees, etc.. There are many variables to consider that’s why it’s just a rule of thumb.