Thinking Early Retirement? Beware of the Four Percent Rule . . .

Recently, USA Today revisited a popular subject amongst early retirement hopefuls: the so called “four percent rule.” The basic concept is that if a retiree withdraws no more than four percent of his portfolio per year, he should have enough to last for thirty years. The thought is that by limiting withdrawals to this amount, the remaining principal, along with investment earnings, should keep the portfolio cranking for years to come.

The question posed by the article is whether the 4 percent rule is still relevant to retirees.  The article concludes that it is, “somewhat” relevant – maybe – but only as a guideline.  In other words, the financial advisers interviewed in the article hedge and dance.  Later in the article, some of the analysts become more frank in acknowledging that the rule really does not work with today’s financial realities, including the low interest rate environment that has been in place for years.  In fact, just a few months earlier, USA Today published another article on the subject of the 4 percent rule that explained why the 4 percent retirement rule is broken.

It is unclear what induced USA Today to mute the alarm sounded by its earlier article.  (It may have just been a writer’s desire to recycle old material with a new spin so as to bolt before the New Year’s holiday.)  Whatever the motive, it does a great disservice because the four percent rule is anything but a reliable rule of thumb on which to base retirement decisions.  It is hardly a concept for practical people to rely upon.

I say this for several reasons.  First, as previously mentioned, the rule was formulated at a time when interest rates were much healthier than they have been over the last several years.  We have gone from the days of six percent interest of 3 month T-bills to the current scenario of a near zero rate on the same vehicle.  Even the thirty year bond is paying a mere 3 percent, or half of what 90 day treasuries paid when this “rule” was formulated in the 1990s.

Why is this important?  Because retirees need to have a substantial portion of their nest egg invested in conservative investments.   Otherwise, they could find themselves promptly in the poor house as the stock market enters its next frightening bear market.  Just image the troubles a retiree would have faced if 80-90% of his retirement portfolio had been invested in stocks during the 2000 – 2002 bear run.  Think about 2008 when the market blew up and erased over half of investor’s portfolios.  Yes, it came back, but only after years of sweat and angst.  That’s no way to plan a retirement.

Another reason why the rule is no longer relevant is because it does not account for the minimum required distribution that the federal government imposes on retirees nowadays.  The basic rule here is that retirees are required by law to withdraw certain amounts from their portfolios — whether they want to or not — so that the government can be sure to collect taxes on the earnings before the retiree dies.  Yes, you can still reinvest the money once you have withdrawn it, but only after you have paid the tax man.  It is therefore a net loss to the portfolio that does the retiree absolutely no good whatsoever.

Remember too that we are living under a cash-starved government that is constantly on the prowl for new ways to take still more of your savings.  You already know that our government has managed an 18 TRILLION dollar debt, the interest alone from which adds six figures with the blink of your eye.  As the number of Americans on the dole increases at a similarly startling rate, and as government monstrosities like Obamacare take hold, the already unsustainable debt will spin more wildly out of control.  Remember too that the social security system is also cash-starved and unsustainable; ditto for Medicare.  As this happens, you can pretty safely bet that the tax erosion of your savings will become more and more dramatic over your lifetime.

The four percent rule also was created during the run-away bull market of the 1990s.  That was the time of “irrational exuberance,” when investors thought we had magically reached the perpetual land of milk and honey.  It was the time when dot com companies were rolling in wealth and success, just before the clock struck midnight in March of 2000.  How do those dot com companies look now?  Has the NASDAQ returned to that 5,000+ point high in the fourteen years since?  No.  Surely we can all agree that a crash that has still not recovered in fourteen years is a bit more than an isolated down year.

But what really shakes me up is how further distorted the rule has become by pie in the sky young people fixated on escaping the world of work.  Mr. Money Mustache, for example, is a very popular website devoted to “Early retirement through Baddasity.”  The site is run by a man who reports that he retired in his early thirties and now lives off of investment earnings.  It is, understandably, an extremely popular site amongst young adults who find the thought of retiring in only a few years very appealing.

Now, don’t get me wrong, I too enjoy many of the blog posts because much of the espoused “Badassity” pertains to frugal living.  The blogger also boasts an enjoyable writing style that reflects a laid-back lifestyle and a healthy philosophy on life.  Unfortunately, however, one of his keys to early retirement is an extreme take on the four percent rule.  In his post on the subject, MMM describes the rule as the maximum rate at which you can withdraw your retirement savings and never run out of money.  Explaining why he personally believes four percent is that rate, he then reasons that an investor can generally count on an average annual investment return of seven percent, while conceding three percent to inflation, and voila, the four percent from which to live appears.

This interpretation, of course, raises yet another problem, which is the eroding effect of taxes.  You see, as soon as you sell off four percent of your holdings, you will get to pay capital gains taxes on any gains.  See also the minimum required distribution of cash poor government discussions above.

And yet countless fans of MMM regale one another with their plans to retire at the age of 30 or 35 with absurdly underfunded nest eggs of $500,000 – $700,000.  Browse through message board threads on the site and you will be amazed at the confidence, indeed certainty, with which these young people assume their plans are rock solid.  How frightening is this?  Do these people honestly think these are realistic scenarios?  (As an aside, I am also always troubled by how few of these people seem to care about the prospect of providing such things as college educations, weddings, and basic inheritance to their children, but that’s another topic for another day.)

But, please, think about it pragmatically before you make a dangerous career decision on such faulty premises.  Do you really want to kiss goodbye a job (and a career) in a country that has a bankrupt government and an unsustainable social security and Medicare system?  Do you believe your nest egg will be perpetually safe in a country where one of two primary political parties flourishes by promoting class warfare and a Robin Hood philosophy of taking from the “haves” and giving to the “have nots?”  Do you want to make yourself dependent on the returns of an oversold stock market that is eerily reminiscent of the 1990s?  I sure don’t.  The prudent course is to err on the side of too much, and allow your children to benefit from any excess.


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