September 14, 2012
Written By Jack Bowers
“You’ve just retired, and your portfolio is your main source of income. How should you invest, and how much can you safely withdraw from your nest egg? Bill Bengen, a California advisor, attempted to answer that question 20 years ago: Maintain a mix of 53% stocks and 47% bonds, and rebalance annually. Start by liquidating 4% of your portfolio balance the first year, then adjust that dollar amount upward by the rate of inflation (CPI). With that approach, Bengen contended, odds are high that your portfolio will last at least 30 years.
“He then added other asset classes, eventually raising his starting point recommendation to 4.5%. Still, his original series of papers were popularly enshrined under the moniker of ‘The 4% Rule.’
“In the 1990s this rule seemed too conservative, and today some would argue that it’s too aggressive. But after running my own evaluation with data starting at the end of 1976 and using the Fidelity Puritan Fund (FPURX) as a stand-in for Bengen’s 53/47 stock/bond portfolio, I’ve concluded that 4% is a solid starting point that’s unlikely to result in disappointment down the road—even in the current era of reduced expectations.
“The longevity of a portfolio with annual living expense withdrawals, rising in tandem with the CPI, is affected more by the rate of inflation than by the returns that are attainable in the stock and bond markets.
“Bengen’s worse-case 30-year test period, the one that actually defined the 4% rule, started in 1969. It began with two bear markets only about five years apart, and was followed by surging inflation and rising interest rates after that. The rapid cost-of-living hikes burdened the portfolio, causing them to reach double- digit withdrawal levels just seven years after retirement began. In contrast, an investor retiring in the year 2000 with a 4% starting draw would only be liquidating at a 6% rate today. While investment returns have been worse in the more recent 12-year period, they haven’t slipped far behind inflation like they did from 1969- 1981.
“Bengen’s nearly even split between stocks and bonds is no accident, and it plays a key role in creating a robust portfolio that stands the test of time. Stocks and bonds only rarely take a dive at the same time, limiting the magnitude of a loss in the short-run. And rebalancing allows for buying low and selling high, much like dollar- cost-averaging. …
“For those with the flexibility to deviate from an inflation-adjusted income stream, it may be possible to substantially extend the life of a stock/bond portfolio. By starting with 4% withdrawals and limiting the annual inflation adjustment to 3% or less, you’ve got a good shot at making your portfolio last 50 years or more. And if you further limit the annual draws so they never exceed 4% of your portfolio’s value, the stage may be set for your nest egg to provide living expense support for an indefinite period.”
Jack Bowers, Fidelity Monitor & Insight, September 2012