There is a lot of talk in financial planning circles these days about whether or not the 4 Percent Rule still holds true. I am a believer that it the 4 Percent Rule is still alive and well, and I believe that it is an important start for financial planning purposes.
Let me start with a bit of history on the 4 Percent Rule. In the 1990’s, financial planner William Bengen declared that retirees could deduct 4 percent from their portfolios every year (in addition to adjusting up for inflation) and not run out of money for at least 30 years. Analysts and academics verified Bengen’s data and supported his assertion.
All a savvy retiree had to do was have a mix of 60 percent stocks and 40 percent bonds, live on 4 percent or so each year (again, adjusting for inflation), and never have to worry about running out of money. So, a retiree with a $1 million nest egg could live on $40,000 a year for 30 years and never have to worry.
Recently, the Wall Street Journal suggested the 4 Percent Rule may no longer stand- this despite the recent highs achieved by the Dow Jones Industrial Average. Perhaps you heard the collective gasp when that headline dropped.
The Journal pointed out, that while the Dow has been soaring to record heights, growth has been sluggish over the past decade-plus. The Dow hit 11,405 on December 23, 1999. By February 1, 2013 the Dow was at 14,009, only 22.8 percent higher (not including stock dividends).
Despite this, I believe that the 4 Percent Rule still holds true- for those using their portfolios as income-generating engines. Remember, if you can live on just the income produced by dividends, interest, and distributions produced by your investments- you don’t need to worry about how long your principal will last. It will outlive you.
True, we are currently in a period of more muted returns for the major stock averages. Even with the banner year for U.S. stocks in 2013, the Dow was still only 43 percent higher over the preceding 14 years (or about 2.6 percent per year), and 10-year government bonds are paying less than 3 percent per year. But a well-crafted income-focused portfolio consisting of stocks, bonds, real estate investment trusts, and preferred stocks can still generate a yield or “cash flow” of 4 percent.
If we experience even moderate growth in the stock market over the next decade, such portfolios should grow beyond that 4 percent cash flow. So, 10 years from now, a larger nest egg should be able to produce a higher level of income while still using 4 percent as a benchmark.
This is how your income should, over time, be able to keep pace with inflation, and this is why I still believe the “4 Percent Rule” has legs. Here are some examples, as of April 2014, of diversified investments that are right in the important 4 percent range (just in annual income). Please be clear that this historical data and I am not making any recommendations. It is always best to talk to your financial advisor or a trusted source when making decisions that impact your bank account.
XLU Utilities Select Sector ETC: 3.55% yield
AMJ JP Morgan MLP Index Fund: 4.82% yield
DVY iShares Select Dividend ETF: 3.04% yield
HYG iShares High Yield Corporate Bond ETF: 5.93% yield
The prices for these exchange-traded funds will go up and down, but the amount of income they produce should stay relatively stable. The income, too, is subject to change, but it should have a bias over time to increase.
So, focus on the cash flow or yield part of the investing equation, and you should find the 4 Percent Rule is alive and well.
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