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By Ed Rempel, CMA, Fee-for-Service PlannerSpecial to the Financial Independence Hub
You want to retire soon. How should you set up your retirement income?
You talk with some friends, read about it on the internet, and talk with a financial advisor. Are you actually getting good advice?
When it comes to retirement income, most financial advisors rely on a few rules of thumb handed down from one generation of advisors to the next. The rules appear to be common sense and are usually accepted without question.
Do these rules of thumb actually work?
Before giving clients this advice, I tested them with 150 years’ history of stocks, bonds and inflation. I wanted to see if these rules were reliable for a typical 30-year retirement. (The average retirement age is 62. In 50% of couples that reach their 60s, one of them makes it to age 92.)
These five rules are the “conventional wisdom” – the advice typically given to seniors:
- “4% Rule”: You can safely withdraw 4% of your investments and increase it by inflation for the rest of your life. For example, $40,000 per year from a $1 million portfolio.
- “Age Rule”: Your age is the percentage of bonds you should have. For example, at age 70, you should have 70% in bonds and 30% in stocks.
- “Sequence of returns”: Invest conservatively because you can’t afford to take a loss. You can run out of money because of the “sequence of returns.” You can’t recover from investment losses early in your retirement.
- Don’t touch your principal. Try to live off the interest.
- Cash buffer: Keep cash equal to 2 years’ income to draw on when your investments are down.
The results: NONE of these rules of thumb are reliable, based on history.
Let’s look at each to understand this.
1.) “4% Rule”: Can you safely withdraw 4% of your investments plus inflation for the rest of your life?
Based on history, the “4% Rule” was safe for equity-focused investors, but not for most seniors.
In the results shown in the graphic at the top of this blog, the blue line is the “4% Rule,” showing how often in the last 150 years a 4% withdrawal plus inflation provided a reliable income for 30 years.
The “4% Rule” only works with at least 50% in stocks.
The “4% Rule” worked only if you invest with a minimum of 50% in stocks. Even safer is 70-100% in stocks. It is best to avoid a success rate below 95% or 97%. They mean a 1 in 20 or 1 in 30 chance of running out of money during your retirement.
Most seniors invest more conservatively than this and the 4% Rule failed miserably for them.
A “3% Rule” has been reliable in history, but means you only get $30,000 per year plus inflation from a $1 million portfolio, instead of $40,000 per year.
These results are counter-intuitive. The more you invest in stocks, the safer your retirement income would have been in history.
To understand this, it is important to understand that stocks are risky short-term, but reliable long-term. Bonds are reliable short-term, but risky long-term. Why? Bonds get killed by inflation or rising interest rates. If either happens during your retirement, you can easily run out of money with bonds.
The chart below illustrates this clearly. It shows the standard deviation (measure of risk) of stocks, bonds and cash over various time periods in the last 200 years. Note that stocks are much riskier short-term, but actually lower risk for periods of time longer than 20 years.
Stocks are more reliable after inflation than bonds after 20 years.
Ed’s advice: Replace the “4% Rule” with “2.5% +.2% for every 10% in stocks Rule.” For example, with 10% in stocks, use a “2.7% Rule.” If you invest 70% or more in stocks, then the “4% Rule is safe.
2.) “Age Rule”: Your age is the percentage of bonds you should have. For example, at age 70, you should have 70% in bonds and 30% in stocks.
