The 4% Rule Is Outdated. I Prefer To Collect Dividends Instead

Selling shares of the very same asset that grows my wealth seems counterproductive.

Photo by Travis Essinger on Unsplash

The 4% Rule: A Traditional but Flawed Approach

The 4% rule has been a widely accepted retirement strategy since William Bengen introduced it in 1994. The principle is straightforward: retirees should be able to withdraw 4% of their portfolio annually, with the expectation that their remaining investments will grow enough to sustain them over time.

For example, a retiree with a $2 million portfolio following this rule would withdraw $80,000 per year while relying on stock market appreciation to replenish their funds. Historically, the stock market has delivered average annual returns of around 10%, supporting the logic behind this strategy.

However, the 4% rule is based on historical back-testing from 1926 to 1976, an economic environment vastly different from today. It also assumes a 50/50 stock-to-bond allocation, which is considered ultra-conservative by modern investing standards. Additionally, this approach forces retirees to sell assets even in unfavorable market conditions, potentially depleting their portfolio faster than anticipated.

While the 4% rule may be a decent option for passive investors who prefer minimal involvement, I believe a dividend-focused approach provides a superior alternative. Here's why.

The Downside of Selling Shares

The fundamental flaw of the 4% rule is that it requires investors to sell shares of their investments to generate income. This creates several problems:

1. Market Volatility Risks – Selling shares during a downturn, such as the market declines of 2008, 2020, or 2022, forces retirees to withdraw from a shrinking portfolio. This makes it harder to recover once the market rebounds.

2. Inflation Impact – In years with high inflation (e.g., 8% in 2022), the purchasing power of a fixed 4% withdrawal decreases, leading to a shortfall.

3. Depleting Capital – Selling shares gradually erodes your capital base, reducing the potential for compounding growth.

Check out my article below on how to earn passive income with dividends!

The Power of Dividend Investing

Dividend investing eliminates the need to sell shares by generating passive income through distributions. Instead of depleting your principal, you live off the income generated by your portfolio. Here are the key benefits:

1. Steady Income Stream – A well-constructed dividend portfolio can provide consistent cash flow regardless of market fluctuations. Unlike capital gains, which depend on market timing, dividend payments are more predictable.

2. Avoiding Forced Sales – During bear markets, a dividend strategy allows you to hold onto your investments without worrying about selling at a loss.

3. Compounding Growth – Reinvesting dividends can significantly enhance long-term returns. Over time, this can create a self-sustaining income stream that grows with inflation.

4. Potential for Higher Income – High-quality dividend growth stocks, such as Broadcom (AVGO), have provided dividend CAGRs of over 30% in recent years, far exceeding typical withdrawal rates.

5. Tax Efficiency – Qualified dividends often receive favorable tax treatment compared to selling assets and realizing capital gains.

Real-World Example: Dividend Income vs. the 4% Rule

Consider two investors with $2 million portfolios:

• Investor A (4% Rule): Withdraws $80,000 annually by selling shares. Market downturns may force them to sell more shares at lower prices, increasing the risk of running out of money.

• Investor B (Dividend Strategy): Constructs a portfolio yielding 5%, generating $100,000 in annual dividends without selling assets. Their principal remains intact, and dividend increases may provide inflation protection.

Over time, Investor B benefits from the compounding effect of dividend reinvestment and potential income growth, while Investor A faces the risk of depleting their portfolio prematurely.

Why More Investors Should Consider Dividends

The financial industry often promotes index funds and the 4% rule as the default strategy for all investors. While index investing is an effective passive approach, it does not suit everyone’s needs—particularly those looking for stable income rather than maximizing total return.

For investors who prioritize financial independence and income stability, a dividend-based approach is a superior alternative. By constructing a well-diversified portfolio of high-quality dividend-paying stocks, you can enjoy a sustainable, inflation-resistant income stream without the stress of market timing.

Final Thoughts

The 4% rule may work for some investors, but it has significant drawbacks that make it less appealing to those who want financial security without depleting their assets. Dividend investing provides a compelling alternative by delivering consistent income, reducing reliance on market fluctuations, and allowing for greater financial flexibility.

Instead of worrying about selling shares during market downturns, I prefer to let my money work for me through a steady stream of growing dividends. After all, financial independence should be about peace of mind—not just hoping the market cooperates when you need to make a withdrawal.

Check out some of my individual stock analyses on Seeking Alpha!