The 4% Rule is a dangerous myth based on a faulty premise. Ignore Safe Withdrawal Rate (SWR) and maximize Perpetual Withdrawal Rate (PWR) to enjoy 50+ years of financial freedom.
Why do we save? For nearly all of us, we save for retirement income later in life.
We use the 4% rule to estimate how much we can withdraw each year of a 30-year retirement. We use 3.5% if we plan to retire early.
I would like to introduce you to the “5% Forever” Rule.
You and I want more than 30 years of financial freedom.
My goal is financial independence at 50 years old. With medical advancements, I expect to live until 100 years old. So, I need my savings to last me 50 years.
The 4% rule governs the land. It’s close to becoming conventional wisdom. And I’m not a big fan of conventional wisdom.
Some quick history.
A financial planner named Bill Bengen first advocated the 4% rule over 25 years ago, in 1994. His clients had questions about how much they could safely withdraw from their nest eggs.
Bengen looked at U.S. market data from 1926 to 1992. He determined that given a portfolio split between stocks and bonds would survive a 4% safe withdrawal rate (SWR) for a retirement lasting 30 years.
4% withdrawn annually would not deplete a portfolio of U.S. stocks (60%) and bonds (40%).
But, consider where Bengen’s analysis wouldn’t hold up:
- Most other time periods in U.S. history.
- Anywhere other than the United States.
- For a time period any longer than 30 years.
The 4% rule was built on shaky ground. It’s not a very robust #.
In fact, since it was published in 1994, a lot of work has been done to validate 4%. It now appears the more robust % for a 60/40 portfolio is 3.5%. The problem is that “4% rule” is so nice and memorable. And now it’s hard to change.
I recommend thinking in terms of a forever rate, or as it is more commonly called, a perpetual withdrawal rate (PWR). At what rate, can you withdraw from savings forever?
Three factors determine how much you can spend each year.
With financial experts recently suggesting that 4% be lowered to 3.5%, how can I advocate raising it to 5%?
The short answer is to adjust how the underlying investment portfolio is constructed. There is a better solution than U.S. stocks (60%) and bonds (40%).
But first, let’s investigate what factors impact the withdrawal rate. There are three.
No. 1 and the most well-known is investment rate of return. A greater investment return is, of course, better. Growing your portfolio faster supports the ability to withdraw larger sums. But this is just one factor.
No. 2 is inflation. If inflation stays low, the cost of living stays low. And investments can grow to easily cover the cost of future expenses.
Inflation can be addressed in your portfolio by owning Treasury Inflations Protected Bond Securities (TIPS). But I recommend doing so only as part of the Fast Follow Investor portfolio.
A better way to protect against inflation is to control how and where you spend money. I call it smart spending. For example, when egg prices are outrageous, buy milk, yogurt, and cheese for protein.
No. 3 will make sense but is discussed much less: investment return volatility. Low volatility means that your nest egg is protected from steep and severe losses. When volatility is high and investments decline sharply, you’re forced to withdraw savings when portfolio values are low. This is commonly called “sequence of return risk”. (Why are financial terms made to be so complicated?)
In summary, to maximize your forever rate, control inflation with smart spending. Then, invest in a portfolio that offers high returns with low volatility.
Use the Fast Follow Investor portfolio to withdraw at 5% forever.
The Fast Follow Investor portfolio offers strong, stable investment growth. It’s predicted to earn 12% annually through all economic cycles.
But, the best feature of the Fast Follow Investor portfolio is its 3-year positive return profile. This means a negative return recovers to neutral within 3 years. It’s only possible because it manages losses, limiting them to a 3-year period historically. This is kind of amazing.
Think about it. Start with $50,000 invested. Once it goes negative (which it will), the portfolio will find its way back to $50,000 again within 3 years. Compare that to 10 years for the U.S. stock market. The stock market return for the lost decade of 2000-2010 was 0%!
The Fast Follow Investor portfolio’s 12% return and 3-year positive return profile work together to achieve a 5% annual withdrawal rate…to infinity.
And that is the 5% Forever Rule!
Retire whenever you’d like to and comfortably withdraw more of your invested savings. Just be sure your savings align with the Fast Follow Investor portfolio.
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