The 4% rule helps us understand how much we can safely take out of our portfolio each year without running out of money in retirement.
Yet, as simple as the 4 percent rule seems, the practical implications are drastically misunderstood. I explore the three common mistakes people make when applying this rule and how to avoid them.
Questions Answered:
How do RMDs impact the 4 percent rule?
Does the 4 percent rule account for changes in expenses and income sources?
Timestamps:
0:00 - Questions from listeners
1:26 - Misconception 1 - RMD
3:27 - 4% rule applies to portfolio
5:51 - Assumption of 30 years retirement
7:51 - Misconception 2 - annuity distributions
10:01 - An example
12:33 - Misconception 3 - static cash flow
13:42 - Examples of changes
17:44 - Summary
Create Your Custom Strategy ⬇️
The 4% rule helps us understand how much we can safely take out of our portfolio each year without running out of money in retirement.
Yet, as simple as the 4 percent rule seems, the practical implications are drastically misunderstood. I explore the three common mistakes people make when applying this rule and how to avoid them.
Questions Answered:
How do RMDs impact the 4 percent rule?
Does the 4 percent rule account for changes in expenses and income sources?
Timestamps:
0:00 - Questions from listeners
1:26 - Misconception 1 - RMD
3:27 - 4% rule applies to portfolio
5:51 - Assumption of 30 years retirement
7:51 - Misconception 2 - annuity distributions
10:01 - An example
12:33 - Misconception 3 - static cash flow
13:42 - Examples of changes
17:44 - Summary
Create Your Custom Strategy ⬇️
The 4% rule is one of those foundational aspects of retirement planning. It really helps us begin to understand how much we can safely take out of our portfolio each year without being excessively worried that we might run out of money in retirement, which, of course, is what most retirees want. They want to know they're going to be okay and that they're probably not or certainly not going to run out of money. The challenge is this as simple as the 4% rule seems on the surface, the practical implications are drastically misunderstood. That's why, in today's episode, I'm going to share with you three common mistakes people make when applying the 4% rule, and I'm going to share what you can do to avoid these mistakes and make sure that you're making the most secure retirement possible. This is another episode of Ready for Retirement. I'm your host, james Cannell, and I'm here to teach you how to get the most out of life with your money. And now on to the episode, and so what I'm going to do is this is I'm going to walk through actual comments and feedback I've received from all of you. One thing I love about YouTube and I love about the podcast is, as I have these episodes, you all get to tune in and you send me feedback and you leave comments and you send emails and I read all of those and a lot of those emails and comments are great. It's other suggestions or it's questions about how do I apply this, and what I'm actually going to do today is take three comments that I've received about the 4% rule that are misunderstood. So I get where people are coming from, but I want to show the error in this thinking because this line of thinking, if not corrected, can lead to some pretty disastrous results. So let's go through these together so we can make sure that, as we're taking things like the 4% rule or we're taking things like standard withdrawal rates and trying to understand how can we apply this to our portfolio, we're doing so in the right way.
Speaker 1:So this first question comes from Thomas. Thomas says you frequently make reference to a 4% as a safe withdrawal rate for retirees. As a retiree who started receiving RMDs, so required minimum distributions, last year, I was surprised to learn that my RMD withdrawal rate will increase annually. Can you discuss the impact of that as part of an overall retirement plan? From Thomas, absolutely, and I don't know exactly, thomas, what you're asking, but I think I know what you're getting at is we hear 4%. Can we say, okay, if I can just take 4% per year from my portfolio, I'm going to be okay for the rest of my life? That's true to an extent. That's typically true as a starting point and if you haven't gone back and listened to other episodes I've done about the 4% rule, which was originally published by Bill Bangan, go back and do so. So I'm not going to go through the ins and the outs and why the 4% rule works and what methods are even better than that.
Speaker 1:But here's what Thomas is getting at with this question the year that you first have to begin taking required minimum distributions so any pre-tax account that you have, depending on your birth year, anywhere between age 72 and 75, if you haven't started taking it yet, it's actually between age 73 and 75, you're going to be forced to start taking distributions from IRAs, 401ks, other types of pre-tax retirement accounts. That first year of these required distributions, your withdrawal comes out to somewhere around 3.8% or so of your account balance. So if you have a million dollars in an IRA, it's your first year of taking required distributions. You're going to be forced to take about $38,000 from your IRA but, as Thomas mentioned, that withdrawal increases every single year. The percentage increases every single year, so much so that by age 85, for example, based upon the IRS uniform life expectancy table, your required withdrawal will be about 6.25% of your account balance. So let's think about that real quick. We want to take 4% per year out of our portfolio, but the IRS is going to force us in our later 70s, 80s and beyond, to be taking out more than 4%. Does that completely blow up this concept of the safe withdrawal rate? The answer to that is no, and the answer is no for three reasons. Number one is this Typically, your required distribution is coming from an account that only represents part of your portfolio.
Speaker 1:So let's say you have a million dollars in your portfolio. Well, if half is in an IRA and half is in, say, a brokerage account, you don't have to take a required distribution from everything, from the full million. You only have to take it from the pre-tax portion of your portfolio. So let's say you're in your later 80s and you have to take 7% of your IRA as a required distribution. If you look at that in panic and say, oh my gosh, that's way too much to take out of, until you realize that 7% is only coming from half of your portfolio. So if you have a million dollar portfolio, what you're actually doing is you're only taking that 7% distribution from $500,000. That comes out to $35,000. $35,000 then represents 3.5% of your entire portfolio.
Speaker 1:So when you're looking at this withdrawal rate, one thing that you need to keep in mind is you want to try to keep your total portfolio withdrawal rate sustainable. So, as a starting point, maybe somewhere around that 4% rule, if you're using the 4% rule as the basis for your withdrawal decisions. So that's the first reason. That doesn't necessarily blow up. The sustainable withdrawal rate is usually not all of your money is in an IRA. Now, maybe all your money is in an IRA and you're saying well, james, for me it is. So does that blow up my sustainable withdrawal rate If all my money is in a 401k or an IRA? The second reason the answer is no is because you can always reinvest that money.
Speaker 1:So let's say you're being forced to take out 7% of your IRA as a required distribution. Well, what we're really concerned about isn't so much how much are you taking out of the IRA, it's how much that are you spending. Because, hypothetically, let's say, you take out that 7%, but then you go reinvest 3% in a brokerage account. What you're really doing is you're taking out a net withdrawal of 4% and the other 3% you're simply shifting to another type of investment, another part of your investment portfolio. So sure, maybe you're taking more from one part, but the net withdrawal is really more and more concerned about. You always have the ability of reinvesting that money. You just can't do so in the pre-tax account. So that's the second reason that required minimum distributions do not violate the 4% rule is you always have the option of reinvesting excess distributions if needed.
Speaker 1:The third reason it doesn't maybe the most important reason this doesn't is the 4% rule is assuming a 30 year life expectancy. Really, the goal of it is to say, for the average retiree that maybe has an average retirement time horizon of 30 years, how do we make sure that they're not taking too much out of their portfolio such that by the end of retirement they've run out of money and are now out of luck? Well, that's what the 4% rule is based upon is saying, how do we make this money last for 30 years? Let's assume you're in your later 80s, maybe your early 90s, and now all of a sudden you're being forced to take 10% 12% out of your IRA as a required distribution. Does that give you reason or should you be panicking because of that? No, because you probably don't have a 30 year time horizon in front of you.
Speaker 1:This is one of those things that needs to be adapted. If you know, you only have and of course, none of us actually know how long we have. But say, if you knew a certainty, you only had two years left because you're 93 years old. Do you really need to keep your withdrawals at 4% of your portfolio? Not, unless you're trying to preserve a big, significant portion of your portfolio for future generations. If that portfolio is just for you, though, hypothetically you could spend 50% this year and 50% the next year you've spent on your portfolio and then you die with zero. So as you think about this, keep in mind that you have to align the amount that you're taking out of your portfolio with your expected retirement time horizon. If you've got 30 plus years, we've got to keep those withdrawals to a lower amount. We have to keep those sustainable because we have to support a lot more living. We have to support a lot more expenses for the next couple of few decades If you're in your 80s, 90s, beyond, you maybe don't have a 30-year life expectancy anymore, so it's okay to start increasing those distributions, knowing that it's okay for this portfolio not to last for 30 years anymore.
Speaker 1:So that's the first misconception about the 4% rule. Is that required minimum distributions will somehow violate your ability to follow the 4% rule, and they won't for the three reasons I listed just above. The second misconception is this People think they can simply go get an annuity and the distribution on that annuity will replace fully the 4% rule. This is a comment I received on YouTube on a video where I was talking about the 4% rule. This individual says I never heard the word annuity mentioned. It's a shame, because you can get 6% in the multi-year guaranteed annuity right now and that's 2% more than the 4% rule. If I do my math right, with no risk, this can cover the 4% rule. Now this is a comment I get all the time.
Speaker 1:This people say why aren't you talking about annuities? You're talking about the 4% rule. Well, look, this guaranteed annuity product will pay me 6%, 6.25%. Here's what those people are missing. That annuity, at least at those rates, is not going to keep up with inflation. That annuity is going to give you a guarantee and it's going to give you an income stream. That income stream is going to level off, meaning it's going to feel like that amount today, but every subsequent year, as inflation goes up and up and up, it's going to feel like a little less money each year. The purchasing power is going to diminish just a little bit each year. Now, if you compare that to the 4% rule or other types of withdrawal strategies, the assumption is when you're taking 4% it's not assuming you take 4% and then never increase that You're starting at a lower rate, because the assumption is you're increasing that with inflation. When the white paper was written and the data was tested, it was saying how can we start with a certain amount of withdrawal that we can then increase to keep up with inflation over time? Because it's not the dollar value that we care about, it's the purchasing power that we care about.
Speaker 1:Let me give you an example to show you what I mean by this. I'm going to go back to this user's comment. Let's assume that you have a million dollars and you're trying to create income that you won't out of in retirement. Well, you can use the 4% rule. By the way, this whole thing. I think there's better ways of approaching this than the 4% rule, but it's kind of that foundational piece of retirement research that helps us to begin to understand what is a sustainable withdrawal rate that we can take out. It's not a bad place to start, but keep in mind, as I'm going through this, it's not necessarily a recommendation that I give to most people to operate under these assumptions only when it comes to retirement withdrawals.
Speaker 1:Let's assume you have a million dollar portfolio and you're trying to figure out how much income can I take. Well, if you did the 4% rule and implemented that, you could take about $40,000. This individual that left this comment on YouTube will say wait a minute, you could take $40,000. Or you could go get this thing called a multi-year guaranteed annuity, so simply an annuity that's going to pay you 6% of whatever premium you put in to that. So if you have a million dollars, put a million dollars into this and you get $60,000 per year. What's to lose here? You're getting the guarantee and you're getting more income. It seems like a win-win, until you realize that annuity payment is going to pay you the same exact amount every single year, without an inflation adjustment. Now that inflation adjustment may not seem that significant because you're saying well, I'm starting with 50% head start, I probably have some margin here to be okay, even with inflation.
Speaker 1:Let's take a look with a 3% inflation rate that $40,000 that you're receiving from the 4% rule, by the end of a 30-year retirement you'd be receiving $97,000 under those same withdrawal rules. So, yes, you started with $40,000 per year on that million dollar portfolio, but that was almost $100,000 per year by the end of your retirement. And that's simply to keep up with inflation. That's simply to maintain the purchasing power that you have today with $40,000 per year. Now, that's assuming a 3% inflation rate, which historically has been about the average of what we've experienced over a several decade time period. What if inflation is higher? What if inflation is only 1% higher and it's 4% per year? Well, now that $40,000 per year, if we can increase that with inflation under the 4% rule, which again is designed to be able to keep up with inflation, that turns into $130,000 after 30 years of retirement, so that $40,000 increased to $130,000, simply to maintain the same purchasing power, the annuity, all the while. That started at $60,000 per year. It's still paying you $60,000 per year at the end of 30 years. So be very careful with this.
Speaker 1:Not saying annuities don't have any place in a retirement plan. They certainly can. Now, depending upon your tolerance for volatility and fluctuation and depending upon your specific circumstances, annuities can have a place in some instances. However, oftentimes people are very short-sighted when looking at those annuities because they're looking at the income today and not appropriately planning for what's that going to look like in the future, after inflation has gone up by 100%, 200% or more over the course of your retirement.
Speaker 1:Then, finally, the third misconception. The third mistake people make around the 4% rule in retirement is this Is they assume that they're going to spend the same amount in retirement every single year. And when I say they assume they're going to spend the same amount in retirement every single year, typically when they actually start running the numbers they very quickly realize hey, I'm not going to spend the same amount in retirement every single year, or I'm not going to have the same income sources in retirement every single year. And here's why that's important. Let's assume you retire in your 67 years old and you have your social security benefit and then you have your portfolio. What's a very simple scenario. You take your social security, you determine what percentage of your portfolio can you take on top of social security? And then you're good. You simply take that and you manage your portfolio the right way and do what you need to do, and that's a very simple solution. That's a very simple scenario. That's not what most people's situation typically look like.
Speaker 1:For most people, either their expenses are going to change, and maybe change somewhat dramatically, during retirement, or their income sources will change, and change somewhat dramatically, throughout retirement, and in most cases, both will change throughout retirement. Here's what that might look like. So the first thing is your expenses might change. Well, why might your expenses change? Maybe you carry a mortgage in retirement and your home is paid off five years in. Well, what does that mean? Practically speaking, it means your expenses are higher the first five years and then, once your mortgage is paid off, your expenses drop. Your lifestyle stays the same, your ability to do things stays the same. You're just no longer paying the bank for your mortgage. Well, what are the implications of that?
Speaker 1:With higher expenses in those first five years, you're probably needing to take more money from your portfolio, so you might take a higher withdrawal for those first five years and then it backs off later in retirement or maybe you want to travel a whole lot more the first five years, 10 years, 15 years of retirement. What does that do to your portfolio? With draw rate, it means you need to take more from your portfolio. There's first five years, 10 years, 15 years to support that and maybe that portfolio withdrawal rate starts to taper off later on into retirement. Or maybe you retire before the age of 65, and you have to come out of pocket to cover medical insurance. Well, your expenses are going to be higher until you turn 65, and then those expenses will drop off. So what you can start to get a picture of is it's not like you retire and take one simple percentage out of your portfolio and increase that forever. The reality is that's not how our lives work. We're going to oftentimes have more expenses up front or maybe more expenses in the back end, and it's not going to be this simple linear projection of what expenses will actually look like.
Speaker 1:Or income might be different. Maybe you retire but you have some type of part-time work or you're doing some consulting. You have some income on the side. Well, if that income comes in, say the first five years, then maybe it goes away after five years. What does that mean? Well, that means you're taking less from your portfolio, less first, five years, all else being equal, and then you take more from your portfolio later on. So it's the opposite scenario. Maybe you're taking less at first and then more a few years into retirement. Or maybe it's the reverse. Maybe you retire at age 64, for example, but you're not going to collect social security until age 70. Well, what does that mean? It means more income comes in later, but you're going to have to take more from your portfolio those first few years to bridge that gap because social security hasn't come in, and then a much lesser amount from age 70 and beyond.
Speaker 1:I see this all the time with clients. We'll run their projections, we'll look at how much they're spending and we'll say, look, you're expected to take six and a half, seven percent per year that first year to retirement. And they'll look at that and say, oh gosh, I can't retire. That's way too much to take out of my portfolio if I want my portfolio to last for the rest of my life. And I'll say, yeah, that would be too much if we were going to take that forever. But look at the graph, look at the projections. You're taking that for two years, maybe three years, but then social security kicks in and all of a sudden that six and a half percent withdrawal rate drops down to three and a half percent withdrawal rate. And then your spouse's social security kicks in the following year and now that three and a half percent rate drops to two percent and what we can start to see is not only can you retire and support a six and a half seven percent withdrawal rate in this specific example, you could actually probably spend more, because once you get through those first couple of few years, your withdrawal rate drops pretty significantly because outside income sources are now covering a big chunk of your retirement lifestyle. So that's something that you have to plan for is how will income change throughout retirement?
Speaker 1:And then here's a tricky one. A tricky one is when people have pensions and these are specifically typically corporate pensions, so not government pensions that typically have some cost of living adjustments. Maybe you have a pension and you say, james, my scenario is pretty simple I've got my pension coming in of 3000 per month, I've got social security on top of that and then I've got my investments on top of that. I just need to know how much do I take my investments each year. Well, it starts out simple, but your corporate pension is not, in most cases, going to increase with inflation. So even though that income source is there all along, every single year, your portfolio is going to have to cover more and more of whatever inflation adjustment you're giving yourself, because your pension isn't going to support that at all.
Speaker 1:So what you can start to see is yes, the 4% rule. Pretty simple on the surface. Take 4% of your portfolio and you're probably going to be good for 30 years, assuming that you invested the right way and follow the rules that the 4% rule dictates. But that's not how life actually happens. Expenses change, your income sources change. In most cases, both of these things change, and so you have to adapt your plan and your portfolio to see how does the 4% rule actually apply here? Given that life isn't linear, my portfolio projections aren't linear. So as we start to go through this, I hope that's helpful for you to see that, whether you're using the 4% rule, whether you're using a guidance guardrails types approach, whether you're using any other type of withdrawal rate, understand that life isn't necessarily linear. The way this happens isn't as simple as we think it is in our heads when we start to envision retirement.
Speaker 1:So, if that's helpful, make sure that you subscribe to the channel. Every single week We've got a podcast on Tuesdays and then every Saturday we release another video here. I hope you'll subscribe. I hope this is valuable. Thank you, as always, for tuning in and I'll see you next time.
Speaker 1:Hey everyone, it's me again. For the disclaimer, please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call to one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.