With Christine Benz, Director of Personal Finance at Morningstar
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Christine Benz, Morningstar’s Director of Personal Finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: Five-Star Strategies for Success, relayed the importance of the 4 percent rule.
The 4 % Rule
The well-known 4 percent rule was designed by financial planner William Bengen to help retirees determine the right amount to withdraw from their portfolios each year without running out of retirement funds.
Aside from being simple to remember, the 4 percent rule assumes a certain rate of return and equity allocation from a mixed portfolio, meaning anyone using the rule will need growth potential from the portfolio, a challenge for anyone uncomfortable with the inherent volatility of the stock market.
Benz pointed out that, in the last 30-plus years, investors had high yields at the outset of the period but were also able to benefit from capital appreciation on bonds. Whether that environment would remain over the next 30 years has been a matter of debate and speculation. Starting yields serve as a great predictor of what an investor will likely earn from bonds or a bond product. When rates were much higher and rates were then declining, the value of those bonds would rise. Benz stated that an investor had to be comfortable with knowing that a portion of their portfolio probably would not have a tremendous return, at least over the next decade.
The 4 percent rule should be viewed as a starting point for discussion rather than a hard-and-fast investment rule. Each portfolio must be viewed individually, taking into account lifestyle, goals, amount of money invested, and age of the investor.
So What Should You Do?
To better determine the right approach for an individual investor, Benz advised seeking professional help and making use of the Monte Carlo simulation, a system that inserts the element of unpredictability into the equation. This allows the advisor to consider numerous financial scenarios to better calculate the best amount of withdrawal for a particular portfolio.
In closing, Benz believed individuals with more seasoned retirement portfolios could probably afford to take a little more out since they had survived harsher financial environments.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: I’m very happy to welcome back Christine Benz, who is Morningstar’s Director of Personal Finance. She’s also the author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: Five-Star Strategies for Success. Hey, Christine, welcome back to the show.
Christine Benz: Hi, Steve, it’s always a pleasure to be with you.
Steve Pomeranz: Thanks, I wanted to talk to you about this old idea that I continually hear about in my practice, and that is the 4% rule. Are you familiar with the 4% rule?
Christine Benz: Why, yes, I am. [LAUGH]
Steve Pomeranz: [LAUGH] Shocking.
Christine Benz: It comes up a lot in retirement-planning circles.
Steve Pomeranz: I know, so, take a moment to describe that rule.
Christine Benz: So, the rule was arrived at by a financial planner named William Bengen, and his idea was that he wanted to help retirees determine how much they could take out of their portfolios per year and spend without running out of money during their retirement time horizon. So like a 25-or-30-year time horizon. And, so he stress-tested a bunch of different percentage rates, starting percentage rates, over market history and found that if you took 4% of your portfolio, initially.
So in year one of retirement, say if you had $1 million portfolio and you took $40,000 from that portfolio and then you took roughly that same amount that gave yourself a little bit of an inflation adjustment as the years go by. So, maybe 41,500 in year two and so on. That based on market history, you were unlikely to run out of money. So that’s where the 4% guideline was born. It was meant to just be kind of a starting point for something that is really difficult to get your arms on when you’re just embarking on retirement.
Steve Pomeranz: There is something about that 4% number that makes it so easy to kind of glob onto it as a solution to, as you said, this complex retirement question of how much can I take from my portfolio? Because to this day, I still hear about it often when discussing retirement distributions, I always hear about the 4% rule. So let’s get into some of the meat and potatoes of it. So, first of all, it assumes a certain rate of return because if you’re pulling out 4% plus inflation where your money has got to be growing by some amount, of course.
Christine Benz: Right.
Steve Pomeranz: And so, what kind of portfolio was he talking about? What was the mix, let’s say, between stocks and bonds?
Christine Benz: I believe the mix he worked with was like 50% stocks, 50% bonds or something in that neighborhood, maybe, 60% equity, 40% bond.
Steve Pomeranz: Okay, mm-hm.
Christine Benz: But definitely, in order for the 4% guideline to have worked in the past, it relied on having an ample equity allocation. So that’s something that people need to know if they’re thinking of taking anything like 4% initially. Well, you need to make sure that you have stock exposure, ample stock exposure because your portfolio needs some growth potential.
Steve Pomeranz: Yeah, which is a problem for many people because they just really can’t stand the volatility of the stock market, and they think, the extreme ones, think the stock market is rigged. Or, it’s just somehow a casino, when I think you and I know that that’s really not how it works, although there are some fringes that work like that. But basically, there’s some underlying good fundamentals for being stocks. But nevertheless, you’ve got to have a fairly good proportion of stocks in the portfolio. Now, the bond portion of the portfolio, I mean, today interest rates are in the 3%, say 2 to 3% area?
Christine Benz: So a little better than they have been in the recent past.
Steve Pomeranz: Yeah, well, it’s better than zero, that’s for sure.
Christine Benz: [LAUGH] Right.
Steve Pomeranz: [LAUGH] But when this formula was derived, interest rates on bonds were much higher, right?
Christine Benz: Well, that’s absolutely right. So, that’s been a subject of some debate in retirement planning circles is sort of that are the raw materials for good investment returns, in retirements, specifically from bonds going to be there. Because over the past 30-plus years, we’ve had this great environment where investors had high yields at the outset of the period, but then they were able to benefit from capital appreciation on bonds. So even though we saw yields decline, bond prices picked up over the past 30 years.
Steve Pomeranz: Yeah.
Christine Benz: Which has been hugely beneficial for bond investors. The big looming question is, will that same sort of favorable environment persist over the next 25 to 30 years? And that’s really an open question.
Steve Pomeranz: Well, just doing some simple math. I mean, if you’re dealing with a 3% return, let’s say today-
Christine Benz: Right.
Steve Pomeranz: And you buy, whether it’s a mutual fund or an ETF of bonds, no matter what, you’re still going to get that 3%.
Christine Benz: Well, that’s the thing, yep.
Steve Pomeranz: Yeah, go ahead.
Christine Benz: Starting yields are a great predictor of what you’re likely to earn from bonds or from a bond product.
Steve Pomeranz: That’s the beautiful thing about, that’s what the beautiful thing about bonds is that-
Christine Benz: Right.
Steve Pomeranz: What your starting yield is what you’re going to get.
Christine Benz: Pretty much.
Steve Pomeranz: Pretty much, yeah, I mean, right. So unlike the stock market, you never know what you´re going to get, but you think it’s going to be x. Anyway, when rates were much higher and rates were then declining, the value of those bonds would rise. So you’d have this 5 or 6 or 7% rate of return from the locking in of the bonds themselves. But the value of the bonds in your portfolio or in your mutual fund would rise, so your total return, interest plus capital appreciation, was fairly attractive.
Christine Benz: That’s right.
Steve Pomeranz: The question is, at 3%, rates are, they’re probably not going to go down from here and give you that boost. So basically, at best, you’re probably going to earn the initial rate of return, which today we’re seeing as 3%.
Christine Benz: Right, exactly, exactly.
Steve Pomeranz: Mm-hm, okay.
Christine Benz: So, you have to be comfortable with knowing, at least that portion of your portfolio probably will not have a tremendous return, at least over the next decade. Beyond that, it’s hard to say.
Steve Pomeranz: If you have a 50-50 portfolio and you’re hoping for 7% and 50% of the portfolio is at 3%, you’re going to have to get something like a 10-12% rate of return on the equity portion, which is probably not going to happen.
Christine Benz: That would be my bias, too. I think that’s probably a problematic assumption. In fact, if anything, I think that there’s too much fear about bonds and probably too much optimism about stocks, at least over the next decade, I, personally would not be surprised, at least given where valuations are today, if maybe equity market returns were sort of in line with bond returns over the next decade.
Steve Pomeranz: Well, that’s going to change a lot of things.
Christine Benz: So that’s a sobering prognostication, but I think people need to be sober. At least when thinking about planning for the next ten years.
Steve Pomeranz: All right, I want to move to the next level here. So, I would say that, like you said, it’s a starting place for discussion, but the 4% is not something that you should count on, this 4% withdrawal rule. So, there’s got to be another way, and there is another way, and that is through Monte Carlo simulation. Can you tell us a little bit about that?
Christine Benz: Well, it sounds like you probably use that in your practice.
Steve Pomeranz: I do, yeah, yeah.
Christine Benz: And so, that would be another way to arrive at withdrawal rates, and there are a lot of different strategies. Here I would say, this is a great spot because withdrawal rates are so pivotal in terms of your retirement plan, success or failure. This is a place to reach out and get some help from a professional. To help determine what is the right approach for you given your asset allocation, given your risk tolerance, given your time horizon, and retirement. So, I do think this is a spot to get some professional help, and a lot of professionals like you would use Monte Carlo simulation.
Steve Pomeranz: We do because they give many scenarios, thousands of scenarios of different rates of return, different sequences of returns, some years up, some years down and the like.
Christine Benz: Right.
Steve Pomeranz: And by doing that, you end up with a probability of things working out. And as the probabilities converge to a set of numbers or small range, you can have a higher and higher level of confidence, kind of like hurricane tracking-
Christine Benz: Right.
Steve Pomeranz: While there’s no perfect answer, at least you have a sense for your own particular personal set of circumstances how much you spend, how much money you have. What you want your life to look like, how much your vacations are. Whether you want to leave money behind for your kids, a certain rate of inflation. All of these are put into it, and I think it’s absolutely a more advantageous way of getting to your number in terms of what is the right withdrawal. Unfortunately, we’re out of time, Christine, you have some final words for us?
Christine Benz: Well, I just wanted to say, Steve, I think it does—another crucial thing to keep in mind is just think about the starting environment of when you embark on retirement because that has such a huge determinant of how much you can take out. So, if you’re embarking on retirement right now, I would be a little bit more conservative for people who are already 20 years into retirement. They probably can take a little bit more of their portfolios because they have made it through some difficult environments like the financial crisis, like the early 00s dot-com sell-off.
Steve Pomeranz: Yeah, also there’s less time. Unfortunately, there’s less time left-
Christine Benz: Exactly.
Steve Pomeranz: To spend the money, so that risk is debated somewhat as well.
Christine Benz: Exactly.
Steve Pomeranz: Christine Benz, Morningstar Director of Personal Finance has joined me today. Christine, as always, thank you so much. I appreciate it so much.
Christine Benz: Thank you, Steve.
Steve Pomeranz: And don’t forget everybody to hear this interview again or if you got a question about what we just discussed, we invite your questions, we love to get your questions and to help you out. Visit us at stevepomeranz.com. Sign up for our weekly update, where we’ll give you a brief rundown on the important topics that we’ve covered that week, and it’ll go straight into your inbox. That’s stevepomeranz.com