The Four Percent Rule (Revisited)

You've just retired, and your portfolio is your main source of retirement income. How should you invest, and how much can you safely withdraw?

Bill Bengen, a once obscure advisor in El Cajon, California, attempted to answer that question some 25 years ago: Maintain a mix of 53% stocks and 47% bonds, and rebalance annually. Start by liquidating 4% of your portfolio the first year, then adjust that dollar amount upward each year by the rate of inflation (CPI). With that approach, Bengen contended, odds are high that your portfolio will last at least 30 years. Bengen went on to add additional asset classes, and eventually raised his starting point recommendation to 4.5%. But his original series of papers were popularly enshrined under the moniker of “The 4% Rule.”

Over the last decade, stocks have recovered from their Financial Crisis lows with brief and relatively mild setbacks. During that time we've strongly encouraged our clients to limit their annual portfolio draws to 4% or less, and to stick with an asset mix with roughly 40% bond exposure if their annual draws are above 3%. We've done that knowing that a bear market could quickly turn 4% draws into 7% draws, and under those conditions, you need to be able to weather the selloff and the recovery period without doing too much damage to your portfolio.

Asset Class Diversification Matters
Bonds are key to the long-term success of this strategy. Without them, the odds of making your portfolio last more than 30 years are reduced significantly.

In the past we have illustrated how an all-stock portfolio can be suddenly exhausted by a severe bear market when the initial draws are above 7%. But the scenario we used (which ran from 1977-2008) didn't really show how you can get into trouble with 4% draws on an all-stock portfolio. That's because it began at a time when stocks were cheap and inflation was running at unusually high levels.

This time around we are showing the effect of 4% draws over 20 years (1998-2017), starting at a time when stocks are relatively pricey. Inflation remains low throughout the period (I think the next 20 years will bring a similar backdrop, though a repeat of the tech bust or the Financial Crisis seems unlikely). In the example below, we are showing the impact of 4% annual draws on four different portfolios: Cash (represented by Fidelity's Government Cash Reserves), Bond (represented by the Barclay's Aggregate U.S. Bond Index), Hybrid (represented by 60% S&P 500 and 40% Barclay's Aggregate U.S. Bond index, rebalanced annually) and Stock (represented by the S&P 500 Index). The chart below tells the story:

  • An all-cash portfolio, as expected, is safe but its 2.0% return (nearly equal to inflation for the period) is no match for draws that start at $20,000 and rise with the CPI. So this option runs out faster than the others (if money market returns and inflation are similar, the 4% rule would allow your portfolio to cover about 25 years of living expenses).
  • 20-Year Performance of Asset Classes When Annual Draws Are 4%

  • An all-bond portfolio is sometimes the preferred choice for conservative investors who want to maximize income, and in this example, it looks capable of meeting living-expense needs for well beyond 30 years. But the 4.9% annualized return for the Barclay's Index is relatively high for a period that only saw 2.1% inflation, mainly because of unusually high yields at the beginning of the period. Over the next 20 years bonds may only return 3-4% per year, which would make this option look more like the cash option. Another consideration is that an all-bond portfolio is the most vulnerable to a surprise jump in the inflation rate.
  • An all-stock strategy is often the favorite of those who want to maximize wealth-building. And in a situation where living expense demands are light (less than 2%), this option almost always provides the best performance over long periods of time (for this test period the S&P 500 returned 7.2% annually). But when the withdrawal burden is at 4% and a bear market hits, you can reach a point of no return sooner than you might expect. In this example, you can see the damage that is done by heavy draws in the aftermath of the tech bust and the Financial Crisis. In the end, the stock portfolio exits the period no worse for the wear, but only because both recoveries came quickly, and the bear markets were separated by a period of about six years. That may not be the case in a future scenario. While the odds seem low for a repeat of the back-to-back bear markets of 1969-70 and 1973-74, something like that could cause an all-stock portfolio to run out faster than the cash option.
  • The stock/bond hybrid option stands the test of time better than any single asset class. Stocks and bonds rarely take a dive at the same time, preserving capital and helping to speed up all recovery periods. Rebalancing helps too, offering the same benefit as dollar cost averaging (the return for the 60/40 portfolio is 6.4% per year, but it improves to 6.8% with annual rebalancing). When burdened with 4% draws, these advantages allow the hybrid approach to outperform the stock-only option.

Outlook For Bonds Improving
At a time like the present, it's easy to dismiss the role of stability that bonds provide in a portfolio, focusing instead on their poor performance relative to stocks. But going forward there is reason to believe that bonds could perform better than they have in the past 12 months. Inflation, after being pushed up by higher energy costs and rising wages, appears to be reverting to the Fed's 2% target. On the energy front we're getting help from rising U.S. shale oil production and shrinking demand in emerging countries (where currency plunges have made fuel much more costly in local currency terms). On the labor front, rising productivity may now be helping to offset the inflationary impact. As for the Fed, rate hikes that come late in the tightening cycle often benefit intermediate- and long-term bonds (that's what causes the yield curve to invert). Most of Fidelity's investment- grade bond funds have hovered near breakeven over the last seven months, and could quickly return to earning their yields.

Third Quarter Review
The third quarter brought clarity to stock investors. Most importantly, trade tensions are not weighing much on economic growth. With GDP expanding at a 4% rate, it’s pretty clear that the corporate tax cuts alone are spurring a generous amount of business spending. It’s not that exports don’t register. But goods account for less than 10% of U.S. GDP. So for all practical purposes, the impact of tariffs on the U.S. economy is not that significant. Many foreign markets, on the other hand, could be negatively impacted. Performance for most was anemic, at best, as investors adjusted their expectations in a downward direction.

Some uncertainty was removed for interest rates too. Year-over-year inflation likely topped out at 2.9% in July. Going forward the strong dollar and rising productivity could set the stage for greater policy flexibility in future quarters. Given how the Fed is normalizing rates slowly, they seem unlikely to over-shoot neutral levels by much, despite all the hawkish talk.

For the quarter, the S&P 500 climbed 7.7% on continuing improvement in earnings that went mostly ignored during the first half of the year (the index is up 10.6% year-to-date). Despite relatively modest foreign exposure, the stock side of our portfolios was held back significantly. Part of the problem was our focus on Chinese technology disruptors, which were hit hard as trade tensions with the U.S. saw no relief. But our exposure to smaller stocks also held us back.

The news was better on the bond side. For the quarter the Barclay’s Aggregate Bond Index was flat (it’s down 1.6% year-to-date), but the bond side of our portfolios - helped by a heavy emphasis on corporate debt - finished about a half percentage point ahead of the benchmark.

Outlook
With little economic risk to either side, the U.S. and China appear to be digging in on tariffs. It should come as no surprise if both sides end up imposing a 25% tariff on everything coming or going. Consumers may come out on the losing end, but it shouldn’t hurt GDP much in either country. In the U.S., we’ll pay more for clothing and low-tech goods, but recent wage gains should easily cover it. In China, there will be less revenue coming from the U.S., but still plenty of economic growth from other parts of the world.

The Fed will likely keep doing what they have to do with short-term interest rates, but it probably won’t hurt bonds as much as it has in the past. The most recent tightening move had little impact on intermediate- and long-term bonds, which is not uncommon for moves made late in the tightening cycle. Odds are the Fed will either have to call an early end to their hawkish plans, or roll the dice on a yield curve inversion. Even if they opt for the latter, we don’t think the odds of a recession would be as high as they’ve been during previous yield curve inversions. Today’s economy is running on business investment and rising employment. Banking lending is not as big a factor this time around.

After making a number of changes in the third quarter, we’re comfortable with our current portfolio positioning. We continue to believe that technology disruptor stocks and small-caps are undervalued relative to their growth potential, so that’s where our focus is on the stock side. And despite a weak year for bonds, we think the funds we are holding have a good shot at earning their yields going forward, so we don’t see any need to revamp our strategy on the income side.


Sincerely,

Jack Bowers




Jack Bowers
President & Chief Investment Officer

Bowers Wealth Management, Inc. is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Bowers Wealth Management, Inc. and its representatives are properly licensed. This website is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Bowers Wealth Management, Inc., unless a client service agreement is in place.

 
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Sincerely,

Jack Bowers




Jack Bowers
President & Chief Investment Officer

Bowers Wealth Management, Inc. is a Registered Investment Adviser. Advisory services are only offered to clients or prospective clients where Bowers Wealth Management, Inc. and its representatives are properly licensed. This website is solely for informational purposes. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. No advice may be rendered by Bowers Wealth Management, Inc., unless a client service agreement is in place.

 
Legal Information   |   Privacy Policy