Since Bill Bengen’s study on this approach back in the 90s, some variation of his 4% Rule is often used in Monte Carlo simulations to see if a retiree’s portfolio is capable of outliving the retiree. While some just look at the high market returns of recent years & suggest that we can withdraw at a far higher rate, there are others who suggest that even the 4% withdrawal rate might be too high to use going forward.
Who is right?

As I get closer to retirement, I’d love to buy a basket of funds yielding 8 or 10% & live high on the hog with those juicy distributions all the way to the end. But I probably won’t do that. Here, I’m going to use 4 funds that have been around for more than 25 years to illustrate why it might be worth paying attention to the 4% Rule. I’m using a mix of American & Canadian funds. I’m ignoring the currency differences, the tax implications, & many other things but, despite that, I think this example will illustrate some interesting points. Many of the newer funds are too new to have much history to look at, but SPY (SPDR® S&P 500® ETF Trust), XIU (iShares® S&P/TSX 60® Index ETF), CLM (Cornerstone Strategic Value Fund, Inc.®), & FBNDX (Fidelity® Investment Grade Bond Fund) all have some history behind them. Indeed, the S&P 500® Index is often used as the benchmark that other funds are measured against. And very few can outperform this index, for total return, over the long haul.

For this example, we’ll look at four retirees with a million dollar investment in each of those funds. And we’ll start the exercise with some folk who retired at the beginning of 2020. That $1m is more than the average Canadian retirement savings, by the way, but it’s a nice round number for doing mental math. Each retiree withdraws 4% in the first year & increases that amount by the rate of inflation (US inflation numbers used for all) for each subsequent year. Why that approach? Because the portfolio income stream then compensates for inflation in a manner similar to OAS & CPP. Income will be able to keep pace with the increasing cost of groceries, gas, rent, etc. Going from 2020 up to the end of 2023, the income stream would grow from $40k to just under $48k for all four portfolios. All good, considering the higher inflation rates of recent years. After those withdrawals, the underlying portfolio values at the end of the period are SPY ($1.37m), XIU ($1.21m), CLM ($1.18m), & FBNDX ($830k). All four portfolios delivered exactly the same income stream, but the underlying value of all the equity funds went up. While the bond portfolio lost value. But don’t give up on bonds just yet, we’re not done!

As a side note, the idea that we can just live off the distributions feels great, but it doesn’t always work. CLM would have delivered huge distribution cashflows, almost $200k in the first year. But if we sucked everything out along the way the underlying fund value would have dropped to about $641k at the end of 2023. And the total distribution for 2023 would have dropped to $131k. Those are not desirable trends. On the other hand, all the other funds would have distributed too little income & selling some shares to boost income to the 4% level would have been required. I know retirees don’t like having to sell shares for income but, for the rest of this example, we’re going to stick with the approach of reinvesting all the dividends & distributions throughout the year. And then selling shares equivalent to the annual income requirement going into the next year.

Now let’s back it up to retirees starting this whole process in 2015. At the end of 2023, they have been retired for 9 years in this scenario. All portfolios delivered the 4% income stream, indexed to inflation, so that income went from $40k at the beginning, to $52.3k at the end. Ending portfolio values were SPY ($2.05m), XIU ($1.36m), CLM ($1.6m), & FBNDX ($760k). SPY put in a stellar performance over this time, the SPY retiree might be adding a luxury cruise or a boat to the retirement bucket list now, eh! CLM, the high yield fund, outperformed the Canadian index by a nice amount, while the poor bond fund took it in the teeth again.

Next, we’ll jump back another 5 years, to start the process in 2010. Once again, income increased for all portfolios, going from the starting $40k up to $56.8k in the final year. Portfolio values at the end were SPY ($4.00m), XIU ($1.62m), CLM ($1.09m), FBNDX ($799k). OMG (that’s not a ticker symbol!), I wish I could go back in time & stick everything into an S&P 500® Index fund! It looks so good, we should just go all in & look forward to retirement, eh?
Not so fast!

For retirees starting in 2005, the income stream would grow from $40k at the beginning, to $64.5k at the end. The portfolio values at the end of this time period are SPY ($2.72m), XIU ($2.28m), CLM ($77k), FBNDX ($637k). That’s a bit of a shocker, CLM is almost wiped out this time. I should point out that American investors can reinvest the CLM distributions at the lower of Net Asset Value or market value. I’m not sure how much this would improve the results for a US investor. But this is focused on Canadians & we can’t do that. Instead, we would have suffered from the significant drawdowns in 2007 & 2008. Those impacted CLM’s value from that point forward. Over this time period, the Canadian fund didn’t look so bad against the American index. And the bond fund, though it lost value, is still hanging in there & delivering income 19 years later. It’s also notable that investing in SPY five years earlier resulted in a significantly lower end portfolio value today, than we had in the last pass. While XIU, under its market conditions, did comparatively better by starting earlier.

One last entry point, this time we’ll start in the year 2000. It’s the same story for starting out with a $40k income, gradually increasing in line with inflation. But the first-pass results only go up to 2014, not our 2023 end point. Because CLM went to $0 in 2014! The dot-com bubble bursting in 2000 hurt all the equity funds for a couple or three years after the bubble burst, but CLM took it hardest. When it got hit again in 2007 & 2008, there just wasn’t enough gas left in the tank to support the 4% withdrawal guideline & it went to zero. Here are the portfolio values at the end of 2014 … SPY ($464k), XIU ($1.19m), CLM ($0.00), FBNDX ($1.22m). That’s pretty interesting now. The American index is seriously suffering & it’s been well surpassed by the Canadian Index. And who knew bonds were so useful. Over this time period, when some pretty bad stuff was happening in the markets, FBNDX was the best performing fund of the bunch!

Let’s do one more run, but without CLM this time. All the remaining portfolios survived up to today & they delivered an income stream that grew from $40k back in 2000, up to $72.9k in 2023. Job done on the income front. Portfolio values at the end of 2023 were SPY ($327k), XIU ($1.50m), FBNDX ($850k). Over this 24 year period, given the withdrawal schedule, the Canadian index fund was a clear winner for end value. And while the bond fund also did well, the American index underperformed. This might be unimaginable for an investor who’s been getting rich on the S&P 500® Index over the past decade & a half. Interestingly, if no withdrawals were being made (an accumulator’s portfolio, rather than a retiree’s portfolio), SPY would have a value of $5.0m at the end of 2023, compared to XIU at $4.7m, & FBNDX at $2.64m. The timing of withdrawals over different timelines & under different market conditions can seriously impact end values. That’s the sequence of returns risk that retirees worry about.

Just for fun, let’s look at a couple of time periods where we start with a 10% withdrawal rate. That means that the million dollar portfolio starts out with a $100,000.00 income stream, increasing by the rate of inflation thereafter. If we begin in 2000, CLM went to zero in 2006. SPY went to zero in 2007. XIU went to zero in 2010. FBNDX went to zero in 2012. None of these portfolios survived more than 13 years. Let’s be real here, the period from 2000 to 2010 was a bad one. But nobody knows when the next bad decade will arrive. If we leapfrog that terrible decade & start in 2010, CLM delivers that $100k+ income stream up to 2019. FBNDX expires in 2021. XIU dies in 2023. Only SPY survives ’til the end of 2023 & the portfolio is still worth $1.68m at that withdrawal rate. Makes for great retirement guesswork, sorry planning, when we do this for ourselves, eh!

On every funds’ website & literature, you’ll find a line about past performance not being of any use in predicting future performance. While that is 100% true, that does not mean that we can’t learn something from historical performance. And this little exercise highlights a few things that should make us pause & think.

One of the most important insights for retirees is that a high withdrawal rate, or living off a high yield, is a bet on good returns over the course of that retiree’s retirement timeline. And it is a bet that the retiree won’t be hit by sequence of returns risk, where an early big hit hurts the durability of the portfolio for the rest of the retiree’s, or the portfolio’s, lifespan. It’s also a bet that high inflation won’t destroy portfolio value in the early years. Look, retirement is a bit of a gamble anyway. Most of us have no idea how long we’ll survive. But we would like our portfolios to survive as least as long as we do. It’s all about striking a balance between living the good life in the go-go years. And, should it be necessary, having enough money for a long term care home at the back end. Everyone’s situation is different too. Some retirees will have a bigger & more secure income from OAS, CPP & company pensions than others. Leaving something for the kids will be important to some, but not for all. There are many factors that can influence withdrawal rates. But all retirees will want their portfolio to survive to the end. Now these sample “portfolios” won’t represent the typical well-balanced or well-diversified portfolio of the average Canadian retiree. However, that wasn’t the point of the exercise. It’s more about thinking cautiously. And using the lessons of history to guide an appropriate level of caution when it comes to withdrawal rates.

Despite Warren Buffet’s advice to just buy an American index fund (& there may be nothing wrong with just owning an S&P 500®Index fund for a 100 year investing horizon!), it might not be an appropriate sole holding based on the real retirement timeline for many retirees. While we would all love to have a high yielding portfolio that delivers steady income, going all in on high income funds may not be the solution for everyone either. It’s worth comparing the total return of any such funds against a selection of domestic & international equity & bond index funds. It’s hard to beat index funds for total return. And if the index funds can’t always guarantee the 4% income stream over a long retirement, then living off the proceeds of a fund that yields 10% might not be viable over the long haul either. Compare the total return performance over a long enough timeline to see if the fund is outperforming the market index funds by enough to justify the higher withdrawal rate. Through good times & bad. If it’s not, then caution is warranted. That doesn’t mean that such funds have no place in a portfolio. There may well be a justification for adding a little income boost in the go-go years, for example. But it does require some careful assessment. After all, it’s never a bad thing to cover your donkey (😜)! In case the markets deliver some negative surprises at the wrong time. Or if retirement goes on for longer than your portfolio expects!

At the end of this exercise, all we can really take away is that the 4% Rule might serve as a good baseline to assess the durability of our retirement income stream. Retire at the right time & we might get away with a far larger withdrawal rate. Retire at the wrong time & even a 4% withdrawal rate might be challenged. Unfortunately, none of us knows what happens next.

Newer investors should also be cautious about recency bias. The outstanding performance of the S&P 500® over the past decade & a half might, or might not, continue. The performance of bonds in 2022 was so bad that some newer investors are avoiding bonds altogether. Note that the original study that created the 4% Rule was based on a 50:50 portfolio of US stocks & bonds. However, there are times when international markets outperform the US. The Canadian market outperformed the US market from 2000 to 2010. Many new high yield funds are considered safe because the underlying holdings are blue chip companies. Just remember that a bad baker can start out with great ingredients & still bake a lousy pie! Only time will tell which of these fund managers will be able to deliver a good total return from these newer income funds. And even for those with a market-matching, or even with a market-beating, performance, taking all the distributions for living income may not allow the portfolio to survive over the course of a long retirement. And finally, all our circumstances are different. A retiree with a lower expected number of years in retirement might withdraw more aggressively. One with a greater life expectancy, & with a goal of leaving lots to the kids, might play a far more conservative game.

Since my crystal ball is broken, I think I’ll be sticking closer to a 4% withdrawal rate when my retirement day rolls around. If you know how to do better, please let me know.

For some, all this may be too challenging to manage. Despite the fees involved, there is nothing wrong with paying a professional to manage your portfolio for you. And to manage the retirement income stream throughout retirement. For some, that will be a good choice. Though figuring out how to choose a good financial advisor has its challenges too.

If you want to learn more about all this from the ground up, I’d like to suggest that you check out Double Double Your Money, available at your local Amazon store.

Important – this is not investing, tax or legal advice, it is for entertainment & thought-provoking purposes only. Data may not be accurate. Check the current & historical data carefully at each fund’s website. Opinions are my own & I regularly get things wrong, so do your own due diligence & seek professional advice before investing your money.