Wealth Sustainability: Best Practices for Drawing on Retirement Resources

Retirees often wonder how much they can withdraw from their portfolio without risking a shortage of funds. To address this concern, retirement planning commonly employs the 4% Rule, a popular methodology that determines the safe amount of annual withdrawal from a retirement portfolio to avoid depleting it too fast.

What is the 4% Rule?

The 4% Rule proposes that retirees can withdraw 4% of their portfolio's value in the first year of retirement and account for inflation in subsequent years. For instance, if a retiree has a portfolio valued at $1 million, they can withdraw $40,000 in the initial year of retirement, adjusted for inflation based on the Consumer Price Index (CPI) in the following years. This methodology assumes a 30-year retirement period, a balanced portfolio of stocks and bonds, and historical market returns.

The 4% Rule was developed using "back-testing," an assessment method that applies an investment strategy or model to historical data. This rule's justification stems from the historical investment performance between 1925 and 1995.

Shortfalls with the 4% Rule:

Like many rules of thumb, there are exceptions and drawbacks. One way to look at the 4% Rule is that it is like dollar-cost-averaging , in reverse. This can be viewed as a weakness. When you are accumulating money, dollar-cost-averaging is an excellent and well-proven strategy for investing in stocks. On the other hand, reversing the process can be fatal to your retirement income. This is because selling stocks when prices are depressed removes your ability to enjoy gains once stock prices recover. In a prolonged downturn, it’s all too easy to ignite a downward spiral in your investment portfolio’s values that ultimately leads to having no income at all.

The past eleven years of unprecedented appreciation in stock prices have caused some to underweight risk. This recent bias makes for a dangerous mindset. It’s always important to have an extended perspective when it comes to returns of the market. A bull market will last on average four to six years. You can’t predict the full nature of the stock market, but having a long-term perspective and possessing strategies to combat a bear market is critical for a successful retirement.

The 4% Rule was derived from back testing, but what is the value of relying upon historical investment results when today’s economy looks so different than the past? For example, in 1994, the 5-year Treasury paid an interest rate of 6.69%. In 2022, the 5-year Treasury paid 1.90% but in 2023, the 5-year Treasury paid upwards of 4%.   Furthermore, in recent years, especially since 2008, we’ve seen major structural changes to the U.S. economy.

We are living in a very, very different world, one with radically transformed drivers of growth. The economy today is much different than the economy 50 years ago. It is important to note that back testing is not a guarantee of future performance, as the market conditions in the future may be different from those in the past. It is also important to use realistic assumptions in the back testing process and to take into account factors such as transaction costs and taxes.

Why do we use the 4% Rule?

There are several reasons why the 4% rule has become a popular guideline in retirement planning:

Provides a framework: The 4% rule gives retirees a framework for determining how much they can safely withdraw from their portfolio each year. By following this guideline, retirees can balance their need for income with their need to preserve their portfolio over the long term.

Based on historical data: The 4% rule is based on historical market data, which provides a reasonable estimate of how a balanced portfolio of stocks and bonds has performed in the past. While past performance is not a guarantee of future performance, using historical data can help retirees make informed decisions about their retirement income.

Adjusts for inflation: The 4% rule adjusts the withdrawal amount for inflation each year, which helps to ensure that retirees can maintain their purchasing power over time.

Helps to avoid depletion of portfolio: The 4% rule is designed to help retirees avoid depleting their portfolio too quickly. By limiting their withdrawals to 4% of the portfolio's value, retirees can help to ensure that their portfolio lasts throughout their retirement.

While the 4% rule is a useful guideline for retirement planning, it is important to remember that it may not be appropriate for everyone. It's important to work with a financial planner to create a personalized retirement plan that considers individual circumstances and goals. At GW Financial, Inc, we are here to help you translate wealth into personal significance and ensure that your financial needs are met so you can have the peace of mind you deserve.

In summary…

During retirement, many individuals often wonder about the amount of money they can withdraw from their portfolio without risking a shortage of funds. The 4% Rule is a well-known methodology that addresses this concern and determines the safe amount of annual withdrawal from a retirement portfolio to prevent its quick depletion.

Under the 4% Rule, retirees can withdraw 4% of their portfolio's value in the first year of retirement and account for inflation in subsequent years. For example, if a retiree has a $1 million portfolio, they can withdraw $40,000 in the first year of retirement, adjusted for inflation each following year. This rule assumes a 30-year retirement period, a balanced portfolio of stocks and bonds, and historical market returns.

Nevertheless, the 4% Rule has certain drawbacks and exceptions. Reversing the dollar-cost-averaging process can negatively impact retirement income, as selling stocks when prices are low can lead to zero income. Furthermore, relying solely on past investment performance is not a guarantee of future results as market conditions may differ.

Despite these limitations, the 4% Rule provides a framework for balancing income needs with long-term portfolio preservation, adjusting withdrawal amounts for inflation annually, and avoiding the rapid depletion of a retirement portfolio.

However, the 4% Rule may not be suitable for everyone, so it is vital to work with a financial planner to create a tailored retirement plan that considers individual circumstances and goals. At GW Financial, Inc., we are dedicated to helping individuals achieve financial security, translate their wealth into personal significance, and attain the peace of mind they deserve.

The content is developed from sources believed to be providing accurate information. The information in this material is not intended as tax or legal advice. It may not be used for the purpose of avoiding any federal tax penalties. Please consult legal or tax professionals for specific information regarding your individual situation. This material was developed and produced by GW Financial, Inc. to provide information on a topic that may be of interest. The opinions expressed and material provided are for general information, and should not be considered a solicitation for the purchase or sale of any security. Copyright 2023 GW Financial, Inc.