Most everyone is familiar with at least one rule of thumb, a “common sense” saying that comes pretty close to the truth, or, as defined by Tom Parker’s Rules of Thumb: Brilliant Guestimates, Shortcuts and a few Shots in the Dark, a “homespun recipe for making a guess.”
Retirement planning has its own rule of thumb, namely the 4% Rule. Popularized in the 1990s, the 4% Rule says that retirees can probably withdraw 4% of their investment portfolios in their initial year of retirement, adjust that withdrawal amount for inflation in future years, and not run a significant risk of outliving their dollars. The work that went into formulating the rule assumed that the retiree held a portfolio of 60% stocks and 40% bonds, and that the portfolio was rebalanced back to the original target each year.
But a March 1st article in the Wall Street Journal recently called into question the validity of the 4% rule. (Say Goodbye to the 4% Rule). The article references work by T. Rowe Price that stated that if someone retired on January 1, 2000 and tried to use the 4% rule, their portfolio would have fallen by a third through 2010. They also estimated that such a retiree would only have a 29% chance of not outliving their assets over the next three decades.
Yikes! Maybe we should throw out the 4% rule (even though the back-testing that led to the rule analyzed all 30-year periods going back to 1926, which included the Great Depression!).
Or…maybe we should dig a little deeper. The T. Rowe Price study assumed a portfolio of 55% US Stocks and 45% Intermediate Bonds, a little more conservative than the original research. The T. Rowe Price folks also assumed portfolio rebalancing every month, and that annual withdrawals increased each year by 3% for inflation.
Monthly rebalancing seems a little frequent. Our current rebalancing schedule is twice a year; some planners only rebalance once a year and some do it even less frequently. Additionally, inflation (as measured by the Consumer Price Index) over the time period wasn’t 3%. It was actually 2.5%. And that’s an annualized figure: annual inflation ranged from 0.3% to 4.28% when you look at each individual year.
When you change the rebalancing period to once a year and use the actual inflation numbers for each year, the results look a little bit different. The portfolio still drops by 2010, but by 20%, not 33%. And if you extend the time period out until January, 2013, the original portfolio had only dropped by 10% from its original value, all the while allowing the account owner to make inflation-adjusted withdrawals.
And that doesn’t even take into account the fact that the portfolio in the T. Rowe Price study was made up of just two assets: large US stocks and intermediate bonds.
With a more diversified portfolio including US Small Cap Stocks, Large and Small US Value Stocks, and International and Emerging Markets stocks, the results get even more interesting. Assuming annual rebalancing and withdrawal amounts consistent with actual inflation, the more diversified portfolio actually led to about an 8% higher portfolio value by 2010, and about 25% higher by 2013.
What’s more, the gist of the article was that bad stock environments have damaged the credibility of the 4% rule. The authors purposefully picked the time period, when the market moved from close to an all-time high in 2000 to a very deep low in 2009. Going forward, and given today’s low interest rates, it’s more likely that below average bond returns will present a more significant challenge to the 4% rule than volatile stock markets.
The 4% rule is just a guideline. It’s not set in stone. At Woodward Financial Advisors, we recognize that our clients’ financial goals aren’t necessarily consistent on a year-over-year basis, and that their goals change over time. In order to achieve those goals, it’s important to construct well-diversified portfolios covering more than just two asset classes, and to rebalance those portfolios according to a judicious schedule. Otherwise, we’d just be twiddling our thumbs.
 Calculations performed using DFA Returns 2.0, Dimensional Fund Advisors. Calculations are pre-tax and gross of fees.
 60% Stock: 15% S&P 500 Index; 15% Russell 1000 Value Index; 8% Russell 2000 Index; 7% Russell 2000 Value Index; 8% MSCI EAFE Index; 2% MSCI EAFE Small Cap Index; 2% MSCI EAFE Small Value Index; 3% MSCI Emerging Markets Index. 40% Bonds: Barclays Aggregate US Bond Index. Investors cannot invest directly in an index. Past performance is not a guarantee of future results; current performance may be higher or lower than the performance reported.
 Calculations made using DFA Returns 2.0; Dimensional Fund Advisors. Calculations are pre-tax and gross of fees.