In 1994, financial planner William Bengen made a compelling case for a very simple withdrawal strategy now commonly known as the 4% rule. His work showed how a diversified investment strategy between common stocks and medium-term Treasuries could help a retiree navigate a 30-year retirement with very little chance of running out of money.
Today, in the age of low-cost exchange-traded funds (ETFs) that focus on indices, it becomes quite simple to create such a portfolio with just two funds. For stocks, the Invesco S&P 500 Equal Weight ETF (NYSEMKT:RSP) certainly worth considering. For intermediate Treasuries, it’s hard to beat the Vanguard Intermediate-Term Treasury Fund Index ETF (NASDAQ: VGIT). Put those two ETFs together the smart way, and they could very well end up being all you need for retirement.
How the 4% rule works
Bengen’s work he came up with the 4% rule it focused on retirees who held a well-diversified portfolio that was somewhere between a mix of 75% stocks and 25% bonds and a 50-50 mix of the two. He looked at historical market returns and inflation rates and assumed that a retiree would want to maintain a stable lifestyle in retirement, after accounting for inflation.
With those assumptions in place, he looked at how much a person could withdraw each year and still have a strong chance of finishing a 30-year retirement without running out of money. He calculated that by keeping that portfolio diversified and balanced, a retiree could start by spending 4% of the portfolio’s opening account balance and adjust those withdrawals for inflation each year.
Let’s say, for example, that you expect to need $48,000 a year in retirement ($4,000 a month) to cover your costs, and that Social Security it should bring you around $1,500 per month. Since Social Security adjusts your payment for inflation each year, you’ll need your savings to cover the other $2,500 per month, $30,000 per year. Thanks to the 4% rule, it looks like you could cover that gap with a $750,000 savings in the Invesco S&P 500 Equal Weight and Vanguard Intermediate-Term Treasury ETFs.
Why list the Invesco S&P 500 Equal Weight ETF?
The Invesco S&P 500 Equal Weight ETF invests in the same companies that make up most of the S&P 500 trackers, but does so a little differently. While the typical S&P 500 fund is weighted by market capitalization, the Invesco ETF uses a equal weight strategy. In other words, you are looking to own approximately the same number of dollars in each company in that index.
That gives the Invesco ETF an advantage in diversification, as by market cap the top 10 companies (11 stocks due to different share classes) make up nearly 30% of the index. By contrast, in the Invesco ETF, the top 10 holdings represent less than 2.7% of the fund’s holdings. That means the Invesco fund is less exposed to the challenges faced by the larger companies in that index than the typical S&P 500 fund.
It offers that diversification benefit while still having a modest 0.2% expense ratio, which means the fund’s shareholders get virtually all of the benefits of owning the underlying shares. Between that modest expense ratio and that diversified portfolio of S&P 500 stocks, the Invesco S&P 500 Equal Weight ETF is worth considering for your retirement portfolio stock allocation.
Why list the Vanguard Intermediate-Term Treasury ETF?
The Vanguard Intermediate-Term Treasury ETF typically invests in US Treasury bonds maturing in three to 10 years.
That time frame is important. As a medium-term bond fund, it does not hold the bonds with the shortest or longest maturities. That three- to 10-year range can provide a sweet spot where bonds offer higher interest rates than shorter-dated bonds, but their price doesn’t fall as much. long-term bonds can when rates go up.
Also, as an ETF that owns Treasuries, it faces fairly low default risk. The US government can print dollars and generally borrow in dollar-denominated bonds. While printing money can lead inflationthat combination, along with the fiscal capacity of the government, provides a very high probability that the US Treasury debt will be paid.
Although medium-term Treasuries may not provide a high rate of return over time, they do offer more price stability than equities. That’s why they play a role in the 4% rule: to make sure you have higher-certainty money available when you need to spend cash. With an almost invisible expense ratio of 0.05%, investors in the Vanguard Intermediate-Term Treasury ETF reap the benefits of owning these very low overhead bonds.
Two funds for a great future
The beauty of these two ETFs is that not only can they be the core of your plan once you retire, but you can also use them as you build your retirement savings. With a longer time horizon while you’re still working, you’ll probably want to tilt your allocation more toward the stock fund.
As your retirement approaches, you’ll want to get closer to the balanced allowance that’s so important when you’re spending your savings. Still, you can get away with just these two ETFs and have a great chance of getting into (and out of) a financially comfortable retirement.
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