Stop worrying about the 4% rule

[steveo]

But I do have lots of confidence that my "4%-rule-plus-safety-margin"-based early retirement's chances of success will be more than high enough to justify my decision to avoid bolstering those odds even further by deferring my early retirement even longer.

This is where I have an issue. If I worry so much about 4% not being safe (I am honestly at this point going to go for 5%) then I have to keep working longer and longer. I don't want to do that. I may have to think about jobs that can pay me a small income with little effort because that is all that I need to live happily on and it would delay my drawdown phase.

[steveo]

Does anyone here think the future is really going to look worse than the past the 4% rule is based on?  I'm not saying it's impossible, just that it's a pretty grim view of the future.

I don't think so. I think the most pessimistic view of the future for early retirees with a close to break even portfolio (say 4%) is that people stop spending and the economy therefore goes through a slow down period ala Japan for 30-50 years. I just can't see that happening. Consumerism is ingrained in people.

[MoonShadow]

Does anyone here think the future is really going to look worse than the past the 4% rule is based on?  I'm not saying it's impossible, just that it's a pretty grim view of the future.

I don't think so. I think the most pessimistic view of the future for early retirees with a close to break even portfolio (say 4%) is that people stop spending and the economy therefore goes through a slow down period ala Japan for 30-50 years. I just can't see that happening. Consumerism is ingrained in people.

I have a suggestion for some reading, in this case.  The Demographic Cliff by Harry Dent.  The very simply summary is the book is about what happens to the economy (and by proxy, the stock market) when you cross the data about average spending as people age (Ty Bernicke's Reality Retirement Planning) with the two distinct birth peaks that resulted in the Boomers and the Millienials, with the X-gen stuck in the low between.  The result is that he predicts a Japan-like 'lost decade' for the United States (and most of Europe as well) roughly between 2014 and 2022.  Considering he was one of not very many predicting Japan's lost decade in the late 1980's, and for similar demographic reasons, his perspective should not be dismissed lightly.  So, if he is correct, the next several years should be a great time to be accumulating.

Even still, the 4% rule should be fine.  One decade or so of flatlined stock values isn't the worst we have seen.

[tooqk4u22]

Does anyone here think the future is really going to look worse than the past the 4% rule is based on?  I'm not saying it's impossible, just that it's a pretty grim view of the future.

I don't think so. I think the most pessimistic view of the future for early retirees with a close to break even portfolio (say 4%) is that people stop spending and the economy therefore goes through a slow down period ala Japan for 30-50 years. I just can't see that happening. Consumerism is ingrained in people.

I have a suggestion for some reading, in this case.  The Demographic Cliff by Harry Dent.  The very simply summary is the book is about what happens to the economy (and by proxy, the stock market) when you cross the data about average spending as people age (Ty Bernicke's Reality Retirement Planning) with the two distinct birth peaks that resulted in the Boomers and the Millienials, with the X-gen stuck in the low between.  The result is that he predicts a Japan-like 'lost decade' for the United States (and most of Europe as well) roughly between 2014 and 2022.  Considering he was one of not very many predicting Japan's lost decade in the late 1980's, and for similar demographic reasons, his perspective should not be dismissed lightly.  So, if he is correct, the next several years should be a great time to be accumulating.

Even still, the 4% rule should be fine.  One decade or so of flatlined stock values isn't the worst we have seen.

A Japan like scenario for the US is probably a more likely one of the possible bad scenarios as there are a lot of similarities - high debt levels, aging population, focused on consumerism, etc. 

However, the Japan had a true demographic cliff whereas ours starts at the after the Millenials which have yet to really play a role in the economy - once this demographic gets going in their careers and household formation (assuming it stops being all about me me me and YOLO mentality) they will drive the economy and backfill the aging/retiring boomers.  GenX gets stuck again but as they say timing is everything.

Additionally, the US still has relatively friendly immigration policies that has and will continue to offset our decling birthrates. 

So full blown Japan scenario shouldn't occur.

[P4J]

Looking back at the historical data (with a nod to the idea that things could always be different going forward):

There is a good historical correlation between the valuation of the market (Shiller PE ratio) at any given time and the SWR applicable to that point in time. I haven't seen anyone run the analysis before, so I did it. See http://plottingforjailbreak.com/safe-withdrawal-rates-for-all-markets/.

The 4% SWR is, as you recall, the "worst case" SWR found in the historical data for 30-year retirements. As it turns out, the Shiller PE in that year was 25, the same as it is today. For all PEs lower than 25, the SWR was higher, with roughly power-law dependence. See Figure 3 in the post linked above. It is pretty amazing how well the data follows the curve.

Historically speaking, 4% is the correct SWR for the market valuations we are seeing today. If the curve fits are to be believed when extrapolated (grain of salt required), a 3% SWR isn't needed until the PE hits 35—which it has only ever done leading up to the peak in the dot-com bubble.

(And, on a side note, I’m not a big fan of the Shiller PE right now, because the 10-year average earnings include the anomalous year or two of crashed earnings during the 2008 bust…so I think the current 25 number is actually artificially high.)

Bottom line—history says that 4% is where you should want to be today. One more reason not to worry about it and work on your flexibility instead.

[tooqk4u22]

(And, on a side note, I’m not a big fan of the Shiller PE right now, because the 10-year average earnings include the anomalous year or two of crashed earnings during the 2008 bust…so I think the current 25 number is actually artificially high.)

Yeah but it also includes the inflated earnings leading up to the crash and the earnings recovery right after the crash so it balances out....that is the logic behind the the rolling 10 year period

Bottom line—history says that 4% is where you should want to be today. One more reason not to worry about it and work on your flexibility instead.

Makes sense that if the Shiller PE is 4% (1/25) and interest rates are 4% (about what they were then) that a 4% SWR would work....but it is not clear to me from you or the link that this is coincedence or not.  It does look like today from a PE and Shiller PE, but interest rates are lower today (both nominal and real) and dividend yields are lower today.....divi yield being lower matters because it is not cash in your pocket, sure it stays with the company to reinvest or buyback stock so it should be neutral on a total return basis but history has demonstrated that companies having excess capital to play with generally results in inferior returns.

[seattlecyclone]

There is a good historical correlation between the valuation of the market (Shiller PE ratio) at any given time and the SWR applicable to that point in time. I haven't seen anyone run the analysis before, so I did it. See http://plottingforjailbreak.com/safe-withdrawal-rates-for-all-markets/.

That is an amazing correlation. Thanks for plotting it!

[brooklynguy]

Nice work, P4J. 

I haven't seen anyone run the analysis before, so I did it.

FYI, Kitces actually did a similar analysis (see: Kitces on Shiller CAPE for Retirement Planning).  Citing research he conducted in 2008, he found an "astonishingly strong -0.74 correlation" between CAPE and SWRs.

That is an amazing correlation. Thanks for plotting it!

Note, however, that CAPE seems to have lost much of its predictive power with respect to SWRs in periods subsequent to 1985, for which we don't yet have fully-elapsed 30-year periods but for which we do have long enough periods to suggest that the relationship between starting-year CAPE and SWR has broken down (unless the future brings some truly catastrophic market performance over the unelapsed portions of those 30-year periods) (see the discussions in these threads: (i) Using market valuations to affect SWR? and (ii) SWR discussion (the portion of the discussion starting at post # 84 in particular).

[k9]

The more I read about stock allocations that have a SWR of 5% or more, the less I worry about the 4% rule. Oh, well, the stock-heavy crowd will have to live with 4%, I guess, but I'm happy to go for 20 years of expenses rather than 25.

[steveo]

The more I read about stock allocations that have a SWR of 5% or more, the less I worry about the 4% rule. Oh, well, the stock-heavy crowd will have to live with 4%, I guess, but I'm happy to go for 20 years of expenses rather than 25.

Stocks have tended to perform better over longer time periods and should therefore provide the highest possible SWR's. The problem is that the valuation of stocks over the past 100+years may not occur again and therefore the 4% rule might be more likely to be required.

Personally I want to go for a 5% WR but I'd like to see stocks decrease a lot in value for me to be comfortable with that WR.

[Tyler]

Stocks have tended to perform better over longer time periods and should therefore provide the highest possible SWR's.

This may seem instinctively true but mathematically it's more complicated than that.  Safe Withdrawal Rates are highly influenced not only by average returns but also by annual volatility.  All things being equal, higher volatility lowers the SWR.  So two portfolios with equal average returns may have drastically different withdrawal rates based on the underlying volatility.  And sometimes portfolios with lower average returns but lower volatility can still beat stocks.  That's how you get interesting results like this:



This plots the returns and calculated SWRs of a variety of different popular lazy portfolios.  Note that the Total Stock Market has one of the highest returns but the lowest SWR!  Also note than none of the top-3 SWR portfolios have more than 40% stocks.  For a more detailed walkthrough, I'd recommend reading this.  And to see an example of a portfolio with only 40% stocks that matches the long-term returns of the stock market with much lower volatility and a much higher SWR, try this.

[MoonShadow]

And to see an example of a portfolio with only 40% stocks that matches the long-term returns of the stock market with much lower volatility and a much higher SWR, try this.

Thank you for this.  I might just consider altering my portfolio based upon this information.

[steveo]

The more I read about stock allocations that have a SWR of 5% or more, the less I worry about the 4% rule. Oh, well, the stock-heavy crowd will have to live with 4%, I guess, but I'm happy to go for 20 years of expenses rather than 25.

Stocks have tended to perform better over longer time periods and should therefore provide the highest possible SWR's. The problem is that the valuation of stocks over the past 100+years may not occur again and therefore the 4% rule might be more likely to be required.

Personally I want to go for a 5% WR but I'd like to see stocks decrease a lot in value for me to be comfortable with that WR.

I don't have a whole lot of confidence in this analysis. I'm reading a bunch of William Bernstein's books now and I think he nails a lot of really good points that I think are not encompassed within that analysis.

Some factors such as:-

1. Hidden costs. Just taking into account indexes does not cater for index fees, buying and selling costs and capital gains costs (tax). This is especially true with small cap value and emerging market indexes. Small cap and emerging markets sound great in theory but the costs may eat up all of the supposed increased returns.
2. Gold doesn't perform well in most situations. Gold performs well in times of deflation however deflation is not a high probability event.
3. Past returns do not equal future returns. Its easy to put together an optimised portfolio based on historical data however that does not mean that this will continue into the future.

I do agree that portfolio theory is a really important component of managing your investments but I think taking into account the various assets available to the investor and the returns that you can expect from those assets over time is probably more important that optimising a portfolio. I also think you will never get a perfect portfolio.

[EscapeVelocity2020]

The most simple and convincing case I have for stocks being over valued is that their main (risk adjusted) competitor, long term bonds, are at all time historic lows.  People who need total return have been forced to buy equities (or other 'riskier' instruments).  If the Fed successfully raises interest rates to a more normalized 2% or positive real return of 4% nominal, equities become less attractive (on a risk adjusted basis).  And this is all assuming that inflation remains constant ~2%.  If we experience deflation or an increase in inflation, all bets are off with earnings staying high as consumers tend to move to the sidelines.

[steveo]

^^^^
This is the type of analysis that I think is important when trying to judge a portfolio including WR's. I think the best portfolio would be pretty simple in theory - put 90%-100% into stocks when they are at all time lows. The problem is that its not going to happen.

[Tyler]

@Steveo --

IMHO, the point is not to try to back test the perfect portfolio.  The important takeaway is simply that different portfolios never considered by the Trinity study may have different SWRs.  I definitely don't think there's a single portfolio that works best for everyone, so you need to do your own due diligence and account for things like taxes and what you're comfortable investing in.

BTW, if you like William Bernstein you might be interested in the SWR for one of his portfolios mentioned in the Intelligent Asset Allocator.  Scroll to the bottom. http://portfoliocharts.com/portfolio/bernstein-portfolio/  Regardless of your outlook for the future, the portfolios you are more personally comfortable with might also surprise you!

[steveo]

@Steveo --

IMHO, the point is not to try to back test the perfect portfolio.  The important takeaway is simply that different portfolios never considered by the Trinity study may have different SWRs.  I definitely don't think there's a single portfolio that works best for everyone, so you need to do your own due diligence and account for things like taxes and what you're comfortable investing in.

BTW, if you like William Bernstein you might be interested in the SWR for one of his portfolios mentioned in the Intelligent Asset Allocator.  Scroll to the bottom. http://portfoliocharts.com/portfolio/bernstein-portfolio/  Regardless of your outlook for the future, the portfolios you are more personally comfortable with might also surprise you!

I agree with your comments regarding different portfolios not being considered by the Trinity study. I am working through what is the best option to take for me personally with regards to my portfolio however I get the impression it will never be perfect.

That Bernstein portfolio is interesting. I think Bernstein is very risk averse and yet that portfolio over 40 years had a 5% SWR. I'm not sure exactly what option I will take however I also want to keep it relatively simple.

[Seppia]

This thread is simply amazing, sorry for the pretty pointless post but I just wanted to thank all contributors

[k9]

Stocks have tended to perform better over longer time periods and should therefore provide the highest possible SWR's.

This may seem instinctively true but mathematically it's more complicated than that.  Safe Withdrawal Rates are highly influenced not only by average returns but also by annual volatility.

This. Reducing volatility is not only about reducing down years (and, therefore, sleeping better) at the expense of CAGR. It is also about improving SWR. The fun thing is, rebalancing two (or, better, more than two) very volatile but uncorrelated assets can produce a low-volatility portfolio with excellent CAGR, because then volatility is not your enemy, eating in your stache, but your friend, letting you make huge rebalancing gains. This is the mechanism that makes those great portfolios mentioned by Tyler shine, even when compared to 100% stocks.

[TomTX]

2. Gold doesn't perform well in most situations. Gold performs well in times of deflation however deflation is not a high probability event.

Gold's done really poorly the lat few years and we are certainly not in inflation.

[MoonShadow]

Gold performs well during periods of high uncertainty, but that is not the only influencing factor.  Other things do well under similar conditions, but are not universally effective or available.  There is no perfect hedge investment, but gold (and silver) is a well established hedge investment.  And one with a huge history.  Don't just automatically discount it because it doesn't earn a return, there will be times that preservation of wealth already accumulated is more important for your portfolio than growth.

[Tyler]

2. Gold doesn't perform well in most situations. Gold performs well in times of deflation however deflation is not a high probability event.

Gold's done really poorly the lat few years and we are certainly not in inflation.

Gold is traditionally considered an inflation hedge, not the other way around.

[TomTX]

2. Gold doesn't perform well in most situations. Gold performs well in times of deflation however deflation is not a high probability event.

Gold's done really poorly the lat few years and we are certainly not in inflation.

Gold is traditionally considered an inflation hedge, not the other way around.

I did some more poking around, and PortfolioCharts only uses data starting in 1972. Basically, a falling interest rate environment and exactly starting when gold was no longer price controlled.

That data set is too limited for me to trust the siren call of higher WRs. It's certainly interesting, but we're missing the traditionally worst starting years for portfolios in the 1960s... 

...and OF COURSE gold does well. No shit. The price had been kept artificially low by the government and it was unlocked. Gold was fixed at $35 before it was unlocked.

The argument is that not all the data sets go back that far - but the effect is to cherry pick your start dates.

[Tyler]

FYI - The starting date for the data, its effect on calculated SWRs, and the reason why more data doesn't necessarily help unless it reflects how you actually invest are addressed at length here:  http://forum.mrmoneymustache.com/investor-alley/asset-allocation-and-safe-withdrawal-rates/

[dabears847]

The point of the thread is that you shouldn't worry much about a 4% SWR failing. But the reality is that you can probably spend more than that, especially if you're 5 or 10 years into RE and you can tell from the past market returns that you have avoided one of those disastrous retirement dates. So you could certainly spend more at times and be OK. Personally, I have multiple funds that I'm working with. I have a base 4% WR fund that will take care of basic minimum expenses. Then I have another fund for fun stuff that I don't need to last forever. And then another fund for paying off the house, some college expense, etc. So do whatever works for you and your spending interests.
[/quote]
So much to read, multiple days getting through this post... I posted another thread a few weeks ago looking for some of this information. There would be huge value to me and others alike if you made the "Playbook of the 4% plan, best ideas from the group, with portfolio mix, rentals, swr, flexibility, triggers, taxes, 72t, 401k conversion, low cost funds, college costs, kids, re-balancing portfolio, etc. Similar to the communication thread.

[thinkinahead]

I may have missed it but what about all the economist talk about secular stagnation? It looks like real interest rates have been declining for some time, which I assume could make the 4% rule a less safe benchmark. Are there any examples of 4% rule holding despite real interest rates <1-2% for an extended period of time?

[Telecaster]

I may have missed it but what about all the economist talk about secular stagnation? It looks like real interest rates have been declining for some time, which I assume could make the 4% rule a less safe benchmark. Are there any examples of 4% rule holding despite real interest rates <1-2% for an extended period of time?

The 4% number came from looking at all of the available historical data.  The original Trinity study went back to 1926 or something, and others have extended it back to the 1880s.   

The underlying assumption of the 4% rule is that the future will be no worse than the past, economically speaking.   It is possible the future will be worse than the past?  Sure!  If you want extra safety, take 3%.    My view is that I'm willing to forgo that extra bit of safety in order to retire sooner/higher lifestyle.  If the stash doesn't look like it will last, then I will reduce my lifestyle. 

[TomTX]

I may have missed it but what about all the economist talk about secular stagnation? It looks like real interest rates have been declining for some time, which I assume could make the 4% rule a less safe benchmark. Are there any examples of 4% rule holding despite real interest rates <1-2% for an extended period of time?

The 4% number came from looking at all of the available historical data.  The original Trinity study went back to 1926 or something, and others have extended it back to the 1880s.   

The underlying assumption of the 4% rule is that the future will be no worse than the past, economically speaking.   It is possible the future will be worse than the past?  Sure!  If you want extra safety, take 3%.    My view is that I'm willing to forgo that extra bit of safety in order to retire sooner/higher lifestyle.  If the stash doesn't look like it will last, then I will reduce my lifestyle.

Here's how I'm going to handle it: in 11.5 years, I qualify for a (partial) pension. With a paid off house, the pension will cover all base living expenses. The plan is to use 2% of the stash for travel/extras, with the ability to tap up to 5% for unusual expenses (HVAC blew up, whatever) on an occasional basis with no worries.

My pension isn't COLA adjusted, so its value will decline over time (or looked at another way, my property taxes, insurance, etc will continue to climb!! - we'll slowly ramp up the draw from the stash until we hit Social Security. Conveniently, the dividend yield on VTSAX is around 2%, so we'll just stop dividend reinvestment and figure that cash is "fun money".

Frankly, I'm probably being too conservative with the spending plans. However, I have to plan for "what if I die" and leave my wife - the pension is significantly reduced if it lasts until the last of us dies instead of until I die. There is only a tiny hit for a guaranteed 10 year payout, so we'll probably do that option. Plus, social security will be reduced notably when one of us dies.

[dividendman]

But, but, but, what if there's a world war? An oil crisis?  A major nuclear meltdown?  A great depression?  Super restrictive economic policy changes?  Super aggressive economic policy changes? Stagflation?  A missile crisis that takes us to the edge of nuclear annihilation?  Another terrorist attack?

Oh wait, the 4% SWR has already survived all of that, and assumes all of those things will totally happen again, and yet it's still 95-100% safe. 

Does anyone here think the future is really going to look worse than the past the 4% rule is based on?   I'm not saying it's impossible, just that it's a pretty grim view of the future.

Not only is it a grim view of the future it goes against the all global trends. The fact is that globally all indicators on lifestyle are increasing. Life expectancy,  real income/purchasing power, worker productivity, crime is decreasing, people killed/impacted by global warfare/strife is decreasing, etc. All of these are trends that have been occurring for centuries (it would have been for thousands of years but the dark ages set us back). Not only that, but they have been accelerating in the positive direction.

Now we can argue whether or not our invested assets will grow at the same rate as a result of the overwhelmingly postive trends but the world being "better" is pretty much a lock (unless we really fucked up bad with global warming - but then your portfolio won't save you anyway).

I like the 5 or 4% rule for the simple reason that the pace of change is accelerating so rapidly it's  silly to think about the world more than 20-25 years out. Hey, we might all get a basic income from the government by then due to magnificent productivity gains of technology and then all of this worrying will have been for naught and we would have all overworked!

[MoonShadow]

But, but, but, what if there's a world war? An oil crisis?  A major nuclear meltdown?  A great depression?  Super restrictive economic policy changes?  Super aggressive economic policy changes? Stagflation?  A missile crisis that takes us to the edge of nuclear annihilation?  Another terrorist attack?

Oh wait, the 4% SWR has already survived all of that, and assumes all of those things will totally happen again, and yet it's still 95-100% safe. 

Does anyone here think the future is really going to look worse than the past the 4% rule is based on?   I'm not saying it's impossible, just that it's a pretty grim view of the future.

Not only is it a grim view of the future it goes against the all global trends.

To be fair, not all of them.  I'm far from a doomsayer, but one trend that might eventually require a re-visit of the 4% rule is the trendline of dividends.  While the US stock markets have trended up by about 6% or 7%, on average, for it's entire existence; the ratio of dividends to capital has been declining.  This is the inverse of the price to earnings ratio, so the PE has been trending up.  I presume that this is a side effect of maturing industrial societies; as in, as the infrastructure & industry of a society improves, the relative number of discoverable improvements in those categories (and thus the relative number of profitable investing opportunities) declines.

[brooklynguy]

To be fair, not all of them.  I'm far from a doomsayer, but one trend that might eventually require a re-visit of the 4% rule is the trendline of dividends.  While the US stock markets have trended up by about 6% or 7%, on average, for it's entire existence; the ratio of dividends to capital has been declining.  This is the inverse of the price to earnings ratio, so the PE has been trending up.  I presume that this is a side effect of maturing industrial societies; as in, as the infrastructure & industry of a society improves, the relative number of discoverable improvements in those categories (and thus the relative number of profitable investing opportunities) declines.

I don't follow your logic.  If anything, a lower dividend payout ratio indicates higher (not lower) growth prospects, because it suggests that management believes reinvesting funds in the business is a better allocation of capital then returning it to shareholders in the form of dividends (which explains why companies traditionally increase their dividend payout ratios as they progress in their lifecycles from young, growing businesses with many reinvestment opportunities to mature, stable businesses with fewer reinvestment opportunities).

The increase in PE ratios that is directly attributable to the decrease in dividend payout ratios causes PE-based valuation metrics to overstate the expensiveness of the current market as compared to historical periods (because those PE-based valuation metrics do not correct for the effects of the downward trend in dividend payout ratios), suggesting that expected future returns are higher (not lower) than they otherwise would be using those PE-based valuation metrics in the absence of a secular change in dividend payout ratios.  (In reality, the downward trend in dividend payout ratios is largely due to a shift in management preferences towards favoring returning capital to shareholders via share buybacks in lieu of dividend payments, in large part precisely because of a lower dividend payout ratio's "artificial" boost to performance metrics.)

[MoonShadow]

To be fair, not all of them.  I'm far from a doomsayer, but one trend that might eventually require a re-visit of the 4% rule is the trendline of dividends.  While the US stock markets have trended up by about 6% or 7%, on average, for it's entire existence; the ratio of dividends to capital has been declining.  This is the inverse of the price to earnings ratio, so the PE has been trending up.  I presume that this is a side effect of maturing industrial societies; as in, as the infrastructure & industry of a society improves, the relative number of discoverable improvements in those categories (and thus the relative number of profitable investing opportunities) declines.

I don't follow your logic.  If anything, a lower dividend payout ratio indicates higher (not lower) growth prospects, because it suggests that management believes reinvesting funds in the business is a better allocation of capital then returning it to shareholders in the form of dividends (which explains why companies traditionally increase their dividend payout ratios as they progress in their lifecycles from young, growing businesses with many reinvestment opportunities to mature, stable businesses with fewer reinvestment opportunities).

The increase in PE ratios that is directly attributable to the decrease in dividend payout ratios causes PE-based valuation metrics to overstate the expensiveness of the current market as compared to historical periods (because those PE-based valuation metrics do not correct for the effects of the downward trend in dividend payout ratios), suggesting that expected future returns are higher (not lower) than they otherwise would be using those PE-based valuation metrics in the absence of a secular change in dividend payout ratios.  (In reality, the downward trend in dividend payout ratios is largely due to a shift in management preferences towards favoring returning capital to shareholders via share buybacks in lieu of dividend payments, in large part precisely because of a lower dividend payout ratio's "artificial" boost to performance metrics.)

You seem to be thinking about how a p/e ratio might rise or fall within a single company.  I'm talking about the general trend of the entire market over it's lifetime.  Take a look at it...

http://www.multpl.com/

Granted, there is a lot of volatility in there, and I don't have the tools to show a precise trend line, but if you look at it you can see that the overall trend of the S&P500 P/E ratio is gradually upwards.  I suspect, but cannot know, that is because the 'lower hanging fruit' of private infrastructure (and thus many investment) opprotunities have already been picked, for an industrial economy as mature as the United States; and therefore, the newer investments are both of a more incremental improvement & of a longer ROI.  Of course, I'm speaking of the entire market in the US today as compared to the past, and not speaking of particular companies, regions or industries; which could move counter to that slow trend over any time period.  So, in our own lifetimes it may not matter, since the 4% rule is very conservative anyway; but it might matter eventually.  It would also imply that 'emerging market' type investments should be part of a 4% withdrawal portfolio.

[brooklynguy]

You seem to be thinking about how a p/e ratio might rise or fall within a single company.  I'm talking about the general trend of the entire market over it's lifetime.  Take a look at it...

http://www.multpl.com/

Granted, there is a lot of volatility in there, and I don't have the tools to show a precise trend line, but if you look at it you can see that the overall trend of the S&P500 P/E ratio is gradually upwards.  I suspect, but cannot know, that is because the 'lower hanging fruit' of private infrastructure (and thus many investment) opprotunities have already been picked, for an industrial economy as mature as the United States; and therefore, the newer investments are both of a more incremental improvement & of a longer ROI.  Of course, I'm speaking of the entire market in the US today as compared to the past, and not speaking of particular companies, regions or industries; which could move counter to that slow trend over any time period.  So, in our own lifetimes it may not matter, since the 4% rule is very conservative anyway; but it might matter eventually.  It would also imply that 'emerging market' type investments should be part of a 4% withdrawal portfolio.

Yes, I realized you were talking about the entire market, but the "entire market" is just a collection of individual companies, whose P/E ratio consists of the aggregate P/E ratios of those individual companies (and, for the reasons I stated, I still don't follow your logic -- higher P/E ratios imply that investors are expecting more growth, not less).

[MoonShadow]

You seem to be thinking about how a p/e ratio might rise or fall within a single company.  I'm talking about the general trend of the entire market over it's lifetime.  Take a look at it...

http://www.multpl.com/

Granted, there is a lot of volatility in there, and I don't have the tools to show a precise trend line, but if you look at it you can see that the overall trend of the S&P500 P/E ratio is gradually upwards.  I suspect, but cannot know, that is because the 'lower hanging fruit' of private infrastructure (and thus many investment) opprotunities have already been picked, for an industrial economy as mature as the United States; and therefore, the newer investments are both of a more incremental improvement & of a longer ROI.  Of course, I'm speaking of the entire market in the US today as compared to the past, and not speaking of particular companies, regions or industries; which could move counter to that slow trend over any time period.  So, in our own lifetimes it may not matter, since the 4% rule is very conservative anyway; but it might matter eventually.  It would also imply that 'emerging market' type investments should be part of a 4% withdrawal portfolio.

Yes, I realized you were talking about the entire market, but the "entire market" is just a collection of individual companies, whose P/E ratio consists of the aggregate P/E ratios of those individual companies (and, for the reasons I stated, I still don't follow your logic -- higher P/E ratios imply that investors are expecting more growth, not less).

Sometimes, but sometimes investors are simply seeking the best yield on capital that they can find.  In fact, I'd say that that's what happens most of the time.  While they may expect that one company is going to grow more than another, they are still two boats riding the same tide.  So while P/E does make sense in your context, trying to decide between multiple specific investments, the overall trend in P/E is still higher.  The demographics of investments (for lack of a better term) implies that capital is increasing & competing for fewer (sound) investments overall, which would be what we would expect to see in a maturing industry.  What I'm saying is, that it looks like the entire investing marketplace, all industries included, are maturing on a multi-generational timeframe; and thus we can expect that yield on capital (dividends in this context) will trend lower, but very slowly.

[AdrianC]

Stocks have tended to perform better over longer time periods and should therefore provide the highest possible SWR's.

This may seem instinctively true but mathematically it's more complicated than that.  Safe Withdrawal Rates are highly influenced not only by average returns but also by annual volatility.  All things being equal, higher volatility lowers the SWR.  So two portfolios with equal average returns may have drastically different withdrawal rates based on the underlying volatility.  And sometimes portfolios with lower average returns but lower volatility can still beat stocks.  That's how you get interesting results like this:



This plots the returns and calculated SWRs of a variety of different popular lazy portfolios.  Note that the Total Stock Market has one of the highest returns but the lowest SWR!  Also note than none of the top-3 SWR portfolios have more than 40% stocks.  For a more detailed walkthrough, I'd recommend reading this.  And to see an example of a portfolio with only 40% stocks that matches the long-term returns of the stock market with much lower volatility and a much higher SWR, try this.

This is very interesting. I've been a stocks + cash guy during accumulation. No bonds. No gold. Now I'm thinking of going RE I wonder about the volatility of a stocks plus cash portfolio. However, I'm also concerned that bonds and gold are not going to do what they did in these SWR studies.

Example: The Permanent Portfolio:
•25% Long Term Treasuries
•25% Short Term Treasuries
•25% Gold
•25% Total Stock Market

For a portfolio to last 40 years at a 4% SWR it needs investment returns of about 2.5% per year after inflation. Then it's all gone.

•25% Long Term Treasuries - Vanguard Long-Term Treasury Fund Admiral Shares (VUSUX) current yield 2.68%
•25% Short Term Treasuries - Vanguard Short-Term Treasury Fund Admiral Shares (VFIRX) current yield 0.99%
•25% Gold - over the long term will likely keep up with inflation, real return of 0%
•25% Total Stock Market - who knows? But valuation is demonstrably high, which correlates well with sub-par returns.

That's not looking good. It's not looking promising for 2.5% over inflation. And it's certainly not looking like 4-5% over inflation, which is, I expect, what most of us really want (and need).

[Tyler]

The math behind SWRs is more complicated than just adding up the long-term real return for each individual asset.  For example, gold does generally average a 0% real return in the long run but it is quite volatile year to year.  Rebalancing a diverse portfolio each year allows you to benefit from those short-term movements by selling high and buying low.  Also, volatility of the overall portfolio is a lot more important than most people realize (see How Safe Withdrawal Rates Work).  So you have to look beyond yield and average returns to get the full story. 

In any case, all portfolios are uncertain looking forward.  IMHO, the key for an early retiree is not to fear or ignore uncertainty but to embrace and plan for it.  Portfolio diversification is just one way to do that, but I think it's a good one.

[oysters]

Maybe getting off topic, but with a diversified portfolio Tyler, what would be a simple rule based mechanism for the pre and post retirement stages? My thoughts were:

PRE.
1. Choose your fund allocations as %es.
2. Set regular date (eg 1st Monday each month) to invest savings (invest whatever you get to. Have your own personal rules for this but NOT based on the market if possible...eg rules could be to maintain a certain slush fund for emergencies, day to day, etc).
3. On that 1st Monday, look at your funds, determine which has lost the most (% wise) since last look (previous month).
4. Invest in that to get you back up to your pre determined fund allocation scenario.
5. Invest in next worse performing fund (if still have savings left).
6. Etc

(or could just dispense of 5, 6 and keep it simple by sticking it all in the worst fund each time. Maybe more likely to get out of whack. Maybe not. This might save brokerage fees depending on your situation (Eg for Aussies, everyone pays fees at the moment as far as I can tell).
Rarely (eg once per year, depending on your countries and your personal tax situation)...sell some of highest performing over the previous period (year if choosing year), to rebalance other funds, if required (assuming savings input during year wasn't enough to maintain balance).

POST (keeping it simple, I'm avoiding the issues of pensions, super, social security, etc).
1. Choose your SWR (however you want. Putting that debate aside for the moment).
2. Determine your frequency of withdrawal (eg month, eg six months-put cash aside).
3. Look at % performance change of portfolio since last withdrawal. Choose worst(s) performing ETFs.
4. Withdraw progressively from worst ETF until withdrawn required funds.

Rarely, perform fund rebalancing same as for PRE retirement.

Does that make sense?

I've also simplified by ignoring dividends particularly in the POST environment...different tax and other implications depending on country.

[Tyler]

Your pre-fire plan is exactly what I did. 

For post-fire, here's what I've done (YMMV).

1) Calculate your budget for the year based on your initial SWR and inflation.
2) Withdraw expenses once a year, coinciding with your annual rebalance.
3) Set dividends and interest to go to cash rather than automatically reinvest.  Use these for expenses first.
4) Sell the assets above your target AA (winners) to make up the difference.  That will also accomplish a partial rebalance.
5) After that, reevaluate what's left and rebalance as needed.  Always be smart about taxes.

It's a good topic.  If you have any more questions, perhaps we can start a new thread. 

[AdrianC]

The math behind SWRs is more complicated than just adding up the long-term real return for each individual asset.  For example, gold does generally average a 0% real return in the long run but it is quite volatile year to year.  Rebalancing a diverse portfolio each year allows you to benefit from those short-term movements by selling high and buying low.  Also, volatility of the overall portfolio is a lot more important than most people realize (see How Safe Withdrawal Rates Work).  So you have to look beyond yield and average returns to get the full story. 

Sure. All good. However, we can look at current valuations and yields, and make informed guesses about future returns for each asset class. The total portfolio return will not be the simple average of the various asset classes, but will it be *that* far away from it? Depends on volatility, rebalance timing and other factors. No way to know. To my mind it's better to reduce assets that are all but guaranteed to return a lot less than what is required to sustain our required withdrawal rate. So long term treasuries are out, for a start. Short term treasuries (cash) is needed, of course.

In any case, all portfolios are uncertain looking forward.  IMHO, the key for an early retiree is not to fear or ignore uncertainty but to embrace and plan for it.  Portfolio diversification is just one way to do that, but I think it's a good one.

Absolutely. Withdrawal rate flexibility is key. A 4% rate may be doable on average, but the early retiree needs to be able to ride through periods of lower withdrawals. Aiming for 3% isn't a bad idea.

[brooklynguy]

You seem to be thinking about how a p/e ratio might rise or fall within a single company.  I'm talking about the general trend of the entire market over it's lifetime.  Take a look at it...

http://www.multpl.com/

Granted, there is a lot of volatility in there, and I don't have the tools to show a precise trend line, but if you look at it you can see that the overall trend of the S&P500 P/E ratio is gradually upwards.  I suspect, but cannot know, that is because the 'lower hanging fruit' of private infrastructure (and thus many investment) opprotunities have already been picked, for an industrial economy as mature as the United States; and therefore, the newer investments are both of a more incremental improvement & of a longer ROI.  Of course, I'm speaking of the entire market in the US today as compared to the past, and not speaking of particular companies, regions or industries; which could move counter to that slow trend over any time period.  So, in our own lifetimes it may not matter, since the 4% rule is very conservative anyway; but it might matter eventually.  It would also imply that 'emerging market' type investments should be part of a 4% withdrawal portfolio.

Yes, I realized you were talking about the entire market, but the "entire market" is just a collection of individual companies, whose P/E ratio consists of the aggregate P/E ratios of those individual companies (and, for the reasons I stated, I still don't follow your logic -- higher P/E ratios imply that investors are expecting more growth, not less).

Sometimes, but sometimes investors are simply seeking the best yield on capital that they can find.  In fact, I'd say that that's what happens most of the time.  While they may expect that one company is going to grow more than another, they are still two boats riding the same tide.  So while P/E does make sense in your context, trying to decide between multiple specific investments, the overall trend in P/E is still higher.  The demographics of investments (for lack of a better term) implies that capital is increasing & competing for fewer (sound) investments overall, which would be what we would expect to see in a maturing industry.  What I'm saying is, that it looks like the entire investing marketplace, all industries included, are maturing on a multi-generational timeframe; and thus we can expect that yield on capital (dividends in this context) will trend lower, but very slowly.

Ah, I see what you are saying.  But your argument is really based on the overall decrease in the earnings yield (the inverse of the P/E ratio), not the dividend yield (the ratio of dividends to share price).  The downward trend in dividend yields is not just a function of higher P/E ratios, but also the downward trend in dividend payout ratios (the ratio of dividends to earnings, which is what I had been referring to).  That is, we have lower dividend yields today than historically not only because share prices are higher relative to earnings (which, accordingly to your theory, may reflect increased investor competition for fewer investment opportunities in a mature market), but also, in large part, because companies simply choose to retain a higher percentage of their earnings instead of paying them out to shareholders in the form of dividends.

[MoonShadow]

You seem to be thinking about how a p/e ratio might rise or fall within a single company.  I'm talking about the general trend of the entire market over it's lifetime.  Take a look at it...

http://www.multpl.com/

Granted, there is a lot of volatility in there, and I don't have the tools to show a precise trend line, but if you look at it you can see that the overall trend of the S&P500 P/E ratio is gradually upwards.  I suspect, but cannot know, that is because the 'lower hanging fruit' of private infrastructure (and thus many investment) opprotunities have already been picked, for an industrial economy as mature as the United States; and therefore, the newer investments are both of a more incremental improvement & of a longer ROI.  Of course, I'm speaking of the entire market in the US today as compared to the past, and not speaking of particular companies, regions or industries; which could move counter to that slow trend over any time period.  So, in our own lifetimes it may not matter, since the 4% rule is very conservative anyway; but it might matter eventually.  It would also imply that 'emerging market' type investments should be part of a 4% withdrawal portfolio.

Yes, I realized you were talking about the entire market, but the "entire market" is just a collection of individual companies, whose P/E ratio consists of the aggregate P/E ratios of those individual companies (and, for the reasons I stated, I still don't follow your logic -- higher P/E ratios imply that investors are expecting more growth, not less).

Sometimes, but sometimes investors are simply seeking the best yield on capital that they can find.  In fact, I'd say that that's what happens most of the time.  While they may expect that one company is going to grow more than another, they are still two boats riding the same tide.  So while P/E does make sense in your context, trying to decide between multiple specific investments, the overall trend in P/E is still higher.  The demographics of investments (for lack of a better term) implies that capital is increasing & competing for fewer (sound) investments overall, which would be what we would expect to see in a maturing industry.  What I'm saying is, that it looks like the entire investing marketplace, all industries included, are maturing on a multi-generational timeframe; and thus we can expect that yield on capital (dividends in this context) will trend lower, but very slowly.

Ah, I see what you are saying.  But your argument is really based on the overall decrease in the earnings yield (the inverse of the P/E ratio), not the dividend yield (the ratio of dividends to share price).  The downward trend in dividend yields is not just a function of higher P/E ratios, but also the downward trend in dividend payout ratios (the ratio of dividends to earnings, which is what I had been referring to).  That is, we have lower dividend yields today than historically not only because share prices are higher relative to earnings (which, accordingly to your theory, may reflect increased investor competition for fewer investment opportunities in a mature market), but also, in large part, because companies simply choose to retain a higher percentage of their earnings instead of paying them out to shareholders in the form of dividends.

I can accept that observation, however the decisions of boardmembers regarding dividends retention or payout tend to reverse themselves over the long run, and don't reflect upon the P/E ratio over generations.  Therefore, the primary (perhaps not the only) long term effect of a generational decrease of earnings yield would be to suppress dividends anyway.  So I don't know how the fact that some companies choose to retain more earnings during one decade over another affects my argument.  In the long run, the dividend yield must still go down proportional to the decrease in the earnings yield; because earnings beget dividends.

[brooklynguy]

I can accept that observation, however the decisions of boardmembers regarding dividends retention or payout tend to reverse themselves over the long run

Do they?  Dividend payout ratios have been declining since at least 1980 (see here), and I think for much longer (but I'm on my phone so I'm having trouble looking up data).

In the long run, the dividend yield must still go down proportional to the decrease in the earnings yield; because earnings beget dividends.

Not necessarily; that's exactly my point.  For the past 35 years (at least) there has been a disproportionately high decrease in the dividend yield owing to the decrease in the dividend payout ratio.  Consider what would happen if every company suddenly decided to follow Berkshire Hathaway's lead and stop paying dividends altogether; the overall dividend yield would suddenly shrink to zero, but that wouldn't indicate anything about underlying market fundamentals.

[MoonShadow]

I can accept that observation, however the decisions of boardmembers regarding dividends retention or payout tend to reverse themselves over the long run

Do they?  Dividend payout ratios have been declining since at least 1980 (see here), and I think for much longer (but I'm on my phone so I'm having trouble looking up data).

In the long run, the dividend yield must still go down proportional to the decrease in the earnings yield; because earnings beget dividends.

Not necessarily; that's exactly my point.  For the past 35 years (at least) there has been a disproportionately high decrease in the dividend yield owing to the decrease in the dividend payout ratio.  Consider what would happen if every company suddenly decided to follow Berkshire Hathaway's lead and stop paying dividends altogether; the overall dividend yield would suddenly shrink to zero, but that wouldn't indicate anything about underlying market fundamentals.

Perhaps, but I think even Berkshire Hathaway will eventually pay out dividends. Warren Buffet won't live forever.  Still, that won't change the trend;if earnings are not paid out as dividends, that typically adds to the stock value anyway, so a generationally rising P/E is going to impact the 4% rule whether by dividends or by capital gains.  But at the trendline rate, it's unlikely that any of us will have to be too concerned.

[brooklynguy]

Still, that won't change the trend;if earnings are not paid out as dividends, that typically adds to the stock value anyway, so a generationally rising P/E is going to impact the 4% rule whether by dividends or by capital gains. 

No, to the extent the increase in P/E is attributable to a decrease in the dividend payout ratio, it would have zero impact on the 4% rule (ignoring tax consequences, if any); all it would mean is that an investor relying on the 4% rule would need to sell more shares (which, as you said, would reflect the higher value of the retained earnings) to make up the shortfall in the dividend payouts, with no net overall impact.

[ender]

It might be interesting to include in this thread a comprehensive list of "things that could go wrong" and "things you could do to improve chances of FIRE" on the same SWR?

I wrote this post and it occurred to me it might be interesting to have a large list of reasons why FIRE could be easier or harder than expected.

[Ursus Major]

Still, that won't change the trend;if earnings are not paid out as dividends, that typically adds to the stock value anyway, so a generationally rising P/E is going to impact the 4% rule whether by dividends or by capital gains. 

No, to the extent the increase in P/E is attributable to a decrease in the dividend payout ratio, it would have zero impact on the 4% rule (ignoring tax consequences, if any); all it would mean is that an investor relying on the 4% rule would need to sell more shares (which, as you said, would reflect the higher value of the retained earnings) to make up the shortfall in the dividend payouts, with no net overall impact.

You are absolutely right that in theory retaining dividends is neutral for investors, but there is one aspect where it would make a difference, whether a company pays dividends or retains them and that is volatility. I believe that on average dividend payouts are much less volatile than stock prices, so downward volatility is going to be much more problematic, if an investor relies on stock sales (and thus stock prices) for most or all of their income generation compared to an investor who gets a decent percentage of their returns as dividend. To the extent that companies now pay less in dividends, this means you have to sell comparatively more of them at low prices during an adverse market event.

This might very well lower the SWR compared to the past.

[brooklynguy]

You are absolutely right that in theory retaining dividends is neutral for investors

I think practice is virtually assured to comport with theory on this point, because, although the stock market is not perfectly efficient (as posited by stronger forms of the efficient market hypothesis), it is nonetheless highly efficient, and certainly efficient enough to correctly reflect so obvious a change (or lack of change) in the intrinsic value of a company's shares as the company's divestiture (or non-divestiture) of cash in the form of a dividend payment (or non-payment) to its shareholders.  In other words, dividend payments (or non-payments) are always correctly priced into the company's shares by the market to begin with, so any market fluctuations would have an equal impact on companies regardless of their dividend payout ratios.

Forum user skyrefuge (who has been inactive lately) was best at articulating this point, so I would recommend looking up some of his posts on the topic (and the discussion starting with this post is a really fun read, if you're interested in going down a rabbit hole on this issue).

[TomTX]

Stocks have tended to perform better over longer time periods and should therefore provide the highest possible SWR's.

This may seem instinctively true but mathematically it's more complicated than that.  Safe Withdrawal Rates are highly influenced not only by average returns but also by annual volatility.  All things being equal, higher volatility lowers the SWR.  So two portfolios with equal average returns may have drastically different withdrawal rates based on the underlying volatility.  And sometimes portfolios with lower average returns but lower volatility can still beat stocks.  That's how you get interesting results like this:



This plots the returns and calculated SWRs of a variety of different popular lazy portfolios.  Note that the Total Stock Market has one of the highest returns but the lowest SWR!  Also note than none of the top-3 SWR portfolios have more than 40% stocks.  For a more detailed walkthrough, I'd recommend reading this.  And to see an example of a portfolio with only 40% stocks that matches the long-term returns of the stock market with much lower volatility and a much higher SWR, try this.

This is very interesting. I've been a stocks + cash guy during accumulation. No bonds. No gold. Now I'm thinking of going RE I wonder about the volatility of a stocks plus cash portfolio. However, I'm also concerned that bonds and gold are not going to do what they did in these SWR studies.

Example: The Permanent Portfolio:
•25% Long Term Treasuries
•25% Short Term Treasuries
•25% Gold
•25% Total Stock Market

For a portfolio to last 40 years at a 4% SWR it needs investment returns of about 2.5% per year after inflation. Then it's all gone.

•25% Long Term Treasuries - Vanguard Long-Term Treasury Fund Admiral Shares (VUSUX) current yield 2.68%
•25% Short Term Treasuries - Vanguard Short-Term Treasury Fund Admiral Shares (VFIRX) current yield 0.99%
•25% Gold - over the long term will likely keep up with inflation, real return of 0%
•25% Total Stock Market - who knows? But valuation is demonstrably high, which correlates well with sub-par returns.

That's not looking good. It's not looking promising for 2.5% over inflation. And it's certainly not looking like 4-5% over inflation, which is, I expect, what most of us really want (and need).

As I have said before, the backtesting used here is bullshit. Not only is it too short - It's since 1972. That's when we went off the gold standard, and gold had a huge runup. Bonds were paying unusually well, rates got higher for a bit - then anyone holding long bonds from 1980 forward made an absolute killing due to the long decline in interest rates (interest rates fall, value of your bonds goes up.) 1972 was also a pretty poor year to start in stocks.

With today's rates, you simply cannot get that to happen. 30 year treasuries are below 3% (!)

[Tyler]

The fact that portfolios using assets not included in the Trinity study had different withdrawal rates than the very specific portfolios used in the Trinity study really shouldn't be too surprising.  When you deviate from the assumptions, you change the conclusions.  All we can do is look at the best data available and come to our own conclusions about where to invest our life savings.   

One is free to dislike particular assets for whatever reason they choose and still find value in the interesting results for other portfolios with assets that make them more comfortable.  They can also choose to distrust those results and only invest in things where they have many more decades of data, or they can choose to distrust all SWR studies and take a completely different path to retirement (rentals, income investing, saving more, etc).  All of those methods are perfectly fine, and reasonable people may disagree on the preferable approach.

IMHO, the only unreasonable approach is to blindly follow a SWR calculated for a specific set of assets you do not yourself own. 

[Ursus Major]

You are absolutely right that in theory retaining dividends is neutral for investors

I think practice is virtually assured to comport with theory on this point, because, although the stock market is not perfectly efficient (as posited by stronger forms of the efficient market hypothesis), it is nonetheless highly efficient, and certainly efficient enough to correctly reflect so obvious a change (or lack of change) in the intrinsic value of a company's shares as the company's divestiture (or non-divestiture) of cash in the form of a dividend payment (or non-payment) to its shareholders.  In other words, dividend payments (or non-payments) are always correctly priced into the company's shares by the market to begin with, so any market fluctuations would have an equal impact on companies regardless of their dividend payout ratios.

Forum user skyrefuge (who has been inactive lately) was best at articulating this point, so I would recommend looking up some of his posts on the topic (and the discussion starting with this post is a really fun read, if you're interested in going down a rabbit hole on this issue).

Hi brooklynguy,

I've decided to "go down the rabbit hole" and start a new thread on this: http://forum.mrmoneymustache.com/investor-alley/dividends-vs-capital-gains-once-again/

My calculations show a different result and I'd be delighted to have this resolved for myself.