The 4-Percent Rule Is Wrong

Here’s Why

THE 4-PERCENT RULE IS WRONG

HERE’S WHY

We tend to like keeping things easy and simple.  Rules of thumb save us time when looking at investments.

But they can also be misleading.

A Good Tool

In the FIRE movement, Financial Independence, Retire Early, the idea of the 4-percent rule has been used to help many people define a financial goal.  It’s known as their FI number, or number at which they have achieved Financial Independence.

The idea is that you can grow your investment portfolio to a certain level, say $1,000,000 for example, then withdraw 4-percent per year and never run out of money.  That would initially be $40,000 per year in passive income.  The FI Number in this example is $1,000,000, producing your target passive income of $40,000 per year.

The FI Number is “reverse engineered”.  First you determine how much you will need in passive income.  So, in this example $40,000.  Then you divide that by 4% or .04.  So, $40,000 divided by .04 is $1,000.000.

Sounds simple and easy.  You just have to keep investing until you reach your target FI number.  At that point you can increase your withdrawals each year to account for inflation.

The 4-percent rule was first published in the Journal of Financial Planning in October 1994 by Bill Bengen, a financial advisor.  It was based on stock market returns from 1926 to 1976 assuming a portfolio consisting of a combination of stocks and bonds.  

He concluded that no historical case existed where someone would run out of money in 33 years, regardless of when they started during the sample period.

Most people would not be expected to live more than 33 years after a normal retirement age.

About The Assumptions

Let’s challenge some of the assumptions.

The rule is based on a few assumptions.  First, you are invested in a combination of STOCK MARKET AND U.S. TREASURIES with a mix of 50-75 percent stocks. Stock market returns have averaged about 10-percent a year for as long as the market has been tracked, while Treasuries have been around 5-percent.  What if we avoid bonds/Treasuries?  Overall returns are higher, so money should last longer.

The market has had some wild swings and you don’t really know what it will do in any given year.  Many people are hopeful, and sometimes many are disappointed.  Like Forest Gump said, “Life is like a box of chocolates.  You never know what you’re going to get.”

The rule also does not account for how you might react in a market downturn.  When money is tight, do you find a way to cut expenses?  Or do you just keep on spending as if the money is growing on a tree?  I would not settle for eating beans and rice, but we would probably put off buying a different car.  We would be more cautious with our discretionary spending.

Some years ago I had a realization.  This was well before hearing about Bergen’s study and the 4-Percent Rule but before I started investing in real estate.

Historically, inflation averaged about 3-percent a year.

If I could average 10-percent a year with the stock market, such as with an index fund, I could withdraw about 5-percent, leaving 3-percent to cover inflation and another 2-percent buffer for variability in the market.  That’s not too far off from the 4-percent rule.  But the same $1,000,000 portfolio could actually provide $50,000 a year to use instead of $40,000.  And the portfolio would never run out of money.

Bergen has since said that the 4-percent is based on worst case scenarios, and that 5-percent is a more realistic reasonable withdrawal rate.

Hmmm.  That’s another approach that leads to a similar conclusion.

What if, instead of investing in the stock market, I chose to invest in INCOME PRODUCING REAL ESTATE?  If most of those investments are producing better than 10-percent returns, then a higher withdrawal rate should be reasonable.  

I can’t promise anything, and like the stock market, past results are not a guarantee of future performance.  

But I can say that most of my real estate investments have fared significantly better than the stock market.  

Passive Real Estate Investments Hold The Key

What would you do if you found an investment that provided 5 to 8-percent cash back on your investment every year and also held an inflation hedge?  That is how many multi-family limited partnerships work.

General partners find and locate the property and line up financing.  Then limited partners contribute funds for the down payment and initial capital.  

As the property produces cash flow, some distributions are paid to the investors, providing them with an income stream.  Several years later, when the property is sold at a higher price, the investors receive back their initial capital investment plus profits realized from the gain in value.  This is a simple view of how a limited partner can have both cash flow and benefit from inflation.  This does not take into account any tax benefits.

Are you seeing how investing in a limited partnership can provide better returns?  Can you see how you could enjoy a larger withdrawal rate in the future from your investment portfolio?

Final Thoughts

The 4-percent rule is a conservative and useful rule of thumb.  In fact, a 5-percent withdrawal rate is accepted by many when the portfolio is primarily invested in a stock market index fund.  However, passive real estate partnerships can grow your nest egg faster and provide more cash flow when it is time to start living off your portfolio.

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