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Commentary

Should You Trust the 4% 'Guideline' for Your Withdrawal Rate?

Financial expert and author JL Collins shares his insights on the recent discourse around the 4% rule.

On The Long View podcast this week, JL Collins, financial expert and author of his latest book How I Lost Money in Real Estate Before it Was Fashionable, discussed real estate, retirement, and his experience with homeownership. 

Here are couple of excerpts on retirement planning from Collins’ conversation with Morningstar’s Christine Benz and Jeff Ptak:   

Retirement Income and the 4% Rule 

Ptak: I wanted to shift and ask you about retirement income. I think you've said that the 4% guideline can be a good starting point for people who want to decide if they've saved enough to be financially independent. Are you concerned that 4% could be too high in an era in which equity valuations are quite high and bond yields are so low? 

Collins: I think there's been a lot of hand-wringing about the 4% rule of late in the last few years, and it kind of reminds me of a few hundred years ago, theologians evidently were debating about how many angels can dance on the head of a pin. I think the problem comes when people say 4% rule. I think if you change that and said 4% guideline, then you're good, because 4% is not a hard and fast rule. If you look at the Trinity study, a 4% withdrawal rate adjusted for inflation over 30 years is just one of the many scenarios that the study looked at. It happened to be one that had a 96% success ratio. And so, it became very popular. But the truth is when you look at that research, 4% is very, very conservative. Five percent, 6%, even 7% withdrawal rates were successful on many of those occasions. So, I look at the 4% rule and I say it's inherently conservative. And by the way, I don't mean to suggest anybody should start drawing 7% from their portfolio, at least not without looking at the Trinity study. So, I think 4% is a pretty reasonable and fairly conservative number. 

Having said that, when I last hung up my last corporate job, I think my withdrawal rate was about 5% because my daughter was in college at the time, and I was comfortable with 5%, because looking at the Trinity study, 5% has an extraordinarily high success ratio. But I was very careful to keep an eye on what the stock market was doing. And fortunately for me, during those years, the wind was at my back. As I mentioned earlier, the markets done nothing but rise for the most part over the last decade, and I've benefited from that. Had the market turned around and plunged again, then I would have adjusted that withdrawal rate in a heartbeat. And so, I don't think anybody would, and certainly nobody should, say I'm going to withdraw 4% or 3%, for that matter, and I'm going to just do that automatically and I'm never going to think about this again, because there is a risk inherent in it. The 4% rule, even before the current environment you were describing, did fail 4% of the time--no connection to the two numbers. So, you're never going to want to do any percentage withdrawal and just set it and forget about it--not only because you might run out of money, but even more importantly, and more likely, your money is going to grow far beyond that withdrawal rate. And if you don't pay any attention, you could wind up 30 years later with a huge pile of money that you could have enjoyed along the way. So, you not only want to monitor it so you don't run out, you want to monitor it so you get the maximum benefit from your holdings. 

What Should Investors Do in the Short Term?  

Benz: One area where you run counter to the conventional wisdom is that you're not a big fan of dollar-cost averaging. You note that the market usually goes up. So, you're just better off getting that money to work in the market as soon as possible. That makes sense for people with long time horizons. But what about for people who are closer to drawdown or financial independence--whatever you want to call it--who do come into a large sum of money? Are they better off dribbling it in over time to protect themselves against the risk of plowing a bunch of money to work into the market at precisely the wrong time? 

Collins: Christine, first of all--and you've alluded to this already--but let's be clear that when I was talking about my daughter and that she's putting money in on a regular basis, and that smooths the ride, that's a form of dollar-cost averaging. And I'm very much in favor of that. But the kind of dollar-cost averaging you're asking about, and you did make this clear, is what if you wind up with a lump sum of money for whatever reason. And in that case, as you correctly say, I am not a fan. 

My thinking about it is this. If you dollar cost average, it's only going to work for you if for whatever period you choose to deploy that money, the market goes down. Because if the market goes up, that means that every additional amount of money you put in, you're going to get fewer shares for that. So, let's say, to make the math easy, you have $120,000 that your rich uncle has left you. And you say, “I don't want to take the risk of putting this $120,000 in all at once because tomorrow might be the day the market crashes 40%. So, I'm going to break it up into $10,000 chunks and I'm going to invest it over the next year.” Well, if the market goes up, the second month you invest you're getting fewer shares for your $10,000 and the third fewer and fewer. So, you will wind up with a less-good result at the end of the day. By the same token, if the market just stays flat, your result will be less because it took you longer to put that money to work. The only time that you benefit is if in fact the market drops, whether it drops suddenly or just drifts lower over that year, then it will work in your advantage. 

We have to sit back and say, “OK we have to make a choice. Which of those things is more likely? Is the market more likely to go up over this year, I'm going to do it? Or is it more likely to go down?” Well, the market goes up three out of four years. To be clear, it doesn't go up three years, and then go down a year, and then go up three years and down a year. It's not that reliable; but on average. So, you have 75% chance of doing less well with your dollar-cost averaging against the 25% chance of maybe it working out for you. So, that's one of the core reasons, I'm not a fan of dollar-cost averaging. 

But here's the kicker. Let's suppose that you dollar cost average, and maybe the market drifts up a little bit, maybe it drifts down a little bit. But at the end of the day, you've got your $120,000 deployed. And then, the day after that is the day the market drops 40%. My point being, you haven't protected yourself from that drop you fear at all. Because the moment you're invested, whether you dollar cost average in or you lump sum, you are always at risk of the market dropping. And as we talked about a little bit earlier, nobody knows when these drops are coming. If you're going to panic and sell, you don't want to follow my advice, you don't want to be in the market at all. You have to be willing to accept the fact that at any given moment, the money you have invested in stocks has the potential of dropping dramatically. And so, dollar-cost averaging doesn't protect you from that, at least not in the long term, and you should be investing for the long term. 

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.