For decades, business owners and investors have been taught to follow the 4% rule. By never withdrawing more than 4% of the portfolio value in a given year, they could make their funds stretch far into the future. Sounds great, right? So, what’s the problem? No two people are exactly alike and we all have unique financial needs. Let’s take a closer look at how business owners can avoid the dangers of the 4% rule.
Follow Along By Podcast or Video:
- 02:02 – How Should Business Owners Adjust Their Plans Given The Dangers Of The 4% Rule
- 03:58 – What is the $5 Rule
- 06:02 – A Rigid Timeframe
- 08:35 – Sequence of Return Risk
- 12:58 – Rule of Thumb
- 17:17 – What Does All This Mean
- 20:33 – Conclusion
The 4% Rule ~ By Definition
Before we dive too deep, let’s take a moment to refresh our memories on the 4% rule. In 1994, there was a researcher named William Bengen who came up with a great idea. He decided to take historical financial data, dating all the way back to the great depression, and determine how much could be taken out of an investment portfolio each year without running out of money.
The way the 4% rule works is still a bit of a mystery to many people. Oftentimes, people have the misconception that you can withdraw 4% of your investment balance and that you can do this indefinitely without ever depleting your funds. The truth is that 4% is a static number that it is meant to last over a 30-year timeframe.
You see, the annual withdrawal is calculated by the first year of the 30-year span. Whatever your investment balance is in year one, you can take 4% of that and that will be your number each year. For instance, if your investment balance is $1 million, you could pull $40,000 from your portfolio. It doesn’t matter if your balance increases to $1.1 million in year two. You still must use your year-one calculation.
There is a caveat, however. Bengen accounted for inflation. What this means is that even though you can only use your first year’s calculation, you may also include a percentage raise to account for the previous year’s inflation rate. If you found that the previous year saw a 2% inflation, then you would actually be able to pull $40,800 in year two.
The Trouble With The Rule
In my opinion, the 4% rule has some dangers that come with it. For one, success is defined by having any amount of money at the end of the 30-year term. It doesn’t really matter if you have $20 million or $20 as long as there is a remaining balance at the end of 30 years. In addition, Bengen’s study used higher fixed-income rates than we currently have at our disposal. Lower interest rates could make the 4% rule an unsafe withdrawal rate if they continue.
Not only this, but the 4% rule is an extremely rigid rule of thumb. As you can probably see, this presents a problem because life is anything but rigid. There are many investors and business owners who won’t make it a full 30 years after their retirement. On the other hand, I’ve seen clients who have relatives that are already well beyond 100 years old.
Clearly some people would be able to safely withdraw a much greater percentage from their portfolios and still have money beyond their days. Others may put themselves into a dire financial situation if they follow the 4% rule and end up living beyond 30 years.
Beyond lifespan, many other variables can and will impact how long our retirement funds will last. Do we want to leave a legacy? How many vacations do we want to take during our retirement? Are we able to supplement our income with social security? The answers to all of these questions play a major role in our financial future. So how does any of this relate to us as business owners?
Banking On Your Business?
What we must consider, as business owners, is the fact that most of our net worth is tied up in our businesses. For the majority of us, that equates to about 80% of our total net worth. However, only about 15% of small businesses (less than 500 employees) are sold for a profit and only a handful of those sell for what the owner actually feels they are worth. With numbers like that, it becomes apparent that we need to plan and prepare for our retirement, doing all that we can to diversify away from our businesses.
Where we really run into problems is with our sequence of return risk. Basically, this describes the risk of receiving lower or negative returns early in a period when withdrawals are made from an investment portfolio. Once we’ve retired, our portfolios are basically set. We are pulling from the investment balance but we are no longer adding to it. When we take money from our portfolios the sequence of returns can have a major impact on the overall value of the portfolio.
Essentially, if we have the misfortune of being in a down market during the early portion of our retirement, that will constrain the level of funding for you and your family later on.
How Should We Respond?
Ultimately, we retire on income, not assets. Although the 4% rule has been a good rule of thumb since its inception, it has its dangers. Dr. Wade Pfau of The New York Life Center for Retirement Income at The American College of Financial Services has stated that the 4% rule has withered to just 2.4% in the face of the Coronavirus pandemic. His recent calculations show how drastically our income could be affected by any market downturn. So how should we respond?
Like most financial situations, planning is a good place to begin. Speaking with your financial advisors and developing a plan is the best way to diversify away from your business and to navigate through the possible dangers of the 4% rule. Understanding where the potential “traps” lie on the path to your retirement is the first step to creating an investment strategy that can help you to meet your financial goals.
If you have questions about how you can build wealth outside of your business and prepare for the retirement you’ve always dreamed of, contact us! The Heritage Investors’ team is here to help!