Well, hi everyone! And welcome to another Wealthy and Wise Wednesday. Glad you could join us on our video and podcast today! So how was last week for you? Last week was Thanksgiving. I hope you had a great one, ate a lot of Turkey and pie and maybe had a good nap too.
At the risk of dating myself, I’m going to tell you one of my favorite things as far as music is concerned, I love the old 70s music and I was just listening to one of my favorite bands back in the high school days. It is The Doobie Brothers and one of my favorite songs from them is called Long Train Running. But they redid that. I don’t know maybe a year or two ago. They took some other music artist and revamped them and redid them. And I really like this one. I’m going to just for a second, I’m going to play it for you so you can see what song I’m talking about.
Anyway, you get the idea. It’s a fun song, really like it. But all that old 70s stuff I love those to bands like Kansas, Styx, Aerosmith, Rush and Doobie Brothers. I mean those were good fun times. So maybe every once in a while as we go through these podcasts and videos, I’ll throw out a tidbit or two of some of the music that is timeless in my opinion.
Alright. So here we go. Today, I wanted to talk to you about what’s called the 4% Rule. Now, what the 4% Rule is, it’s kind of developed back in the 90s. And basically, what it was, was a kind of a way to determine how much money you should take out or spend each year during retirement and they came up with what was called the 4% Rule.
If we dial that back a few more years, back into the 80s, that rule might have been a 6 or a 7% rule. See, it is kind of based on what is going on in the economy at that time. And interest rates obviously have a lot to do with it because what happens to most people when they retire is they begin to take money that was more aggressively invested and they put it into more safer conservative investments that are again a little safer, guaranteed, typically your fix type investments. This might be kind of annuities, it might be bonds, it might be a very conservative real estate, but the idea was to come up with this rule that if you took x percent out every year, it should last you as long as your life expectancy would be.
Well, the 4% Rule then, was kind of put together in the 90s again and it became pretty mainstream with the financial planning community. So they would take all your assets, bundle them all together, figure about 4% withdrawal rate and there you have it. But the problem is several things and let’s just cut right to the chase.
By the way, I got asked from a few people on my video why I keep looking at my computer. Well, I want you to know that I’m not necessarily scripted but I definitely have some notes that I want to make sure that I hit and stay on track because otherwise as we get talking we could get way off track or I may miss something that’s really important. So for those of you who are watching the video, I will try as much as I can not to look at the computer but that’s what’s on there. It’s just a few notes just to make sure that I hit the highlights.
But, so back to this 4% Rule and the problem and why it’s no longer applicable in our current environment. It’s a number of things. One is life expectancy. Just even since the 90s, life expectancy has gone another year or two. Not exactly sure where it is this year but last year they were estimating men at I want to say 79 and women at 82. So that again has been expanded and increased over the years, which means that’s another year or two or 3 or 5 of income that we’ve got to produce during our normal life expectancy.
The other is the nest egg that we used to rely on or used to use as a rule of thumb needs now to be much larger. So in other words, if you could get 6% off of your nest egg, or maybe a million dollars would be enough, that produce about $60,000 a year and for a lot of people that would be fine. But now that nest egg needs to be approached in 2 and a half million dollars or more because of where the low-interest rates are.
And that again is the big problem. Interest rates are so low that it’s hard to find fixed instruments where you can get a reasonable rate of return that you can rely on that would be around for a while and that can produce the income that you need off of your nest egg. So between the lower interest rates, it requires a higher amount of capital that we need, and then, of course, the lower return.
So what’s happening is the 4% Rule is turning more into the 2 or 3% rule. 2 being very safe. 3 probably going to make it. But 4 is definitely pushing it unless somehow someway you have a way to build your capital for a few years during retirement or just wait longer until you start taking distributions.
So if you look at a million dollars at a 2 or let us just say a 3% withdrawal rate, that’s going to produce about $30,000 in income. Now, that might be taxable if it’s coming from a 401(k) or an IRA. Depending on your tax bracket that could take a pretty good chunk out. If you take too much out of your 401(ks) and IRAs then your social security gets taxed as well. So all that can help reduce some of your income, which is brutal again based on the fact that you’re trying to get your money to last you as long as you do. Right?
The idea is to have enough money to last at least as long as you’re lifetime if not longer and if you want to leave a legacy for family, kids, definitely want to protect the spouse potentially, those things have to be factored in as well.
Well, there’s this stress test as what I call them but they are technically called Monte Carlo simulations. And what they do is they go back, that’s far back as you want, 30 or 40 years, and they plug in your portfolio and what they do is the Monte Carlo simulations then test or stress test what’s going on in that portfolio and they run it through several different environments like what happens if the markets go up, what happens if the markets go down, what happens if interest rates go up, what happens if interest rates go down, what happens if we have a stock market crush, what happens if we have a real estate crush, depending on the assets that you have, everything works a little bit differently and can be affected differently as well.
So these Monte Carlo simulations basically say that if you have x number of dollars and you’re taking out 4% out each year, well, you have a 90% success rate, which means, 9 out of 10 people, let’s just say, will survive the stresses of economic environments changing and that they will survive at 4% withdrawal rate.
So 90%. You think, “Okay. Well, that’s pretty good. I might take those odds. Because if 9 out of 10 are going to be okay, statistically speaking I might be one of those 9.” But here’s the problem, and this gets a little bit deep into the weeds so sorry I don’t mean to be too complicated. But if you look at the 10% that failed, in other words, 90% made it, right? But 10% that didn’t make it during the stress test or during those simulations, that 10 %, the majority of them occur in environments just like we’re in right now.
In other words, low interest, market soaring, the economy looks pretty good. And those are when the simulations started. That’s where we’re at right now. Low interest, markets are soaring, the economy looks pretty good. What happens to those 10% failures is that the markets went against them, interest rates might have gone up, down or sideways and the economy didn’t necessarily continue to perform as it is right now.
In other words, there were some corrections, some significant corrections that changed all those parameters. And those corrections occurred for the majority of the people who failed the simulations were in that 10% area, that 10% area where all people just like us going through this particular economy. So essentially these Monte Carlo simulations you can just toss them out the window. They’re almost useless for us because of the fact that the 10% that failed is in the exact environment that we’re in right now. They just didn’t continue to last the rest of your lifetime.
You think about it right now, in America, you can plan about a 30-year retirement. You retire at 65. There’s a lot of people who had need their money to last them at least 30 years. And that’s a long time. And it’s a long time for money to have to last especially when it’s been pulled back into very conservative positions. So as a result, you probably ought to be thinking in terms of 2 to 3 percent withdrawal rate to be safe to make sure your money is going to last and hey, if the markets change and things get really good and your nest egg actually continues to grow even after you start taking withdrawals, you might be able to have a little more fun in life or increase your income.
So here are the solutions. If we believe that the markets might have some corrections, if we do need to be more conservative, if we can’t rely on the 4% Rule any longer, then some of the solutions are just to save more, right? Get a bigger nest egg, which is certainly recommended, and again, approaching that 2 to 2 and a half million dollar range is more of a cautious way to approach retirement when back in the 90s, million dollars might be able to do it.
The other thing we can do is spend less. So instead of thinking that we’re going to need 50 or 60 or 70,000 a year in retirement maybe we dial that back 5 or $10,000 a year so that we can stretch our money out that much further. The other thing we can do is get higher investment returns. What does that typically mean? I don’t really buy into this philosophy of risk, take a greater risk or greater reward. And we’re going to go over that in future podcast and videos but the reality is just because you accept higher risk does not necessarily mean you are going to get a higher reward. But you may need to be looking for ways to get a higher return on money to again build greater capital and have a better retirement income stream.
So save more. Spend less. Get a higher return. Those are some ways to offset these low-interest environments and offset the 4% Rule that is no longer really valid and we got to be looking at 2 or 3 percent to be realistic.
And one of the things you can do especially if you are watching this video and you are still in your 30s, 40s, and the 50s, there is a lot of ways that you can control the outflows of your money and control debt and those kinds of things can help build wealth certainly the way that we like to talk about how to handle your cash and your cash flow and where to put your money in a tax-free environment can help tremendously.
In fact, right now, in the tax-free environments that we like to use, get this if someone were to retire today in this environment, they could take about 5 and a half or 6% off of their tax-free investments. Never paid tax as well. So again, using the million dollars, we’re talking about 55 to 60,000 dollars a year tax-free and does not go against your social security.
So those are things you definitely want to talk about and put into place as early as possible because that is going to help prepare for a very nice retirement income stream in the future. So those are just a few things to be aware of on the 4% Rule just really doesn’t apply anymore. So if you are talking to a financial advisor and that’s what they are showing you, make sure either they understand, well they need to understand but you need to understand that that’s just not going to be applicable.
And if they start showing you Monte Carlo simulations, showing that 90% of the people who went through this was successful at the 4% level, the reality is they forgot to look at what was the environment in that caused the 10% failure. And then decide, do I want to save more, spend less, have a higher return. And then finally, where can I put money to give me the greatest tax-free income that I can get and maybe even higher than the 4% Rule in a safe, conservative environment.
If you want to talk about this more and have a strategy session with us, hey, just feel free to shoot me an email, set up a time, spend 10 or 15 minutes on a call together, and we can at least discuss some of these ideas. In the meantime with any other questions, feel free to shoot me an email at firstname.lastname@example.org. Happy to answer them just as quick as we can.
And by the way, it’s going to be kind of fun in here in the next few weeks. We’re going to have a podcast that just answers questions coz we get a lot of questions and a lot of duplicate questions. We thought it would be nice to give you a whole realm of Q & A on an upcoming podcast so watch out for that.
In the meantime, always subscribe to the podcast. You never miss one. Subscribe to the video channel if you prefer the videos and we’ll keep these things coming every Wednesday on our Wealthy and Wise Wednesday. And as always, just be as empowered and educated about money and finance as you can be so you can make the best financial decisions. Until next week! Take care.
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