Will inflation and the stock market conspire to kill the 4% rule?

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A recent WSJ headline sent shivers down the spine of every retiree: “Cut Your Retirement Spending Now, Says Creator of the 4% Rule.”

In the article, the WSJ quoted the father of the 4% rule, William Bengen, as saying “there is no precedent for today’s conditions.” Stock and bond prices are still at record highs. Mix in a reference to 8.5% inflation and the WSJ starts to look like an insurance salesman offering indexed annuities.

So, is it really that bad? And should retirees rethink the 4% rule? I don’t think so, and here’s why.

The 4% rule is now the 4.4% rule

In the article, Bengen said he believed a safe initial withdrawal rate was 4.4%. Yes it is a increase of his first discoveries in his 1994 article.

In his 1994 article, he assumed that retirees were investing in the S&P 500 and intermediate Treasuries. That’s it. Since then, he has expanded the asset classes to include mid-cap, small-cap, micro-cap and international stocks. This diversification led him to increase the safe withdrawal rate from 4% to 4.7%. However, due to the unprecedented conditions mentioned above, new retirees might want to start at 4.4%, he said.

As far as I know, the 4.4% rate is not based on data. Still, this represents a 10% increase, not a decrease, from his original 4% rule. It doesn’t seem so bad.

Are we living in unprecedented times?

Bill Bengen thinks we live in unprecedented times. From the WSJ,

“The combination of 8.5% inflation with high stock and bond market valuations makes it difficult to predict whether the standard playbook will work for recent retirees,” Bengen said. He even went so far as to put 70% of his personal wallet in cash. When the father of the 4% rule cashes in, shouldn’t we?

I do not think so. To begin, it is important to understand how Bengen developed the 4% rule. He looked at 50-year retirement periods dating back to 1926. For each, he identified the highest rate of withdrawal one could take in the first year of retirement, adjusted for inflation of following years, without running out of money for at least 30 years.

As you can imagine, each year had a different initial withdrawal rate. In some years the departure rate was double what it was in others. Here is the key point. He did not average all of these initial withdrawal rates to arrive at the 4% rule. He took the absolute worst year – 1968.

Learn more about how the 4% rule works.

What does it mean? This means that the 4% rule survived the stock market crash of 1929, the Great Depression, World War II, the Korean War, the Vietnam War, the inflation of the 1970s and the early 1908, the stock market crash of 1987, September 11, the Great Recession. and Covid-19.

Stock prices

No matter how difficult past times were, current conditions seem horrific in a way that history can never feel. One need look no further than Robert Shiller’s CAPE (Cycle Adjusted Earnings Ratio) of the S&P 500 to raise concerns. It sits at about double its average and at all-time highs. It was only higher once, and that was during the tech bubble.

Yet, as “unprecedented” as it may seem, it is not for two reasons. First, most portfolios do not have the same PE as the S&P 500, even if measured using CAPE. Add mid-cap, small-cap, and international stocks, and the PE drops significantly.

Second, and more importantly, the S&P 500 CAPE would fall to the mean with a 50% decline in the S&P 500. That wouldn’t be fun, but it wouldn’t be unprecedented either.

As shown above, the market lost 90% to kick off the Great Depression. And going back to the tech bubble, the market lost 9%, 12%, and 22% from 2000 to 2002. It’s not quite a full 50% loss, but close. And from peak to trough during the Great Recession (2007-2009), the market lost more than 50%.

The 4% rule has survived like a cockroach.

Bond prices and inflation

Bond yields hit historic lows. I say “were” because that is no longer the case. The 10-year Treasury’s yield of around 3% is still below average, but there are many years back to the 1800s when it was lower. And when Bengen published his 1994 article, TIP

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S were in three years and the first I bond was still in four years. So at least now we can keep up with inflation.

Here is the key. The 4% rule has survived Treasury yields as low as 1-2%. It also survived inflation over 13% and a decade of inflation at 6% or higher.

And like the Energizer Bunny, it just keeps going and going (or ticking for you Timex fans).

Final Thoughts

Some years could be worse than 1968 for new retirees. Maybe 2022 will turn out to be the worst time to retire since the late 60s. Maybe 30 years from now we’ll know that for 2022 the initial safe withdrawal rate was 4.2% at instead of 4.4%.

But can we really predict this based on current conditions, when the 4% rule has survived much worse? I do not think so.

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