The coronavirus has wreaked havoc on the economy and basically every aspect of our life. And up until a few weeks ago, it was punishing the stock market. But now things have leveled off and are starting to trend upward.
However, some experts have predicted a flat or stagnant market for as much as the next decade. So how does that impact our ability to save for retirement and actually retire? Does the 4% Rule still apply or is it null and void in this economic climate?
Find out everything you need to know below, where we recap the podcast where Rob answers a reader question.
But before we get started, let’s recap the actual question Joshua asks in case you missed it. He says the following:
So, basically, Joshua is asking if it makes sense to stick with income-generating investments (via dividends) since the likes of Jack Bogle predicted stagnant markets for the next decade, and COVID-19 has only furthered the support for that idea.
Table of Contents:
What is VYM?
First, let’s break down what VYM is. VYM is the Vanguard High Yield Dividend ETF. In the video, Rob shows that the yields (both SEC and 12-Month) are pretty favorable, both hovering around 4%. And when compared to a similar S&P 500 fund, the yield looks even better (the S&P fund had a yield that was 175 basis points lower).
Why Does This Matter?
The reason this matters, is because we get so hung up on yield–especially when looking at a dividend-paying investment. For many reasons, we should consider looking at total return instead, not just the dividend yield.
One of the major reasons is that it can significantly alter our perspective on retirement, namely the 4% rule. By focusing on yield–and even total return to an extent–we’re missing a critical element as a part of the equation, which I’ll discuss below.
What is the 4% Rule?
Before I talk about the key piece of data you need, I want to take a quick detour and talk about the 4% Rule, so you have a better understanding of why this data is so important. In simple terms, the 4% Rule says that you can safely withdraw 4% of the total value of your portfolio each year and maintain your principal balance. Basically, your money will outlast you.
But there’s a caveat. And it comes from the original ideator behind this philosophy – William Benjen. In his 1994 article, “Determining Withdrawal Rates Using Historical Data,” Benjen states that you need to adjust that withdrawal rate by the rate of inflation in subsequent years after year one.
So – in year one, you would withdraw 4% of your portfolio’s value. In year two, you’d adjust that percentage by the rate of inflation–either up or down. And therein lies the secret to all of this–inflation.
Let me explain.
What was Benjen’s Test?
Benjen wanted to test how long someone’s money would last if they retired in a certain year. So he took historical stock market and inflation data and ran the numbers to see if the money would last 50 years by retiring in a certain year.
In his first test, he used a 3% withdrawal rate as a baseline on a portfolio that was 50% stocks and 50% intermediate-term treasuries. In that test, starting in 1926 and going all the way to 1976 (mind you, living through several wars and stock market crashes, among other key historical moments that change our economy), your money would have lasted 50 years in every single case.
So even if you retired during the stock market crash of 1929, by using a 3% withdrawal rate, your money would have lasted 50 years (again, assuming you kept a 50/50 portfolio). Let me remind you that the stock market dropped a total of 61% from 1929 to 1931.
So how could this be?
Before I go there, let me show you his second test–the 4% withdrawal rate.
When Benjen ran the same test using a 4% withdrawal rate, things generally looked okay, but they weren’t as stable.
But as you can see, there were a few years in the late 30s, as well as a lot of the 60s that we saw the money not lasting a full 50 years. Granted, it still lasted about 35 years–which is amazing, but the point is understanding what happened here.
What Happened in the Years the Money Didn’t Last 50 Years?
The answer is inflation. As Rob shares in the video, inflation has a significant impact on our ability to retire, and take advantage of this 4% Rule. To explain this further, let’s look at another chart Benjen did:
Notice anything weird?
The total stock returns were all abysmal in these three examples. In fact, look at 1929 to 1931. It dropped 61%, yet this was one of the most stable areas in the above chart–when retiree’s money lasted a full 50 years.
Take a look at the inflation column. As you can see, during the “Big Bang” period, inflation was 22.1%. And during the “Big Dipper” period, it was 10.5%. However, during the “Little Dipper” period, it was nearly a 16% recession.
What exactly does this mean, then?
In short, although the markets were getting crushed in the late 20s and early 30s, your buying power was also increasing since inflation was moving in the opposite direction. In the other two scenarios, stocks were getting crushed AND inflation was extremely high.
That means you have to grossly over-adjust your 4% withdrawal rate just to maintain the same level of spending power–not live a richer life.
What Actually Causes Inflation to Increase?
Inflation is pretty simple when you boil it down. Basically, if the cost of goods and services go up (and demand stays relatively consistent), prices will go up, causing inflation. The same goes for demand. If demand for goods and services goes up significantly (for whatever reason), it will typically cause inflation.
What is the Inflation Rate Now and in the Future?
According to Knoema, “US CPI inflation will be within the range from 2.1 to 2.3% in 2020 and average at around 2.2% in 2021. All agencies are consistent that CPI inflation will increase in 2020 from an average of 1.8 in 2019. Over the longer-term up to 2024, CPI inflation in the US is expected to be around 2.3%.”
So we can expect inflation to be around 2% for the next few years. That means if you’re using the 4% Rule, starting in year two you’ll need to adjust your withdrawal rate by about 2%.
We really don’t know. What’s weird is that, while job losses are at an all-time high and every other indicator is suggesting a recession, the stock market is steadily working its way upward. To me, this is scary. It either means that the market doesn’t care about what’s happening economically (and they’re moving inversely), or we’re on the cusp of a major drop.
That being said, Victor Li, professor of economics at the Villanova School of Business, recently said that once the coronavirus crisis goes away, there’s a high likelihood we’ll see a lopsided economic recovery with slow output growth and accelerating prices and inflation. He coins this stagflation.
So What is the Lesson Here?
I think there are a few lessons to take away from this.
First, don’t panic, and don’t ONLY look at yields or total returns. Inflation is a critical element to consider.
Second, make sure you keep a balanced portfolio–and keep rebalancing it every year. The numbers that Benjen pulled were highly-dependent on a portfolio maintaining a 50/50 split between stocks and lower risk securities.
We don’t know what the future will hold, but historical data is starting to give us a pretty darn good idea of what we can do now to prepare.