Not understanding 4% SWR fully

[neonlight]

Hi all, after reading the materials there is still a doubt:

How are we factoring in inflation, aren't we suppose to include inflation rate as well? So for US residents the stash should generate 7% return (3% for inflation, and 4% for SWR spending).

Or is it implicit that by saying 4% SWR we are assuming implicitly that our stash returns 7%, whereby 3% is accounted for inflation. Many people keep saying a return of 4%, are we saying real return of 4% but we really need to be making 7% (or more since tax is not factored)

Many thanks :)

[2Cent]

The assumption is that you can take out 4% each year because on average stocks make more than 4% + 2% inflation. I think the expected return is even 8% but you don't want to depend on that.

[ooeei]

The 4% rule isn't based on a mathematical formula where you need to "factor things in", it's based on historical data gathered and analyzed in "The Trinity Study". Inflation happened during the study period, so it's already in the data.

It looks at every year from 1925-1985(ish). It assumes when you retire you set your spending rate on that date as 4% of whatever you have. That rate then increases with the CPI (inflation) every year, regardless of how your investments do. Over all 60 years they studied, starting with a rate of 4% always ensured your money would last at least 30 years. Most of the time you could start with more than 4%, but 4% was the safe bet. Granted, this assumed a 30 year retirement, the math changes a bit for 60 years. The articles below are a good read on the implications of the study.

http://www.madfientist.com/safe-withdrawal-rate/

http://www.mrmoneymustache.com/2012/05/29/how-much-do-i-need-for-retirement/

[plainjane]

From Wikipedia -  "The 4% refers to the portion of the portfolio withdrawn during the first year; it is assumed that the portion withdrawn in subsequent years will increase with the consumer price index (CPI) to keep pace with the cost of living."

For the 4% SWR the premise is that some years will be down, and some years will be up. Historically speaking, if you only take out 4%, even on years when it goes up much more, then your portfolio can survive on the years that it goes down and will give you enough room for it to grow back.

I'm not sure what you mean by "reading the materials", but if you want to understand this better "Trinity Study" is a good search term for where the 4% comes from.

[rugorak]

As the other readers said your worries are already included. You withdraw 4% plus inflation. So year 1 you take out 4%. Year 2 you take out 4% plus the inflation rate for that year.

And the end of the day it is not a hard and fast do this specifically rule. It is a historical observation on how much money you could save to safely retire and not run out of money. Your individual situation may differ. The whole point is to get a more realistic amount of money you need to retire. So the 4% rule means that you need 25 times as much as you spend each year. It is better than the 70% of income or other such rules of thumb because it looks at spending rather than income. Some people consistently spend (or plan on spending) more than they earn so 70% of current income may not be enough. By looking at spending and finding an amount that would have been safe to pull out in the past you can better estimate how much you should have saved.

But as with all investing advice past performance may not be a guarantee of future results. But it is better to plan based on data than blind guessing. And then when you actually retire be prepared to make adjustments as your personal situation warrants.

[solon]

From Wikipedia -  "The 4% refers to the portion of the portfolio withdrawn during the first year; it is assumed that the portion withdrawn in subsequent years will increase with the consumer price index (CPI) to keep pace with the cost of living."

Here's what I don't understand. Why are we taking out 4% the first year, and then indexing for inflation? Why not just take out 4% every year?

[ooeei]

From Wikipedia -  "The 4% refers to the portion of the portfolio withdrawn during the first year; it is assumed that the portion withdrawn in subsequent years will increase with the consumer price index (CPI) to keep pace with the cost of living."

Here's what I don't understand. Why are we taking out 4% the first year, and then indexing for inflation? Why not just take out 4% every year?

This study was based on someone planning a 30 year retirement, or basically a normal retirement. Someone who's 65 wants to know what their budget is, and generally doesn't want to have to worry about their budget being cut in half due to market forces. "I have $____, how much can I spend per year and not go broke?"

It's designed as basically a self managed annuity. You have a set number to budget around that you know will last the full length of the "term". It's simple and easy to manage. If you are flexible and spend less in down years, you can be a bit riskier with the percentage and still be safe. The original study was based on simplicity, not optimization. It showed what worked with this particular strategy, it didn't say that this strategy was the best.

[MDM]

Here's what I don't understand. Why are we taking out 4% the first year, and then indexing for inflation? Why not just take out 4% every year?

Well, that would guarantee that you would never run out of money (unless you actually lost everything in your investments).

But as ooeei indicated, would you be willing (and able) to cut withdrawals in half if your investments lost 50%? 

Although most would agree that a rigid implementation of a 4% WR is unwise (e.g., see Variable percentage withdrawal - Bogleheads), it's a reasonable simplification for both academic and practical interest.

[yachi]

From Wikipedia -  "The 4% refers to the portion of the portfolio withdrawn during the first year; it is assumed that the portion withdrawn in subsequent years will increase with the consumer price index (CPI) to keep pace with the cost of living."

Here's what I don't understand. Why are we taking out 4% the first year, and then indexing for inflation? Why not just take out 4% every year?

Because you're yearly expenses aren't going up and down with the whim of the market, they're going up and down with inflation.  If you want to feel rich one year and poor the next go ahead and base your WD on your nest egg balance.  Also because a fixed percent of your next egg will never technically fail until you try to withdrawal 10% of a penny.  Obviously it has failed to meet your needs prior to that.