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May
05

Rule of Thumb
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If you follow a rule of thumb you can retire successfully or… beat your wife?

It is often claimed (incorrectly, as it turns out) that the phrase “rule of thumb” gave a husband permission to beat his wife provided he used a stick no bigger around that a man’s thumb. It turns out that in 17th and 18th century England and America, this rule of thumb was often rejected by the courts and ridiculed as nothing more than an excuse for spousal abuse – which it clearly was.

 

So, rules of thumb can often be poor guides to accomplishing a goal. In fact, even the origin of many of these “rules” is uncertain. Another example is the rule that in retirement you can withdraw 4% of your retirement nest egg annually and chances are the money will last for the rest of your life.

 

But this rule of thumb needs some clarification. For example:

  • Withdraw 4% of what? Of the beginning year balance in the nest egg? Or is it 4% of the nest egg balance when you retire?

This can make a difference. For example, if your nest egg on the day your retire is $100,000, the rule states that you can withdraw $4,000 in year one. In year 2 say the balance has grown to $103,000 ($100,000 minus $4,000 withdrawn plus $7,000 in earnings). Do you withdraw $4,000 in year 2 or can you withdraw $4,120 ($103,000 times 4%). What if inflation was 5% for the year? The amount withdrawn $4,120 will not have kept up with inflation.

  • What if you retire at age 60 rather than at age 65 – does that mean you can still withdraw 4% even though it may be over a much longer period of time?
  • What happens if in year 1 the market goes through a correction and in year 2 your nest egg retirement account has dropped to $80,000? That would reduce your annual withdraw at 4% to $3,200. Ouch.

The 4% rule of thumb is supposed to work like this. Once you establish the withdrawal amount in year 1 ($4,000) you can increase the withdrawal by inflation to keep up with the cost of living. So if inflation in year 1 is 5% you can increase the withdrawal to $4,200 ($4,000 times 5% is $200). The withdrawal amount increases regardless of what happened to your nest egg (even if the nest egg increased to $120,000 due to a big year in the stock market, you still only withdraw $4,200).

The idea is to provide you with a predictable source of cash flow – something that you can’t do if the 4% withdrawal is tied to the value of the nest egg. Presumably, someone tested this withdrawal rate against all the possible returns a retirement nest egg can achieve and concluded that a 4% withdrawal rate had a greater than 90% chance of lasting x number of years (for sake of argument let’s say 30 years) before being depleted.

OK, but what doesn’t the rule of thumb tell you? It doesn’t make allowances for extremes in the market – say a drop of 50% or more over a short period of time by the stock and bond market. If we’ve learned nothing else over the last few years we learned that the unexpected (the so-called black swan!) does happen.

At Core Capital Solutions, LLC we believe establishing a withdrawal plan at retirement is crucial but we do not use a rule of thumb. We review withdrawal plans with our clients once a year and make changes, if necessary. If you think your situation is not unique, that economic conditions never change and you are just like every other retiree, the 4% rule of thumb may be for you. If you believe you are unique and a good withdrawal plan is a flexible plan, call us.

Written by Life After 65.