The 4% rule is often used by investors to figure out how much they can safely withdraw from their portfolios annually without running the risk of losing it all.
According to this rule, an investor can withdraw 4% of their portfolio value each year without worrying about running out of money. This rule is based on the idea that a portfolio’s return will average out to be around 7% per year, so withdrawing 4% will ensure that the portfolio will last for at least 25 years. However, there are several reasons why this rule is not a good idea. William Schantz will explain some of them below.
Why the 4% rule is an Outdated Concept
According to William Schantz, the biggest reason why the 4% rule is not a good idea is that it does not account for inflation. Over time, the cost of living will go up, and 4% of your portfolio’s value will buy less and less.
For example, let’s say you have a portfolio worth $100,000. If you follow the 4% rule, you can withdraw $4,000 per year. But if inflation is 3%, then after 10 years, your portfolio will only be worth $79,511 in today’s dollars. This means that your $4,000 withdrawal will only be worth $2,916 in today’s dollars.
Sequence of Returns risk
Another reason to be careful with the 4% rule is that it doesn’t account for the sequence of returns. This is the order in which you experience gains and losses in your portfolio.
For example, let’s say you have a portfolio that consists of 50% stocks and 50% bonds. Over a 10-year period, the stock market might return an average of 7% per year while the bond market returns 3% per year. However, this doesn’t mean that you will earn 3% on your bonds and 7% on your stocks every single year.
Change of Needs Over Time
The 4% rule does not account for the fact that people’s needs change over time. There can be any reason for this, like job loss, medical bills, or even the desire to retire early.
For example, let’s say you lose your job and need to withdraw 8% of your portfolio each year for the next five years. If you’re following the 4% rule, you could only withdraw 4% per year. This would not be enough to cover your needs and would likely lead to a decrease in your standard of living.
Investment Returns Will Vary
Another issue with the 4% rule, as per William Schantz, is that it assumes that investment returns will be constant. In reality, returns will go up and down over time. There might be some years where you would earn more than 7% and other years where you might only earn 3%.
Effect of Taxes
When an investor withdraws money from their portfolio, they may owe taxes on the withdrawal. This can reduce the amount of money available to them and cause them to run out of money sooner than they would if they had not withdrawn the money.
Increase in Life Expectancy
Finally, the 4% rule does not account for the fact that people live longer than they used to. This means that an investor may need their portfolio to last for 30 years or more, which is a longer timeframe than the 4% rule is designed for.
The 4% rule for investments used to be a good idea. However, as William Schantz has highlighted, it is no longer relevant today. People are better off following a more conservative withdrawal rate, especially if they are retired or close to retirement. Withdrawing 4% of your portfolio each year may not be enough to cover your needs, especially if you live a long life.