Things that can go wrong with the 4% rule
By Lizelle Steyn
1 August 2019
Last week I covered the 4% rule and how to use it to calculate your magic number. As mentioned it's just a rule of thumb - a good one, though - and like all simplification it has the potential to trip you up if you're not aware of the shortcomings. Here are the most important things that can go wrong with your journey to financial freedom if you navigate by the 4% rule.
1. Your portfolio doesn't beat inflation by 4%
The 4% rule works on the assumption that your portfolio needs to beat inflation by 4% per year for your money to last forever. If you download my fianancial freedom calculator (link below) you'll see that once you reach your desired financial freedom age, your portfolio value stays constant for decades when converted into a figure that shows it's value in today's terms. Why is this?
In my calculations it's assumed that inflation will be 6% in future and your portfolio will grow at 10%, in other words 4% more than inflation. If you withdraw that 4% every year, your portfolio is left with the 6% growth, which is equal to inflation, which means in today's terms your portfolio value stays constant.
But to beat inflation by 4% you need to include some high-growth assets like shares, equity ETFs, balanced funds, and listed property. If you put your shares in low-growth assets like money market funds and fixed income funds, your chances are almost zero of getting a return of 4% more than inflation; 2-3% more than inflation is more realistic. That means it will take longer to get to your magic number, plus your magic number might not be that magic after all and after a few decades you might run out of money, as shown in the 8% growth chart (click on the 8% growth tab on the financial freedom calculator).
2. The value of your portfolio goes up and down
This is a very important part of long-term investing and we all need to be well prepared for what's actually going to happen with our portfolios. When you invest in the type of assets that will beat inflation by 4% per year, that refers to the average performance of your portfolio. The charts shown on my financial freedom tool are therefore all theory. In practice, your portfolio will never perform in a straight line. Some years you'll get 15%, other years 5% or even -20%!
So, brace yourself for lots of ups and downs in terms of the actual amount that you get when you withdraw 4% of your portfolio every year. The best preparation is to keep bringing in some active income doing something you enjoy, so you have the option to use that instead of your portfolio to live from in those 'down' years.
3. The sheriff wants his share
You may have shot the sheriff by investing in only tax-free accounts and retirement funds, but once you start drawing money you can't get away from the deputy. A tax-free account is always tax-free in every way, but retirement funds are more tricky. While your money stays invested in a retirement fund, you won't pay income or dividends tax on your income, or capital gains tax when you switch between funds. But once you start drawing an income from your retirement funds, chances are you'll need to pay at least some income tax. And you'll also need to consider capital gains tax when cashing in your unit trusts or ETFs.
You'll therefore have to build some fat in when deciding on an amount that you'll need to draw down every year by adding a buffer to your expected expenses to reach a before-tax amount. How much to add will vary greatly, depending on how you blended tax-free accounts, retirement funds, unit trusts and ETFs into your portfolio.
4. All your money is stuck in retirement funds
Retirement funds, for example RAs, are often ignored by the financial freedom community, because they only allow you to start withdrawing money at age 55. But they have a long list of benefits, the most attractive being the tax relief they offer before retirement - especially for high-income earners. It's not such a great idea to invest your entire portfolio in them, though. If you reach your magic number before age 55, all your wealth will be stuck in retirement funds and the only way you can get any money out would be if you decide to formally emigrate or have the misfortune of poor health and can prove that you have a low life expectancy. So, make sure part of your portfolio is also in tax-free accounts, ETFs, unit trusts or property so you have something set aside for the pre-55 years.
Despite all its shortcomings, the 4% rule is still a reliable guide towards your magic number. Just make sure you're prepared with the right vehicle (a mix of high-growth assets), something for the taxman, and the right attitude, always prepared to occasionally jump out and earn some income when your fuel tank drops along with the markets.