In the realm of personal finance, few topics evoke as much fervour as the debate over how best to withdraw from one’s portfolio in retirement. For many adherents of the FIRE (Financial Independence, Retire Early) movement, the venerable 4% rule has long served as a rule of thumb. Yet, as markets evolve and tax considerations become increasingly complex, there is growing interest in an alternative approach—one that eschews selling assets for income in favour of a more nuanced strategy: build a stock portfolio, borrow against it, and ultimately bequeth the remainder to successors.
Rethinking the 4% Rule
The 4% rule, which advocates withdrawing a fixed percentage of your portfolio each year, has been celebrated for its simplicity and historical efficacy. However, it implicitly requires liquidating portions of an investment portfolio, potentially sacrificing the compounding power of capital appreciation. For those who have achieved financial independence, this method, while serviceable, may not be the optimal path for both sustaining income and maximizing long-term wealth.
(For an in-depth examination of the 4% rule, you may find the articles here helpful : The 4% Rule – Part 1.)
The Alternative: Build, Borrow, Bequeth
The alternative strategy pivots on three interlinked pillars:
- Build: Assemble a robust, diversified stock portfolio that is engineered for long-term growth. Rather than diminishing this reservoir through periodic sales, the emphasis is on its continuous appreciation.
- Borrow: Instead of liquidating investments to fund retirement expenses, one may opt to borrow against the portfolio. This approach preserves the underlying assets, thereby allowing the portfolio to compound unabated, while still providing the necessary liquidity to maintain one’s lifestyle. Borrowing, when executed prudently, can be an effective means of drawing income in a tax-efficient manner.
- Bequeth: Finally, the strategy culminates in bequeathing the entire, un-eroded portfolio to one’s heirs. Not only does this method maintain a higher portfolio performance compared to systematic withdrawals, but it also offers significant tax advantages. Inheritors benefit from a step-up in the cost basis at the time of inheritance, meaning that capital gains taxes on the portfolio’s appreciation can be largely sidestepped.
Weighing the Benefits and Risks
The benefits of this strategy are twofold. Firstly, by avoiding the sale of appreciated assets, investors may see a superior portfolio performance over time compared to a 4% withdrawal approach. Secondly, the tax efficiency inherent in passing on an untouched portfolio can be considerable—a critical consideration for those focused on legacy planning.
However, as with any strategy that involves leveraging assets, there are inherent risks. The effectiveness of borrowing against one’s portfolio is inextricably linked to market returns. A downturn could precipitate leverage limits or even a margin call, thereby introducing a layer of risk absent in traditional withdrawal strategies. Consequently, investors must approach this method with a clear understanding of their risk tolerance and the operational mechanics of margin lending.
A Promising Alternative Worth Watching
While numerical simulations and real-world examples are forthcoming, it is intuitively apparent that the “build, borrow, bequeth” strategy could offer a more resilient and tax-savvy alternative to the 4% rule. For the discerning retiree, this approach marries the dual goals of maintaining portfolio growth and ensuring an efficient transfer of wealth to the next generation.
In future articles, we shall delve into detailed simulations and case studies to explore whether this strategy truly holds the promise of superior performance in practice. Until then, the build, borrow, bequeth paradigm invites a reexamination of conventional wisdom and encourages a broader dialogue on how best to navigate the complexities of retirement income planning in a modern economic landscape.