The 4 Percent Rule: Is There a New Normal for Canadian Retirees?
How much do I need to retire? How much income can I create from my investment portfolio? These are two of the most common and important questions that retirees will often ask.
Those two questions are certainly related, or let’s say one can determine the other. If you can earn a 7 percent annual return from your investments that will generate much more income compared to investments that only earn a 1 percent return. A $500,000 portfolio generating that 7 percent return could pay out $35,000 per year and maintain the original portfolio balance. You get ‘paid’ that $35,000 and you still have your initial $500,000.
A 1 percent return on your portfolio will only deliver $5,000 per year. Of course you could simply take out the $35,000 per year from your lower yielding portfolio, but over time the money will disappear.
So how much can you ‘safely’ take out of your retirement investment portfolio?
The financial gurus would suggest that spending 7 percent of your portfolio is much too aggressive. The gold standard retirement studies suggest that you can take out 4 percent – 4.5 percent of your portfolio value, inflation adjusted (2-3 percent annual increase in spending) and you will have a high probability of success over a 30 year period. You are creating perpetual income, just as would a pension. In fact, if your investments are positioned sensibly you are mimicking a pension – you are creating your own pension.
It’s an industry standard so much so that they call it – The 4 Percent Rule.
The 4 Percent Rule: A Safe Withdrawal Rate in Retirement
The 4 percent rule is based on the work of Bill Bengen. The rule has been challenged and studied perhaps more than any other research in the retirement landscape. Mr. Bengen also took another look and challenged his own 4 percent rule in this 2012 article for Financial Advisor Magazine, How Much is Enough?
Here’s the final thought from Mr. Bengen in that article. While there are no guarantees in life, and in investing, the rule of thumb has held up.
In summary, the 4.5 percent rule (and its infinite variations for time horizon, tax bracket, current market valuations, etc.) may be challenged in coming years. However, it appears to be working now.
The sensible retirement portfolio (pension) will typically consist of two components, a growth component (stocks) and a risk reducing agent (bonds). Durable income is created from enough growth in the stocks in a lower risk or lower volatility arrangement. Investing can be quite simple, even in the more ‘complicated’ retirement funding stage. Once again, we’re back to that simple mix of stocks and bonds. As always, we want to keep our fees as low as possible. This is no time to be paying ‘others’.
But is that 4 percent rule dead? Many think so. The reason for that is that the bond component of the portfolio, well, it kinda stinks these days. Or at least the yield or income from the bonds is nothing to write home about.
Challenges with the 4 Percent Rule
Go back a couple of decades and your basic lower risk investment grades bonds would pay retirees 6-7 percent. The bonds on their own were enough to create durable income in a lower risk environment. Retirees did not need to take on much or any stock market risk. These days it might be difficult to generate more than 3 percent from your bond component. The yield on Canadian Bond Universe Exchange Traded Fund (ETF) XBB from iShares is 3.18 percent.
Yields have started to creep up over the last year, but they are still historically low. And bond yields can stay low. They do not have to go up just because they are down. Bond yields can and have in the past stayed very low for decades. We should always keep in mind that we do not know where bonds will go over time, just as we do not know where stock markets will go over the near term.
And speaking of those stocks, it appears that retirees need some of that growth potential if they’re going to be spending at that 4 percent rate, inflation adjusted. The problem there is that many write that stocks are ‘expensive’. We’ve had a long stock market run (at least in the US where we’re in the midst of the second longest stock market run in history) and those stocks also might not deliver ‘like they used to’. Vanguard suggests we might only see 3-5 percent returns for portfolios over the next decade or more.
While inflation is expected to remain low, investors should expect the nominal rate of return on their investments to be in the range of 3 to 5 percent, compared with historical averages of 9 to 11 percent, a panel of Vanguard economists said.
So, we’ve got bonds that might not do their thing. We’ve got stocks that might not do their thing. Yikes! So much for that 4 percent rule, or are too many of the experts crying wolf? I checked in with James Gauthier, the Chief Investment officer at JustWealth, one of the leading Canadian robo advisors.
Here’s what James had to say…
“… we review our longer-term forecasts annually, and our estimates for longer-term equity returns is 7 percent – this is below historical returns (if you go back far enough), but has been a pretty consistent estimate for us over the past few years. Our estimate for bonds is 3% which is again below historical returns, but it has moved up modestly from previous years as yields have begun to creep up off their lows established a few years ago.”
I’d have to agree that stocks might continue to ‘do their thing’. There is decent economic growth in Canada, the US, and around the globe. We should keep in mind that many of the stock market naysayers are referring to those US markets. The Canadian stock market (TSX) has not experienced that mostly uninterrupted roaring bull market run. Many will write that the Canadian and International markets are poised to outperform the US markets over the next several years.
Once again, we’re back to simple portfolio construction, that’s why we hold Canadian companies, US companies and International companies, and we manage the risk with bonds.
When you buy a stock or stock market fund or ETF you are buying a current yield, just as a bond delivers a yield. Today, the Canadians companies are ‘making you more’ (current yield) than those US companies. And that basket of International companies is making you more than the US basket.
Embracing the 4 Percent Rule
I would suggest that Canadian retirees still embrace that 4 percent rule. That means for every $100,000 that you hold in your portfolio(s), you might withdraw and spend $4000 – $4500. That 4 percent rule or guideline will also allow you to estimate how big a portfolio you might need in retirement to reach your spending needs or goals.
There’s no guarantee of success of course in anything that is investment related, but based on stock and bond market history, there is a very decent ‘chance’ of success. And here’s the thing, as a retiree you don’t have to sign on to the 4 percent rule in stone. If the stock markets do all tank in concert for many years, and the bonds are not offering enough support, you can adjust your spending plans – and spend less.
As always, I’d suggest that retirees and near-retirees consult with an advisor to ensure they they’re on track and to check that the portfolio is set up in favourable fashion to create durable income. You can use a fee-only advisor, meaning that you can pay a one time fee for the advice that you need, and then you can move on to self direct your investment portfolio. An advisor will also ensure that you are set up to withdraw your funds in the most tax efficient manner.
Thanks for reading. Happy investing. Happy retiring.
And thanks to Robb for allowing me to share some thoughts with readers of Boomer and Echo.
Dale is a still-recovering former advertising writer and creative director. He then moved on to become an advisor on lower fee index funds. These days Dale helps Canadians find the many sensible lower fee investment options available by way of his site, cutthecrapinvesting.com
An important caveat that doesn’t get enough attention is that many of these studies don’t include the effect of fees. Michael James on Money had a great post a few years ago on that — even using a robo-advisor paying ~0.7% (headline fee + MER of underlying funds) would cut the “4% rule” down to the “3.6% rule”. For someone paying 2.4% at their local bank branch (though said person isn’t likely reading this anyway), the 4% rule becomes more like the 2.75% rule.
Hi Potato, that is a great reminder. And it brings up the truth that perhaps fees are even more important in the retirement funding (decumulation) stage. Of course, and ETF route might be best on that front. Or ETF plus individual stocks to eliminate some MERs.
Keep in mind though that some of the Robo’s can do ‘things’ that might offset the fees, or some of the fees to help with retirement spend rate. Retirement funding success comes by way of growth in a lower volatility setting, or having some of those negatively correlated to stock assets. Some of the robo’s design for better risk adjusted returns. I am doing a robo series. A second pass at the robo’s will be on retirement funding models, where they might exist.
Keep in mind that taxation with affect spend rate as well, for those who are fortunate enough to have taxable portfolio assets. Again that’s why a check up might be in order. Money well spent at times.
Dale
I think a variation of the 4% rule works fine as long as you continually review and adjust spending. There are 2 main risks: investment return, which you discussed, and inflation. But you can control the inflation part if you adjust your spending. I think the more important thing is to understand the math … if you always make 4% (net of fees) and you withdraw it all, then you can keep doing that (with no inflation adjustments) forever. At the very least, if your return is zero, your money lasts 25 years. So, you should be good for somewhere between 25 years and forever. If you apply that rule regularly throughout retirement, you’ll always know where you stand. The real problem with decumulation is that compound interest starts working against you once your assets have gone below a certain threshold. And there’s a huge issue if your assets run out by 90 but you live to 95. My conclusion: I can’t spend every penny before I die … I’ll have to leave something to my kids.
Hi Karen, great post. Yes as per the article, we keep an eye on the spend rate. That is the key. And we can certainly adjust that spend rate on the fly. That said, many will choose to mostly deplete or draw down the portfolio value over time. They say the best estate planning is to mostly ‘die broke’. 🙂 There are times when we don’t want to have considerable assets in a portfolio, the tax man will come in year of death. Also, retiree spend rates mostly decline over time (after a period of enjoyment), so the 4% rule is not really based on how retirees spend. We spend in waves and patterns.
There are so many nuances to personal retirement funding. That’s why these ‘rules of thumb’ are only guidelines for general framing or op line planning. We are all snowflakes, especially snowbirds.
Dale
That’s a very good point Potato. And since you brought it up there is a question I’ve been meaning to ask about Fees but not sure how to ask without sounding too ignorant. The question is as follows; The fees are set by whom exactly? And why are the fees not adjusted to market values? I mean I understand people need to get paid for the work they do but wouldn’t lower fees attract more volume and thus create their income regardless? Then again I suppose it falls to those big profits banks always seem to make / report. Maybe I just answered my own questions???
As I recall, the 4% was the average yield from a 60% Equity/40% Fixed portfolio that would last a 65 year old until age 90. This is over a long period of history and without any fees. Any contributions from OAS, CPP, or pensions would reduce the need for 4%. S&P500 total return over the last 20 years has been just over 8%! So we have been lulled into a false sense of security. I think the only safe approach is to have a healthy equity component and adjust spending based on market returns.
Hi Keith, the need for that 4-4.5% spend rate is based on the investment portfolio and does into take into account the CPP and OAS and other pensions. One might use the portfolio to fill the gap, after pension amounts.
The greater chance of success comes by way of a very aggressive portfolios according to many studies.
Dale
We spend 1.8% of our portfolio after 15 years of retirement, largely because of other pension amounts received. We are working to increase it by gifts to charities and family, as well as Blowing More Dough!
Hi Keith, now that’s a perpetual spend rate even in a Balanced Income model. Congrats on that.
Dale
Hi Gert, there’s really two worlds when it comes to fees. With ETFs you can see the pressure to keep fees low (and they have been coming down over the last decade). There, fees are a main point of competition, and when Vanguard entered the Canadian market you could almost feel the competitive tension kick up. Then there are most mutual funds sold at bank branches or fund firms like Investors Group. There the fees are nearly invisible, and not a point of competition (indeed, few would consciously choose them over DIY or robo-advisors if they knew how much they were paying for what they were getting), so fees have remained high.
I know that CIBC started showing the fees explicitly last year, and they show up as deductions to our accounts monthly.
When I first came to Canada in 1976, I started work selling encyclopedia! door to door. The trainer asked each of us what our goal was and at that time I was making $3.5 per hour and the banks were paying 8-10% on Savings. I told my trainer I needed $85,000 saved in the bank and I would retire. Fast forward to 2018 I think I need 10 times that.
Isn’t this all rather theoretical, considering that government dictates how much you have to withdraw from an RRSP/LIRA? And it’s much more then 4%.
Take it out of your RRIF/LIF and put it in your TFSA. You don’t have to spend it.
Hi Karen, and then we have those tax considerations of course for monies removed from RRIF and LIF. The gov get’s their piece eventually.
Dale
Paul: withdrawing from an RRIF is not the same as spending. You can take money out of your RRIF and continue to invest it in your TFSA or non-registered account (or take money out and spend that as well as additional funds from your non-reg or TFSA, depending on your retirement spending needs and where your portfolio lives at the time).
Also, the 4% rule was based on the initial portfolio, but the RRIF formula is of the current balance. So if you start spending $40k/yr out of what at age 65 is a $1M portfolio, by the time you’re 85 and looking at a 8.5% minimum withdrawal, that might be $54k (with inflation) of a $635k portfolio. Or a $2M portfolio, depending on how things go.
Good article about issues with the “4% Rule”!
The truth is that that the “4% Rule” does not work for most retirees – especially now. The 33-year bond bull market from 1982-2015 is completely different now that interest rates have stopped falling.
The 4% Rule suggests you can make a safe retirment income by withdrawing 4% of your investments every year and increasing that by inflation.
The problem is that most retirees invest conservatively. They often use the “Age Rule” (your age is the percent of bonds in your portfolio), which directly conflicts with the “4% Rule”.
In the last 150 years, using the Age Rule and the 4% Rule, 31% of retirees would have run out of money. Few people would feel safe with a 1/3 chance of running out of money during retirement.
Retirement is long and bonds can be killed by inflation. Stocks are much more risky than bonds short term, but are more reliable long term (20+ years).
The “4% Rule” should be replaced with a less catchy but reliable: “2.5% + .2% for every 10% in stocks Rule”.
For example, the “4% Rule” has been reliable 97% of the time in history for retirees that invested 70-100% in stocks. (My study is here: https://lnkd.in/dZEUj8D )
Ed
Thanks Ed, I agree that the age = bonds is a bogus rule of thumb. A more aggressive stance has a much higher rate of success, but most retirees do not like that added volatility.
Thanks for the link and info.
Dale
Great Summary of the 4 % rule, I’m glad you pointed out at the end that if you are flexible in your spending from year to year depending on market conditions it can greatly increase your probability of sucess. Fire Calc https://www.firecalc.com/ is a fun online retirement calculator that allows you to play with a lot of the different options for implementing the 4 % rule and what effects it will have on your success rate.
Flexibility is key, plus if you’re retiring early it’s quite possible you’ll earn some money in the future, even if you didn’t intend to.
Retiring right now using the 4% rule might be a bit risky given the current bond yields and equity multiples but as long as you go into it knowing that you might need extra flexibility in the next 5-10 years then you’ll be able to avoid much of that risk in the short term if you need to.
Thanks Owen, yes we keep using the word flexibility for good reasons. I will make hay while the sun shines.
Dale
Income from bonds is taxed heavily, the same as employment income. Income from the dividends paid by Canadian corporations (not foreign or US stocks) is negligible by comparison. It is possible to generate a steady 6% to 8% dividend income. At the same time, if you chose stocks that have the potential for their share price to grow, you can see the capital worth of those stocks easily double over time. The problem with bonds is you have to pay a significant fee, based on their total value, to buy them and a significant fee to sell them. They are a lousy investment. Stocks can be purchased, no matter what the value of the purchase, for less than $10 per transaction – as long as you manage your own portfolio. Paying an investment adviser 2% of the value of portfolio, no matter what the results, is guaranteed to enrich the adviser but not necessarily the investor. Not taking the time to learn and understand why you money is invested in any asset is begging for your portfolio to disappear over time.