The 4% rule vs the 8% rule
It’s every passive investor’s dream to build up a wealthy portfolio that can safely fund their post-retirement years. The purchase of real estate is one of the most popular wealth building strategies employed by the passive investor to enjoy consistent passive income going into the future. However, it can be confusing to figure out just how much income you need to support yourself throughout retirement while retaining a comfortable level of wealth.
What Is The Four Percent Rule?
If you’ve spent any amount of time looking into retirement planning, you’ve likely heard about the four percent rule. This has been around since 1994 and was coined by William Bengen, a world-renown financial advisor. This rule was constructed to help individuals figure out how much money they should be withdrawing from their retirement portfolio each year to ensure the balance covers them for 30 years.
” Retirees should withdraw four percent of their retirement portfolio their first year of retirement. That amount should then be adjusted each subsequent year by the inflation rate to ensure a steady income for 30 years. “
Let’s Look At An Example
To better solidify the four percent rule into your wealth building knowledge, let’s work through an example. Let’s say you have one million dollars in your retirement account. Upon your first year of retirement, you can spend four percent of that total amount.
$1,000,000 * 4 Percent (.04) = $40,000
In this example, you may spend up to $40,000 in the first year of your retirement. After the first year, you’ll need to take inflation into account. Let’s say that your second year of retirement has a two percent increase in the inflation rate. Let’s do the math to figure out how much you can spend during your second year of retirement.
We’ll start with the base amount of $40,000 that we calculated the first year. We’ll want to add that two percent to our base amount to get the total amount we can spend during the second year of our retirement.
$40,000 * 1.02 (1 + 2 Percent) = $40,800
According to this example, you can spend a total of $40,800 throughout the second year of your retirement. The amount of money you can spend each year can go up or down, depending on how inflation moves. For this same example, let’s say the inflation rate actually decreased by two percent. The math would look like this:
$40,000 * .98 (1 – 2 Percent) = $39,200
Assumptions Of The Four Percent Rule
The four percent rule is a broad rule of thumb that uses historical data from stocks and bonds over a 50-year period. It’s very simple and has helped financial planners and retirees work to set a viable portfolio withdrawal rate that they both understand. However, this broad rule doesn’t take into account things like inflation, life expectancy, and other similar factors.
When the four percent rule was initially announced by Bengen, he utilized some initial assumptions about the market. These are the following:
- 3 Percent Historic Inflation Rate
- 7 Percent Stock Return
- 4 Percent Bond Return
- 50 Percent Stock / 50 Percent Bond Allocation
The Flaws Of The Four Percent Rule
With every hard and fast rule, there will always be some flaws that can diminish its capabilities to prove effective for a passive investor. It’s important to consider what these flaws are so you can successfully out maneuver them to ensure the four percent rule works for your passive investing strategy.
Assumed Investment Mix
In this case, the first major flaw is that this investment strategy assumes you’ll have a 50/50 mix of stocks and bonds. When Bengen researched the 50 year past of stocks and bonds, he created the four percent rule based on how they fluctuated. Unfortunately, not every investor, especially those who rely heavily on real estate passive investing, are following this investing mix to grow their wealth.
If you weigh more towards putting 80 percent of your retirement funds in bonds, you won’t have the same outcome as those who put 50 percent in bonds and 50 percent in stocks. The same goes for real estate. The only investment mix taken into account was 50 percent stocks and 50 percent bonds. Any investment portfolio with a different investing mix will produce different results.
Outdated Bond Rates
It’s currently 2020, and the four percent rule was established back in 1994 based on data from the previous 50 years. A lot in the investment world has changed, including bond rates. When you look at charts from the 50 years before 1994, bond rates were significantly higher than they are today.
Putting this into simple terms, bonds don’t produce the same level of return they did when Bengen created the four percent rule. This can throw a wrench in your ability to continue to withdraw from your retirement for at least 30 years.
Could The 8 Percent Rule Be The Answer?
Many financial experts are changing their recommendation from the four percent rule to the eight percent rule. The idea is that people are working longer and don’t need as much in their retirement fund. In fact, many who have followed the four percent rule have found that their retirement actually outlives them. While this is great news for beneficiaries, this means that retirees may have skimped out too much on their needs.
A Look At Early Retirement
It’s very easy to get attracted to a rule of thumb like the four percent rule for its simplicity. However, life is not simple, and our needs change over time. One of the biggest areas of failure that many financial advisors point out regarding the four percent rule is that some retirees are not eligible for social security or their pension until a few years after retirement.
To receive social security benefits, you must be 62 years or older. If you opt for retiring earlier, say age 60, that leaves you with two full years of no social security passive income. If you follow the four percent rule, it can be difficult to scrape by on your retirement funds alone. The eight percent rule can allow you to have more money to live off of throughout those years without social security.
Huge Retirement Accounts Upon Death
When Bengen did his research of stocks and bonds, he used historical data from a 50 year period. This period was from 1926 to 1976. It’s important to note that this took into account the great depression years from 1929 to 1933. This inclusion has swayed the return ratios a lot.
During Bengen’s own research, he showed that many individuals could make their retirement last for up to 50 years. However, he stuck to guaranteeing 30 years in the event that economic crises take hold. This has resulted in many retirees finding out that the four percent rule can be adjusted.
While it may be nice to pass some money down to your children, you should consider the bigger picture. When you switch to using the eight percent rule instead of the four percent rule, you’ll have more money to spend on enjoying time with your children and grandchildren. Whether it’s affording special vacations or taking everyone out for an expensive dinner, you can do it when you live by the eight percent rule.
How To Plan For The Eight Percent Rule
Now, you should have a pretty good idea of what the four percent rule is and why you should switch it out for the eight percent rule. The next question that comes to your mind maybe, “Well, how much do I need to save in my retirement account?”. The eight percent rule is very simple for understanding how much to spend once you’ve retired. But, you’ll have to do some math to discover how much to actually contribute to your retirement account.
You’ll need to start by reverse engineering your retirement portfolio amount. We know that you’ll be withdrawing eight percent of the total amount in your retirement portfolio in your first year of retirement. So, what amount seems like a viable sum of money that you could comfortably live off of for the year?
Consider Your Expenses
It’s important to consider what your financial situation will be when you retire. While you likely will no longer have a mortgage payment, there are some other expenses you should consider that your passive income from retirement will need to cover. These include:
- Home Insurance
- Property And School Taxes
- Internet / Television
- Cell Phone
It’s a good idea to add up what the total costs of these will be to get a ballpark estimate of what you’ll need. Of course, things are going to be more expensive in the future, and you’ll need to plan for that. When assessing the total amount you’ll want to have available to spend during your first year of retirement, you’ll want to add in a buffer of 15 percent of the total amount.
Don’t Forget A Buffer
Let’s say you’ve determined you’ll need $30,000 to pay for your annual expenses. Let’s multiple $30,000 by 1.15 to get your total amount with the buffer. This amount equates to $34,500. So, you’ll want eight percent of your total retirement portfolio at the time of your retirement to equal $34,500.
For those math wizards out there, you know that your retirement portfolio needs to have $431,250. If you’re lost, let’s review the process. We’re trying to discover the total portfolio amount you’ll need, let’s call this “X”. We’ll put this into an easy to understand formula.
X (Portfolio Amount) * .08 (8 Percent Rule) = $34,500
To figure out X or the portfolio amount, we’ll need to divide $34,500 by 8 Percent. This amount equals $431,250. Let’s check our work. We have $431,250 in our retirement account. We’ll spend 8 percent of that amount in the first year of our retirement. So, $431,250 multiplied by 8 percent equals $34,500. This is the total amount we determined we’ll need to spend the first year of our retirement.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.