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4% is more of a guideline than a rule

Originally published on Marketwatch.com http://www.marketwatch.com/story/4-is-more-of-a-guideline-than-a-rule-2014-08-26

In my last column I wrote about some considerations retirees should make when calculating how much money they are planning to withdraw from their retirement portfolio.

I closed that article with a very brief discussion of the Trinity Study, also known as the 4% rule.

The Trinity study was originally done in 1998 and found that by starting your retirement income at a rate of 4% annually and adding an inflation adjustment each year, you’d have a 96% probability of your money lasting 30 years or more with a traditional 50/50 stock and bond portfolio. The authors initially analyzed 50 years of data from the period 1926-1995. The study was updated in 2011 with data up through 2009. The follow up study found that a 50/50 stock and bond portfolio would last 30 years or more at a 7% withdrawal rate with an 85% probability.

The way the 4% rule works is straightforward, if you have a $1 million portfolio, in your first year of retirement you’d withdraw $40,000. If the rate of inflation was 3%, in the next year your income would increase to $41,200 and so on.

Since the first study was done, we’ve witnessed some large price swings in the stock market and have seen interest rates fall to record low levels. From August, 2000 to September 2002 the S&P 500 dropped over 40% and it didn’t recover until 2006. From October 2007 to February 2009 the S&P 500 fell over 50% and didn’t recover the 2007 highs until 2012. Interest rates have also fallen to record lows, Treasury bond yields hit historic 200-plus year lows. The benchmark 10-year U.S. Treasury bond was yielding less than 1.4% in the summer of 2012.

Low bond yields coupled with stock market volatility have made this a difficult time for retirees. It may be prudent to plan for a lower initial withdrawal rate if you need your retirement account to last for 30 years or more. According to a study by Vanguard, the yield on a 50/50 stock and bond portfolio was over 4% from 1926-2011 and by 2011 the same portfolio yielded only 2.8%.

The inflation adjustment could also be problematic. In the last few years we have witnessed low interest rates and highly accommodative monetary policy in the form of QE or quantitative easing. If inflation begins to rise, the inflation adjustment to your income could become difficult. The CPI has been relatively tame the last few years and the Fed is currently targeting an inflation rate of 2%. However, retirees should look at their actual budget and consider the effects of rising prices on the goods and services that they consume. According to John Williams of ShadowStats.com, if the CPI were still calculated the same way today as it was in 1980, inflation would have averaged over 9% the last four years. Making a 9% annual inflation adjustment to your retirement income will make a big difference in the longevity of your portfolio compared with a 3% increase.

The 4% rule really shouldn’t be considered a rule, it is more of a guideline. The analysis from the Trinity study does give some good information about long-term stock and bond returns and acceptable distribution rates. Retirees should always evaluate their own unique, individual situation and not take a cookie cutter or a one-size-fits-all approach. Also, the original study was calculated using the Standard & Poor’s 500 Index SPX, -0.11%  and didn’t take into account fees and expenses.

It’s very important to understand the expenses you actually pay and factor them into your withdrawal calculation, 1% or 2% more a year in expenses can make a big difference.

Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.

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