The 4 Year Rule

One of the most difficult challenges of transitioning to retirement from the working world is a complete change in mindset with regards to an investment portfolio.

You go from being a saver to a spender. There’s no future income or nearly as much time to soften the blow from bear markets. Growth is still necessary but you have to be cognizant of the fact that you’ll need to protect some of your assets for spending purposes.

One of my readers, a retiree named John Thees, offers an interesting case study in how to approach this change in mindset. John and his wife retired in the spring of 2000, just before the bursting of the tech bubble.

The timing couldn’t have been worse as stocks in the U.S. over the ensuing decade went on to deliver some of the worst returns on record. Studies have shown that a market crash at the beginning of retirement can be deadly for a portfolio that could have to last for another three decades or more.

Yet John and his wife survived the bursting of the tech bubble as well as the great financial crisis a few years later because they had a plan in place that accounted for the possibility of down markets. Here’s John with a condensed version of how they did it:

Please note that what I say below is based on the following two key assumptions about the stock market.

1. Major stock market downturns last from 8 to 24 months (average length is 16 months).

2. Major stock market upturns last 4 to 8 years (average is 5 to 6 years) and the market rises faster during the first two years of an upturn.

The Strategy
1. Five years before retiring start to accumulate a cash reserve (money market funds, CDswithin your retirement plan if possible (to defer taxes on interest). Your goal should be to accumulate four years of living expenses, net of any pension and Social Security income you will receive, by your retirement date.

2. When you retire, your portfolio should consist of your four year cash reserve plus stock mutual funds allocated appropriately. Then, if the stock market is up (at or relatively close to its historical high level) take your withdrawals for living expenses only from your stock mutual funds, and continue to do so as long as the market remains relatively steady or continues to rise. Do not react to short-term minor fluctuations up or down. (As you do this, be sure to keep your allocation percentages more or less at your desired levels by drawing down different stock mutual funds from time to time.) On the other hand, if the market is down significantly from its historical high levels or has been and still is falling fast when you retire, take your withdrawals for living expenses from your four years of living expenses cash reserve.

3. In the event you are taking withdrawals from your four year cash reserve due to being in a severe, long-term falling market, when the market turns up again, continue taking your withdrawals from the cash reserve for an additional 18 months to two years to allow the market to rise significantly (the market almost always rises fast during the first two years of an up market period) before switching back to taking withdrawals from your stock mutual funds. Then return to living off of your stock mutual funds and also start to ratably replenish (over a period of 18 months to two years) your now significantly drawn down cash reserve in order to bring it back up to its required level. Once the cash reserve is fully replenished you are ready for the next severe market downturn when it inevitably occurs.

What do you think?

There are no easy answers on how to go about setting the correct risk tolerance in retirement because everyone’s portfolio size and distribution needs will vary. But I like the fact that John approached this decision from a spending perspective based on worst case scenarios (that basically came true).

He used the Charlie Munger method of inverting a problem and looking at it backwards to come up with a reasonable solution.

It seems like much of the retirement planning advice out there focuses on distribution rates, the percentage of income to replace, asset allocation changes or a determination of how much risk is suitable for a retiree’s portfolio without ever considering actual living expenses or spending needs.

There are no hard and fast rules on these decisions so there can be some finesse involved in the implementation of this type of strategy. John has a much more detailed piece with more specifics on how he has used and refined this four year rule so if anyone’s interested feel free to send me an email request and I’ll pass it along.



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What's been said:

Discussions found on the web
  1. John Thees commented on Aug 17

    One of the things that appeals to me the most about this Cash Reserve method is that the amount of stock assets I have in my portfolio is determined not by some arbitrary percentage, but, instead, by how much I income I spend each month after taking Social Security benefits and pension income into account. This results in my having more stock assets in the portfolio than I would have if I were using the generally recommended rules of thumb.

  2. Martin commented on Aug 18

    I like this approach. It is still early for me to do this kind of planning but I can adopt this as a plan and start working on it in due time. I really like it so thanks for sharing.

  3. Marc commented on Aug 18

    In general this is an excellent approach, but I would recommend a couple of changes. Instead of a four year cash reserve, have a 5-7 year high quality bond ladder (I prefer the slightly longer cash duration) with a year’s worth of expenses maturing each year. This way, if a bear market occurs, you have a year of cash becoming available at the maturity date so that you do not have to sell stocks, and in a bull market you can buy new bonds as the ones you own mature, and you thereby benefit from the higher interest rates that high quality bonds give versus cash or CDs. By high quality bonds, I mean AA- or better, so that there is not significant credit risk.

    • Ben commented on Aug 18

      Agreed, bond ladder is another solid option. Helps with interest rate risk and gives you a nice steady income stream along with periodic principal payments.

  4. Tony C commented on Aug 18

    The problem with your two key assumptions about stocks is that they vary in lenght. There is a huge difference between stock market downturns that last 8 months to 24 month bear markets. Like you said, bull markets can last 4 – 8 years, which is also a huge range.
    This huge range isn’t very useful for stock picking and trading.

    • Ben commented on Aug 18

      That’s true. No easy answers. The 2000-02 period was actually the longest since WWII as far as earning back your original investment in stocks (almost 6 yrs) including dividends. Have to have a process but be flexible to account for the fact that no two cycles are ever quite the same.

      • Martin commented on Aug 20

        Can dividend investing help smoothing this out, so you will not be pressed that much selling your stocks for income (4% rule) and using dividends rather than your principal. Granted, not all people invest into individual stocks and with mutual funds the dividend growth strategy for example isn’t as profitable as with the individual stocks.

  5. Dawn commented on Aug 18

    me too . I think its a very good idea thanks for sharing.

  6. John Thees commented on Aug 22

    I don’t remember where I read the following quote, but it perfectly reflects why I believe a cash reserve, not a bond reserve, is the best way to go —

    “…The purpose of a cash reserve is to manage risk (having to sell shares of stock or stock mutual funds in a severe down market); it is not to generate high returns.”

  7. ek1949 commented on Mar 02

    This looks like a workable strategy if you are worried about volatility. I’d use stocks and funds that pay substantial dividends to decouple from the volatility risk. If you retire just before a crash your divs might take a temporary hit, but nothing like the extent of price. In the longer run a diverse group of dividend payers will give you a growing income regardless of market gyrations. That’s my plan, anyway.

    • Ben commented on Mar 03

      True. That works as long as your dividends cover your living expenses. I’d recommend at least a small allocation to bonds or cash in the event that an unexpected expense comes up that over and above the dividend yield (although you could always create your own dividend by selling shares too).

      • ek1949 commented on Mar 03

        Ben, in my case divs plus SS cover me well with a safety margin. I’m 66, retired and fairly frugal. I have no job to lose or big purchases to make so my big worry is medical expanses above what insurance covers. I think that’s a problem for everyone who isn’t seriously rich.

        My dividend strategy is a hybrid of high yield and dividend growth designed to deliver high current income with dividend growth at a portfolio yield of ~7%. Naturally growth will be slow but high current income means pure dividend growth investors will catch up to me decades after they die.

        My partner and I have over 100k in income from 900k in assets plus a paycheck from a part time job and two SS checks. Depending on realized cap gains it might be more like 130k some years but that should decrease a bit. It ought to, that is, as I intend to do less selling and more holding as my optimization project inevitably slows down.

        • Ben commented on Mar 03

          Good point on the SS. That’s a fixed income and has to be taken into account. I agree with you on the importance of having your healthcare costs figured out. Sounds like you have a great strategy. Thanks for sharing. I’m always interested in how different people pull that off.