How much retirement savings does a person need to retire safely, making sure they don’t run out of money?
As someone with relatively simple tastes and I’ve always imagined that with a nest egg of a couple million dollars I wouldn’t have trouble retiring without touching the principal. I came to this conclusion by using the 4% rule — a conservative investing rule that seems more like a rule of the universe than any specific thing someone came up with. But there is, of course, a history to the 4% rule.
The History of The 4% Rule
William Bengan, a financial advisor, first devised the 4% retirement rule in 1994. Since then it has been in the air as a fairly cautious approach to retirement spending. According to his original paper (linked below) withdrawing 4% of your portfolio (adjusted for inflation, so starting with 4% and increasing distributions slightly each year to adjust) would have protected retirees from running out of money during every 30-year period since 1926, even considering the Great Depression.
The 4% rule dictates that you should able to safely withdraw 4% from a 50% stock / 50% bonds retirement portfolio without risking the principle too much. So the 4% rule has typically been thought of as a safe, conservative drawdown strategy to aim for, but if you needed to, you could probably let your withdrawals creep up to 5% or so. Here’s the theory:
Historical Yields of SP500, DOW and Bonds
Stocks have historically yielded between 8-10%. SP500 has yielded an average annual return of 10.49% since its inception in 1957 (it actually existed in some form, only 90 stocks originally, as far back as 1926, but we won’t go there). The Dow Jones has yielded an AAR of 7.75% in the last hundred years (since 1921) without adjusting for dividends, which is currently yielding 1.81% because of some big dividends yielders like IBM, Verizon and 3M. So that nets out to 9.56% for the DOW. Let’s take the lower of these two and call stock performance 9.5% on average.
Bonds are trickier to calculate. We have been in a declining bond yield environment for 38 years — (bonds were paying 13.75% in 1984). I downloaded a historical 10 year treasury 54-year historical dataset and ran the average, which came in at 5.9%. If we use a shorter average (we have the data set, why not), for the last 20 years we get 2.92%. They are currently paying 3.04%. So let’s use 3% which seems fair.
Now that we have our historical rates of return, let’s figure out what our hypothetical $2,000,000 nest egg will earn us.
The 4% Rule In Action
We’ve divided our portfolio into 50% stocks and 50% bonds, so we can easily average 3% and 9.5% and get 6.25%. 6.25% will earn us $62,500 per million in the bank, so our hypothetical retirement portfolio should increase by $125,000 per year without us touching it. But, of course, we do want to touch it. We need it to produce enough income to live on. Recent census data shows that the median retirement income in 2021 for retirees 65 and older is $47,357. The 4% rule dictates that we can withdraw $40,000 per million, or $80,000 per year, safely from out $2,000,000 portfolio. Great! That doesn’t even account for social security income or any other income we might have in retirement. With this calculation we have a 2.25% margin of safety, too, which should allow our investments to continue to grow as the cost of living increases, or if there are any unexpected extra expenses.
Links:
The DOW Jones
https://indexarb.com/dividendYieldSorteddj.html
https://tradingninvestment.com/stock-market-historical-returns/
Bonds
https://fred.stlouisfed.org/series/DGS10
https://www.macrotrends.net/2016/10-year-treasury-bond-rate-yield-chart
Bill Bengan Paper:
https://www.retailinvestor.org/pdf/Bengen1.pdf
