Sunday, December 6

Week 231 - Can the 4% Rule Sustain You in Retirement Without Eroding Principal?

Situation: You don’t want to outlive your money. So, you’ll need a retirement plan that is robust enough to stay on track until you’re 100. Monthly payments from Social Security, plus Required Minimal Distributions from a 401(k) Plan, should see you through. However, a fixed-income private annuity or a workplace pension plan won’t keep up with inflation. After age 50, you’re allowed to add $6,500/yr to your IRA, which can contain stocks, bonds and mutual funds of your own choosing. To spend from your “Nest Egg” in retirement, most advisors recommend some variation of the “4% Rule." Its originator, Bill Bengen, back-tested the math (assuming an even split between bonds and stocks) and “found that retirees who withdrew 4 percent of their initial retirement portfolio balance, and then adjusted that dollar amount for inflation each year thereafter, would have created a paycheck that lasted for 30 years”. Nowadays, interest rates are being held at artificially low levels by almost every Central Bank. So, you’d better start your retirement with an appropriate adjustment (~60% stocks and ~40% bonds).  

Mission: Find out if a new retiree who has stocks and bonds in a 60:40 mix can follow the 4% rule without drawing down principal (the initial retirement balance adjusted for inflation). Given that retirement savings are defensive by definition, those bonds should be 10-yr US Treasury Notes and/or a low-cost intermediate-term investment-grade bond fund like the Vanguard Interm-Term Bond Index (VBINX in the Table). Those stocks should be issued by 6 or 7 large-capitalization companies (i.e., those in the S&P 100 Index) selected from the list of Dividend Achievers representative of the 4 defensive S&P industries (HealthCare, Utilities, Communication Services, and Consumer Staples). 

Execution: The Table reflects a 20 yr period of analysis using our standard spreadsheet. The assumption is that retirement began 20 yrs ago, and that each line item had the same value as every other line item at that time. No additional funds have been added. PLAN A represents my approach, i.e., to invest in 7 stocks that are collateralized with 10-yr US Treasury Notes (reinvested upon reaching maturity). PLAN B uses a bond fund instead of 10-yr Treasuries and stocks that are more growth-oriented (see Column L in the Table). Overall, there are 12 stocks in the S&P 100 Index that qualify by having Dividend Achiever status, an S&P stock rating of B+/M or better, and an S&P bond rating of BBB+ or better. NOTE: NextEra Energy (NEE) meets all criteria for inclusion in the S&P 100 and will likely be added soon, making a total of 13 stocks that are suitable for inclusion in a conservative retirement plan.

Bottom Line: Inflation averaged ~2.2%/yr over the past 20 yrs, so the 4% rule would fail to maintain principal if the average total return/yr for Plan A or Plan B were less than 4.0% + 2.2%. Plan A returned over 7%/yr and Plan B returned approximately 10%/yr. So, the value of the original investment, corrected for inflation, remained intact over the first 20 yrs of retirement. The same is true for the past 5 yrs (shown in Column F of the Table) when inflation averaged ~1.5%/yr. There is no material difference between PLAN A and PLAN B, given the slightly higher risk profile of PLAN B (see Columns J through L in the Table).

Risk Ratings: 4 (PLAN A) and 5 (PLAN B)

Full Disclosure: I have stock in KO, JNJ and WMT, and dollar-average into NEE, T, PEP and ABT as well as 10-yr T-Notes.

Note: Metrics highlighted in red denote underperformance vs. our benchmark (VBINX). Metrics are current as of the Sunday of publication.

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