The Rule of 4%


Have you ever heard of the 4% Rule? The idea behind this old-fashioned concept was that you could afford to spend approximately 4% of the value of your portfolio each year and never run out of money. This was standard thinking back in the days when a traditional balanced portfolio consisted of 60% in stocks and 40% in bonds.

What was the basis of the 4% Rule? The math only works on the assumption that, back in those halcyon days, stocks provided a long-term total return (growth and dividends) of 10%, and intermediate-term bonds, a taxable yield of 6%. Thus, with 60% in stocks @ 10% and 40% in bonds @ 6%, the expected return each year would be 6% plus 2.4% for a total of 8.4%. The 4% Rule assumed that taxes and the inflation rate would take 4.4%, leaving 4% that could be spent. The assets attributable to inflation would be invested so that their purchasing power would not be eroded over time. This math did not account for those in the highest tax brackets, periods of high inflation, or the fact that stocks can never be relied upon to deliver a 10% total return!

Roll forward a couple of decades, and many investment folks started to cast doubt on the 4% rule being relevant in a world where interest rates were around 2%, and the return of the stock market was running at 8%. Under these conditions, the math for a 60/40 portfolio would be 4.8% plus 0.8% for a total of 5.6%. With inflation and taxes running at more than 1.6%, this left less than 4% to spend. Some argued that the new “spend rate” should only be 3%.

To whom does the 4% (or 3%) Rule apply? The media and most studies on this topic are concerned with the average American. Vanguard recently published its annual study on the savings patterns of Americans (How America Saves 2022). The study reported that the median balance for defined contribution retirement plans (the ‘centerpiece’ of private sector retirement in the US, according to Vanguard) was $87,725 for those aged 65 or older. The median balance for those earning over $150,000 p.a. was $225,478. At retirement, the ‘median’ American would have to use social security and any savings to supplement the meager income available from their retirement accounts under the 4% Rule. Whether they can make it through retirement without continuing to work will depend on the level of their expenses.

It stands to reason that, given a fixed level of expense, the more investment assets an individual owns, the less dependent they will be on the 4% Rule, and the more they will be able to allocate to assets that can grow over time. As an example, with expenses of $10,000 per month, it would be possible to have an investment portfolio of $5mm almost entirely in equities and live off the dividends.

In summary, it is important to understand who the audience is. The 4% Rule might well only have relevance for the mythical average American.

Nick Hoffman