What is the 4% Rule in Retirement Account Distributions?

What is the 4% Rule in Retirement Account Distributions?

With Michael Sayre

Transcript

Hey everybody, welcome back to the In Your Business podcast, your go-to podcast for leadership, business, and finance. I'm your host, Michael Sayre. CUI Wealth Management produces this podcast. CUI Wealth Management focuses on financial advising for business owners and retirement plans such as 401k plans. So, if you need a second opinion on either of those, please contact us; we're happy to help.

Today, I wanted to talk about something important; it's a common question we always get, and it's critical because everyone wants to know how much they can take from their investment accounts without running out of money in retirement. This is a valid question because think about it like this. The average American lives to age 77 these days, and the average retirement age is age 61. You might say, well, I thought I was 65 or 67 or something like that. Why is it 61?

This is one of the reasons why the average retirement age is age 61. It's because sometimes we don't choose when to retire. Sometimes, our body gives out before we hit retirement age. Some people just can't wait to get into social security as soon as possible. Some people have health problems or get laid off from their jobs early on.

So, whatever the case is, there are reasons why not everybody waits till age 65 or 67 to retire. Now think about it like this. If you retire at age 61 and you live till age 77, that's 20% of your life that you need to be able to fund in some form or fashion. And part of the reason why this is such an important topic is because people look at social security. They say the other option is to fund it mainly by Social Security.

Still, we all know that that is made to fund about a third of your retirement, or at least that's what it generally funds for the average person, is about a third of their retirement. Not to mention that with the current projections, it's looking like it will run out of funds by 2041 if things continue to do what they are currently doing so.

At any rate, as you can see, this is a critical topic and something that needs to be addressed and talked about. The other thing that I think is important for us to remember is that there are a lot of financial entertainers out there who talk about some strategies that can be outright dangerous when it comes to making withdrawals from our retirement accounts and investments. We'll address that in a minute. Let's talk about it.

These are the standard rules of thumb for taking money out of our retirement accounts. The most common rule of thumb is the 4% rule. So, generally speaking, if you talk to most financial advisors and financial planners, they're going to say you can take about three to 4% of your total assets every year without having the risk of running out of money. Now, that is not a guarantee by any means.

And that is assuming you will take the money out for 30 years. It's also assuming a balanced portfolio. A balanced portfolio is a 50 -50 stocks and bonds portfolio or a 60 -40 stocks to bonds portfolio. Like I said before, following those numbers and that advice does not guarantee anything, but that is at least a rule of thumb commonly used in the industry and has been looked at from multiple angles. So here's what is outright dangerous: many financial entertainers who may not be licensed to give financial advice have recommended or have at least shown the possibility of taking more, a higher percentage, out of your retirement nest egg annually.

Let me give you an example of why this can be dangerous and why it is sometimes tempting for people to want that to happen. When you look at the average retirement account in the US, it's somewhere around 100,000. Now, that looks at those who are just entering the workforce and those who are retiring. So when you look at averages, and we're going to be talking about averages in a minute, and why this is important when you look at averages, that doesn't tell the whole story.

But if your retirement account is low and someone gives you hope that you can take a much higher distribution rate, it's tempting to want to believe that. So think about it like this. The S&P 500, the 500 largest companies in the United States, has averaged about 10% over the last 30 years, ending December 2023.

Looking at that, it's tempting to say, if it's averaging 10%, why can I only take 4 %? And now that's also assuming that you had everything in equities, which is not something you generally want to do when you're in retirement, right? Because there's so much more risk that's involved. But if it's average 10%, why can't I just take 8 % and invest everything in the S &P 500? Let me give you a little bit of perspective as to why this can be dangerous.

When you look at averages, it doesn't tell the whole picture. So you look at the S&P 500 has done about 10% on average, but if you break it down year to year, even when the years are positive, generally there is going to have, there is often a point during that year where it has been negative during the year. Also, there have been some big market swings over the last 30 years.

There have been times when the market has decreased 30% or more in a year. There are times when it's been up to double digits, but there are also times when it's been down double digits. But if you average it out, it's 10% again. Here is an example of how this can be dangerous. Let's say you have a million dollars in a portfolio, and let's say that you decide to take 8 % out as a distribution rate.

Now, this is all hypothetical. This is just giving you some ideas and something to consider regarding how this principle works. You take 8% out. Let's say the market had a horrible year that year, dropping 32%. That hypothetical once again. Now, if you had a million dollars and that happened, that 8% plus that 32% drop, you'd be down 40% in your portfolio.

How much does it take for that portfolio to return to that million dollars that you started at? It's not going just to take 40%. So if you take 600,000, times it by 40%, it's $240,000. If you add that back together, if you had a 40% return after a 40% loss, you will only be at a total of $ 840,000.

It takes 66.66% to get close to where you were before. So if you take 600,000 and multiply it by 66.66%, it doesn't quite get you there, but it gets you very close within striking distance of a million dollars. So that's assuming you made over 66% in one year after a 40% drop in the market.

But you must remember if you're in retirement and taking 8% out every year, you will need to take 8% out the following year. And so while it's recovering, you're hitting that again. You're taking another dive into those funds. And so this is what's called a sequence of returns. Now if...

In a perfect world, if everything were always 10% yearly, that would be a different story. But because markets don't act in a linear way where it's just, you can expect 10% every year, it doesn't happen like that. Just because the average is 10% doesn't mean you'll get 10% yearly. So that's the first thing I want to talk about.

The second thing I want to talk about is another way of looking at distributions, and that's through Monte Carlo simulation. Monte Carlo simulation looks at the probability of running out of money based on the distribution rates you're taking and the type of portfolio you have. The Monte Carlo simulation looks at thousands of iterations of possible outcomes in a portfolio. It takes all of that information, and it puts it into a probability of being able to, you know, stay afloat. So, for example,

They'll say you have a 90% probability of not running out of money if you have this type of portfolio over this period. The reason why this can be helpful is because then you can make adjustments. You can say, okay, perhaps we change our portfolio. Perhaps we can adjust there or change how much we're taking out in retirement. And that is going to have an impact on the probability that your money can last for the long term.

So that's something to take into consideration. That's something that we help our clients with and that we can look at in addition to the other tools that are out there. And then the last thing I want to touch base on because this group that listens will mostly be executives and business owners, is what about your business? How do you turn that into an income over time? And there are a couple of things you can consider with that.

Often, business owners like your business as your baby. You put so much time into it. You sacrifice time with your family. You sacrifice so much to build your business. And it is so important to you that, you know, sometimes that's where you put all your money. And I get it. I understand how that is. I'm a partner here at CUI Wealth Management. And so I have been involved in that starvation phase where you're doing everything you can, and it takes.

It's time for it to grow. The issue I see with business owners sometimes is that because they put everything into the business, they don't diversify their portfolio. They're waiting for that day when they get and sell that business and can get a significant sum of money for all the work and sacrifice they put into it. And that's great. And in the perfect world, that's all you need. But in reality, we generally see that it usually takes a little bit more than that. You want to make sure that you have

A diverse portfolio when it comes to your business and taking that into account, but don't make that your sole source of income for retirement. You don't want to have all your eggs in one basket. That's one of the reasons why it's essential to have other investment sources, including your employer-sponsored retirement plan, such as your 401k plan, that can help you reduce your tax liability as you go but also give you another source of income when you get to retirement. I hope this has been helpful.

You can contact me or someone from my team if you have questions or needs. Once again, it is CUI Wealth Management that produces this podcast. This is the In Your Business podcast. If you've gained value from this or learned something new, please like and subscribe. And so you don't miss out on upcoming episodes. Once again, I'm Michael Sayre. Thanks for joining. We'll see you next time.

If you are looking for a Salt Lake City, Utah-based 401(k) advisor or wealth manager, please reach out to us.