Author Topic: 4% safe withdraw question  (Read 6077 times)

Bea

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4% safe withdraw question
« on: September 30, 2013, 11:45:02 AM »
Hello Mustachians! I am pretty new and I have to admit not super great at math. After reading the 4% article and the "amazingly simple math" article I am still kind of confused. Ok so I get that 25 times your spending will provide you with infinite retirement based on withdrawing 4% of the dividends per year. But, doesn't this assume that you will always maintain the same spending rate? Even the most frugal family must bend to the will of inflation, right? A very frugal person could live on $5000 in 1960 but no one could live on that now. If I'm retired for 50+ years won't I be FORCED to spend more even for the most frugal of life styles over time? Any clear explanation of this would be so appreciated!

brewer12345

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Re: 4% safe withdraw question
« Reply #1 on: September 30, 2013, 12:00:55 PM »
Its 4% of the strating balance adjusted for inflation.

matchewed

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Re: 4% safe withdraw question
« Reply #2 on: September 30, 2013, 12:13:48 PM »
Also - http://www.bogleheads.org/wiki/Safe_withdrawal_rates This explains the usage of the 4% SWR better.

nawhite

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Re: 4% safe withdraw question
« Reply #3 on: September 30, 2013, 12:23:10 PM »
Brewer is right, the studies that the math is based on come to the conclusion that you spend 4% of the starting balance each year and you increase the amount by inflation every year.

So for instance lets use $1M in savings, so a 4% withdrawl rate gets you 40k/year. Lets assume inflation is 2% per year. Year one, you can spend 40k, year two you can spend 40,800, year three you can spend $41,616 etc.

That all being said these calculations rely on a RIDICULOUS number of assumptions most (but not all) of which make 4% more conservative than necessary for a 30 year retirement.

For instance, if the market has a bad year, you can choose not to take a vacation, or to get a part time job, or to craigslist some stuff etc, in order to bring your spending for that year down. The math behind the 4% rule assumes that you will spend Exactly the defined amount every year despite market fluctuations. This is a huge help to people who want to retire early because the #1 or #2 effect on decreasing your nest egg is withdrawls during down markets. If you can minimize these withdrawls, then you will be in much better shape than the models would indicate otherwise.

A different assumption which is pessemistic for Early retirement is that the 4% is based on having at least $0 at the end of 30 years. If you end up living long enough to require a 31 year retirement then hopefully you are lucky. Granted the 60 year safe withdrawl rate is still like 3.5% according to the models, but the longer year models aren't as good because there aren't as many 60 year periods as there are 30 year periods.

So yes, according to the models, you can increase your spending every year by inflation and still follow the 4% withdrawl rates. But its in your best interest to understand the assumptions that number is based on.

Bea

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Re: 4% safe withdraw question
« Reply #4 on: September 30, 2013, 12:26:08 PM »
Thanks for your replies! that makes way more sense now.

DoubleDown

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Re: 4% safe withdraw question
« Reply #5 on: October 01, 2013, 07:35:25 AM »
@Bea -- I'd like to add one other thing in case it wasn't already clear from what you've read. As pointed out already, the 4% SWR (or whatever rate you use) already includes inflation, and that's because it assumes you will get more than that rate in your investment returns. So, if inflation is 3% annually, and you are withdrawing 4% annually, you need to get at least a 7% return on your investments in order to to sustain your spending forever at that 4% withdrawal level (or make other adjustments such as reducing spending or picking up some income elsewhere). It will not be enough to hold investments in just "safe" investments that only get 4% nominal returns -- then you definitely would feel the bite of inflation.

Bea

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Re: 4% safe withdraw question
« Reply #6 on: October 01, 2013, 12:31:33 PM »
@ Doubledown, Thanks! yes I had realized that the whole scenario was based on the 7% interest number but it's great to have things clarified. Being a visual learner it's sometimes hard to follow the the logic but I think, over time I am starting to understand more concepts and I hope to be able to cautiously apply them to my life and finances. So I guess my other question is, if a person has achieved early retirement, say in their 50's using this strategy would it make sense to at some point switch to a more conservative portfolio? A person in their 70's probably won't have much opportunity or desire to return to the workforce in any serious way were the markets to turn down for a while so would it make sense to insulate themselves from down markets with safer options and assume that they will start using up the principal and eventually die with less principal then they retired with? or is this undue risk because that person could live till 90 or even longer?

footenote

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Re: 4% safe withdraw question
« Reply #7 on: October 01, 2013, 12:57:52 PM »
Bea - You outlined the classic asset allocation-as-you-approach / live-in-retirement thinking. Generally, advisors call for less stock market exposure and more bond investments over time.

(There is a lot more to it than that, but that's the basic advice.)

Yes, planning for varying longevity is very tricky. Some of the 4% (or even lower) Safe Withdrawal Rate advice is planned "so that you'll never run out, no matter how long you live."

You may want to check out cfiresim.com. It allows you to model various portfolio, longevity and withdrawal rates (as annual income).

DoubleDown

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Re: 4% safe withdraw question
« Reply #8 on: October 02, 2013, 10:46:48 AM »
@Bea - Great question, one we just about all wrestle with, and as footenote noted, a classic asset allocation question or dilemma. Hard to say what answer is right for you, that will very much depend on your own tolerance for risk, your willingness to do things to make it through potentially harder times (like going back to work, etc.). I'd say though that retiring in your 50s should make it a little easier since it's less life span to cover than retiring, say, in your 30s. I guess the two camps of thought go like this, with an infinite spectrum in-between:

1. I don't want any risk to my portfolio going down through market volatility, so I will keep it in mostly (or even all) in investments with little or no risk. I acknowledge that my portfolio will almost certainly become less valuable over time through inflation, and if inflation is bad enough, I might not have enough to meet my expenses in later years.

2. I think inflation could ravage my portfolio over time, and the only way to keep up or stay ahead of it is to have significant exposure in the stock market (i.e., to have a large percentage of your portfolio in stocks). I acknowledge that there could be some significant ups and downs along the way, and have to be able to stomach large drops and not get spooked out of the market when it does, under the belief that over time it will recover. But it's possible it may never recover.

One way financial advisors often recommend to find a balance is to determine what your most basic living expenses are, and identify some fixed income streams that are super safe to cover those. For example, Social Security or a purchased annuity indexed for inflation are some ways to ensure you'll always have at least enough for shelter, food, utilities, etc. Then for the more discretionary expenses, have an asset allocation that has a fair amount invested in the stock market to (hopefully) keep your portfolio growing. In this way, you can feel confident that you'll never go hungry or without a roof over your head, and won't have to worry about occasional, and inevitable, bad times in the stock market. In the long run, your assets invested in reasonable indexed stock funds and a healthy mix of bonds should do well and hopefully hit that 7% nominal return.

As an example, if you determine you need a minimum of $3000/month, or $36,000/year to meet your minimum living expenses, then find some safe income sources to cover those, like your expected Soc. Security payment, pensions, annuities, rental income, etc. If you'd like to have another $12,000/year for travel, discretionary purchases, etc., then keep 25 x $12,000 = $300,000 in a mix of stocks, bonds, etc. (probably mostly in indexed stocks).

- Let's say you will get $2000/month from Soc. Security. Now you need another safe source of income to cover the remaining amount needed of $1000/month
- From your assets, purchase an annuity from your assets that will provide income of $1000/month. Or perhaps purchase a rental home that will provide $1000/month in income after all expenses, management fees, vacancies are deducted.
- Whatever is left in your portfolio, invest in indexed stocks and bonds

Obviously prior to eligibility for Soc. Sec. you'll have to find a different income stream for the $2000/month.

Also, another great hedge against risks to depleting your portfolio over time or suffering large setbacks early in your retirement are to do things to reduce drawing down on it early, so you won't be in that situation where you need to go back to work in your 70s. For example, if you're satisfied with the idea of picking up a little part time work in your first few years of retirement while you're able-bodied, that will allow you to withdraw less than 4% for those first few years, and your portfolio should grow even larger, giving you more security for later years.

Ishmael

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Re: 4% safe withdraw question
« Reply #9 on: October 02, 2013, 12:24:40 PM »
My eventual retirement plan breaks my budget up into 3 levels:
  • Core essentials: basic groceries, transportation, known medical expenses, etc.
  • Luxuries: Some spending cash, simple vacation, christmas/birthday gifts, etc.
  • Super Luxuries: Nice vacation, other hobbies.

So it's obvious what would get cut and it's easy to come up with a spending range that I would need for each year.

I wish tools like Firecalc would allow you to enter income ranges like this, and auto-adjust the spending based on the year's performance when doing it's calculations. Then, it could tell you how many years you were able to indulge on super luxuries, how many times our base expenses cut into your principal, etc.

tooqk4u22

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Re: 4% safe withdraw question
« Reply #10 on: October 02, 2013, 12:40:57 PM »
My eventual retirement plan breaks my budget up into 3 levels:
  • Core essentials: basic groceries, transportation, known medical expenses, etc.
  • Luxuries: Some spending cash, simple vacation, christmas/birthday gifts, etc.
  • Super Luxuries: Nice vacation, other hobbies.

So it's obvious what would get cut and it's easy to come up with a spending range that I would need for each year.

I wish tools like Firecalc would allow you to enter income ranges like this, and auto-adjust the spending based on the year's performance when doing it's calculations. Then, it could tell you how many years you were able to indulge on super luxuries, how many times our base expenses cut into your principal, etc.

Me too.....Lets say you need $30k to meet basic living needs but want $50k to live with whatever your WANTS are....then you can FIRE when you hit $30K and work for the wants or you can FIRE with $50k and have $20k of cushion or somewhere inbetween.

dragoncar

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Re: 4% safe withdraw question
« Reply #11 on: October 02, 2013, 02:47:17 PM »
Someone on here made a fire calc alternative that I believe can do something like this.  Forget the name unfortunately

matchewed

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Bea

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Re: 4% safe withdraw question
« Reply #13 on: October 04, 2013, 09:30:22 PM »
Thanks everyone! Like I said I'm not great with numbers so I'm just still trying to wrap my head around this. I was wondering, if I'm planning for future retirement say 20 years in the future, how do I figure out the amount of money I will need given inflation? example: right now I spend 25k a year so that would mean I will need 625K to retire according to the 4% but doesn't the 625k number mean if I were retiring right now? how do I know what I will need in 20 years? should I be shooting for some other number in 2033 dollars?
argh! so confusing.

daverobev

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Re: 4% safe withdraw question
« Reply #14 on: October 04, 2013, 10:46:37 PM »
Thanks everyone! Like I said I'm not great with numbers so I'm just still trying to wrap my head around this. I was wondering, if I'm planning for future retirement say 20 years in the future, how do I figure out the amount of money I will need given inflation? example: right now I spend 25k a year so that would mean I will need 625K to retire according to the 4% but doesn't the 625k number mean if I were retiring right now? how do I know what I will need in 20 years? should I be shooting for some other number in 2033 dollars?
argh! so confusing.

Inflation is baked in to the SWR - in 20 years you will need the same as you need today, multiplied by 20 years of inflation. The assumption is that: stocks return 7%, inflation is 3%, hence SWR of the 'other' 4% (7 - 3 = 4!).

The $25k means you will need $25k * 25 = $625k to retire now. In 20 years, the $625k will grow with inflation less the roughly 4* of the total each year you withdraw to live on.

Basically the $625k will (in theory!!) remain stable; it will always allow you to live the same life without depleting the fund. In 20 years you will be able to withdraw whatever number of dollars $25k 2013 dollars has become - you will be able to buy the same number of bananas, lumps of cheese, and loaves of bread as today. The actual number of dollars is irrelevant - your purchasing power is relevant, and (in theory) will not have changed.

The thing is - in a stock-market-catastrophe year you should probably cut back your withdrawals a bit, if it makes sense to do so - or rather, if you can do that, it increases the chance your stache will outlast you.

SnackDog

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Re: 4% safe withdraw question
« Reply #15 on: October 05, 2013, 04:11:45 AM »
Many people overlook taxes in this calculation.  4% is what you will withdraw, not what you will spend.  You must subtract federal (and possibly state) income taxes to arrive at your spendable income.  Your tax bracket in retirement will depend on what investment vehicles you used for savings and could be as low as 0% or over 30%.  This makes quite a difference so don't ignore it.   There are  also many other caveats for the 4% rule, like market conditions the first few years after you retire (<2% SWR was recommended for 2010 retirees, for example), fees for your investment activity, behavior of the global market of the future vs US-dominated market of the last 100 years and longevity (4% only works for 30 years).

Bea

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Re: 4% safe withdraw question
« Reply #16 on: October 05, 2013, 04:24:51 PM »
Thanks everyone! maybe I should just accept that it is works but it's my nature to try to understand. Really appreciate your replies.