How retirees could go broke with the 4% rule

You’re a brilliant stock picker. You own some of the best. Over the past decade, you’ve averaged more than 20 percent per year. Now you’re ready to retire, travel the world and scuba dive in the South China Sea.

Unfortunately, several years from now, you might only be diving into dumpsters for your dinner.

That might sound dramatic, especially if you know about the 4 percent rule. Back-tested studies say retirees should be able to withdraw an inflation-adjusted 4 percent from their portfolio each year. That portfolio, it’s said, should last at least 30 years.

But two forms of kryptonite could sink the retiree’s ship.

1. If stocks crash during your first year of retirement and stay down a few years.
2. If your portfolio lacks diversification.

Let’s start with a primer on the “4% rule.”

Assume you retired with $1 million. In your first year of retirement, you could withdraw $40,000 from your portfolio. That’s 4 percent of the total. In the years that follow, you would withdraw more to match the rising cost of toilet paper, airline flights, cereal, electricity and, if you’re unlucky, arthritis medication.

In other words, the only time you calculate 4 percent of your portfolio’s value is in the first year of your retirement.

If inflation, during the next five years of your retirement were 2%, 4%, 5%, 2% and 3%, your next annual withdrawals would be $40,800, $42,432, $44,553, $45,444 and $46,808.

If stocks, however, dive when you first retire, you might struggle if you only own “the best performing stocks.” (Pro tip: investors should never use the word “performing” when it comes to investing. Anything you see that has performed well is not “performing.” Instead, it has “performed.”)

Assume you retired 25 years ago, in January 2000.

The global and US stock markets fell in 2000, 2001 and 2002. Your retirement portfolio consisted of just 4 stocks. But they weren’t just any four stocks. They were among the 1990s best performers: Amazon, Cisco Systems, Intel and Microsoft.

Retiring with this portfolio might have made you feel like Michael Jordan.

But according to Morningstar, this all-star collection plunged 70 percent during the first 15 months of this hapless retirement. And that doesn’t include any withdrawals you would have made. If you began withdrawing an inflation-adjusted 4 percent in the year 2000, your assets would soon mirror a now-broke heavyweight champ, instead of the Chicago Bulls great.

Those 4 stocks were called growth stocks. Such stocks perform well when stocks soar. But they fall hardest, and are slowest to recover, when the market turns around.

I can hear what you might be thinking: “I would never own just 4 stocks!”

OK, let’s diversify a bit.

Let’s include 700 randomly selected US growth stocks. According to portfoliovisualizer.com, from 1990-2000, US growth stocks averaged 21.44 percent. That’s 597 percent after just 10 years. You might feel great retiring with those stocks, given their past returns.

But if you retired with US growth stocks (and that’s all you owned) you would have needed friends, family or a soup kitchen to keep your belly full. After just 18 years, you would have run out of money.

Below, you can see the market value of a retiree’s US growth stock index, with annual inflation-adjusted withdrawals based on the 4% rule.

US Growth Stocks and the 4% Rule
2000-2018
Starting with $1 million

Now let’s diversify further.

Instead of owning a portfolio of growth stocks, imagine owning a global stock index. This would include growth stocks and value stocks from the US, Europe, Asia, Canada, New Zealand, Australia as well as the emerging markets.

If a retiree had 100 percent of their portfolio invested in a global stock index, their money would have lasted longer than 18 years. But it might not last thirty.

Below, you can see the portfolio’s value over time.

Once again, it shows a portfolio of $1 million in January 2000. The retiree would have withdrawn $40,000 in the first year of retirement, while increasing those withdrawals each year.

By 2025, the portfolio would be worth about $420,000. That might sound decent. But the scheduled withdrawal for 2025 (remember the increases every year) would be about $74,000. That’s a whopping 17.6 percent of the portfolio’s value.

If global stocks fell in 2025 and 2026 (something akin to 1973-1974; 2000-2002; or 2008) the retiree would run out of money before 2030.

100% Global Stock Index and the 4% Rule
2000-2025
Starting with $1 million

Now let’s diversify further.

Imagine a retiree’s portfolio comprises 60 percent global stocks, 40 percent global bonds in January 2000.

Global stocks thumped the performance of global bonds over the following 25 years. Yet, a balanced 60/40 portfolio (in green) performed much better for retirees than a portfolio comprising just a global stock index (in blue).

Below, you can see that the 60/40 portfolio would still have about $1.05 million after 25 years of withdrawals. That’s about 2.5X more than a retiree would have with 100 percent invested in a global stock index.

60% Global Stocks, 40% Global Bonds vs 100% Global Stock Index
The 4% Rule
2000-2025
Starting with $1 million

You might think, “Global stocks thrashed the returns of global bonds over this period. In fact, bonds earned weak returns! How could the 60/40 portfolio have held up so well?”

Here’s how:

If stocks fell hard, the retiree would sell more bonds than stocks. That isn’t based on clever maneuvering. It’s simply the result of maintaining a consistent allocation between stocks and bonds.

That means, when stocks fell from 2000-2002 and again in 2008, to maintain a consistent allocation (60% stocks, 40% bonds) the retiree would have sold far more bonds than stocks when making their inflation-adjusted withdrawals.

Not only was the portfolio more stable during the downturns (see the chart above), but the retiree sold fewer stock market assets when stocks were down.

You might say, “I’ll never own bonds. I only want stocks. The sequence of returns will never be as bad as it was from 2000-2025.”

If you can see the future, stop reading this.

Go out and save some people.

As for the rest of us, it pays to be prudent.

The future could be worse than the past.

That’s why retirees should diversify with global stocks and keep 20-40 percent invested in bonds.