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Tuesday 15 September 2020

Bullet-Proofing The 4% Rule

Don't let the market shoot holes in
your financial freedom
If you are familiar with the 4% rule, you will know that it's a great guide for retirement planning, as well as for managing your drawdown in retirement.

A quick recap on the 4% Rule if this is the first time you are hearing about it – the 4% Rule is based on some research which found that, historically, the maximum starting drawdown (money you take out) of an investment portfolio should not be more than 4% of the portfolio’s value if you don’t want to run out of money in retirement. You can then increase this amount by inflation and, in theory, you should be good for many decades.

The rule came about because of a dilemma that has (and will continue) to plague us – how do you make sure your money lasts for the whole of your retirement?

The 4% Rule is a great way of answering this question, but it is of course just a guide – there is always the very real possibility that it does not work out (I ran some of the numbers a few years back, and while the rule is pretty solid, it is not a sure thing (nothing ever will be))

Running out of money in retirement could be a f-up of epic proportions big problem, and it is definitely a risk that anyone retiring (early or otherwise) would like to mitigate.

On the other hand, there is another (way more palatable) problem with the 4% rule – it often leaves you dying with way too much money. We would all hate to be left wishing we ordered the lobster in Monte Carlo instead of the burger in Umhlanga.

Nice problem to have though!

Right, so how do you deal with these two problems? How do we balance our drawdown rate so that we don’t run out of money, but are able to spend/give more to ensure we don’t die with a proverbial shit-tonne of money either?

Well, you could mitigate the risk of running out money by using a lower starting drawdown rate (e.g. using 3% instead of 4% will make it far less likely you will run out of money). But then you considerably increase the likelihood of dying with far too much money.

Conversely, you could make sure you get some decent spending out of your portfolio by using a higher drawdown rate (e.g. using 5% means you will be able to spend more.) But then it is far more likely that your investment balance will hit 0 while you still need an income.

So it seems benefiting on one side leaves you light on the other, and vice versa…

I think a slight tweak is required…Let’s throw another rule at the problem.

The 20/10 Rule

When you layer the 20-10 rule on top of the 4% rule, you end up with a nice framework that is able to manage both the problem of running out of money as well as the problem of dying with too much money.

Here’s how it works.

You start your drawdown rate as per usual (e.g. at 4%). Then, just as the 4% rule allows, you adjust the amount you take out of your investment portfolio by inflation with each passing year. Nothing unusual here.

But while you are doing this, you also keep an eye on the investment balance of your portfolio. With each passing year, as the markets do what they do, your balance will rise and fall. And here is where you start applying the 20-10 rule.

Before drawing down on your portfolio each year, check what percentage of the portfolio your planned withdrawal is at.

The 20 part of the 20-10 rule now kicks in.

If the percentage you are planning on taking out differs by more than 20% of your starting drawdown rate, then you adjust the amount you would have taken by – yes you guessed it, the 10 part of the 20-10 rule – 10%.

In other words:
  • If your next drawdown percentage is >20% higher than your initial drawdown percentage, it means your balance is low, and the chances of you running out of money is now higher. So you have to take a 10% pay cut.
  • If your next drawdown percentage is >20% lower than your initial drawdown percentage, it means your balance is growing, and your chances of running out of money has decreased. So you can give yourself a lekker 10% pay rise.
Okay, all that is a bit of a mouthful, and it may seem quite complex. So I think it's time for an example to help simplify and explain it.

Let’s say you call it quits with an investment balance of R9 Million. You start your drawdown at 4%, and take out R360k to cover the next year of expenses (that’ll give you R30k a month).

So the first thing to do, is bed down the 20% of the 20-10 rule.

If the starting drawdown is 4%:
20% more than 4% => 5%
20% less than 4% => 3%

So, if the amount you are planning on drawing out ever gets to 5% or more, you will need to take a pay cut of 10%.

And if the amount you were planning on drawing out ever gets to 3% or less, you will give yourself an increase of 10%.

For this example let's assume that inflation is 5%.

So each year you increase the amount you take out by inflation, as the 4% rule allows. In year 2 you take out R378k, and the year after that R396,900 and so on.

That means, in the fifth year, you would be planning to take out R437,580.

Now let’s look at two scenarios.

Scenario 1 – Low Market Returns

Let’s say the market had not performed as expected, and there were a few years of low/negative returns. As a result, your investment balance after 5 years is R8.58 Million.

Since you planned on taking R437,580 from R8.58 Million, it means your planned drawdown is 437,580/R8.58 Million = 5.1%

This means the drawdown percentage has breached the 20% high level, and you need to implement a 10% pay cut. Instead of drawing out R437,580, cut that by 10% and take out R393,822.

Of course this isn’t lekker, but at least you will not be blindly relying on the 4% rule and increasing the risk of running out of money.

Scenario 2 – Good Market Returns

Now let’s say the market had a good run in those 5 years, and your investment balance reaches R14.6 Million (never say never!)

Since you planned on taking R437,580 from R14.6 Million, it means your planned drawdown is 437,580/R14.6 Million = 3%

The drawdown percentage has hit the 20% low level of 3%, and it’s time for a 10% pay rise. Nice! Instead of drawing R437,580, up that by 10% and take out R481,338. Go on an extra holiday, spoil somebody, donate to charity.

This is how the above two scenarios look in picture form (click for a larger image).

In the following year you continue aiming to increase the drawdown amount by inflation, and you again check the percentage you are taking out to see if you have hit the 20% high and low level (5%/3%).


And that's pretty much it!

The 20/10 rule is a great addition to your retirement drawdown tool kit. It helps protect you in environments where returns are low by stopping you from eating too much out of your retirement capital. At the same time it allows you to increase your spending if the circumstances permit.

While the 4% rule is pretty rigid and can fail if the market is not on your side - adding the 20/10 rule on top of it gives you some flexibility, and can be a great way to reduce your retirement drawdown risk.

Till next time, Stay Stealthy!
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