Author Topic: Why do the majority of Mustachians equate "25x Expenses" with "4% SWR" ?  (Read 7909 times)

Frugancial Advisor

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Hi everyone,

I've been lurking through the forums for some time now and am so glad to see discussions focusing on retirement as a lifestyle and not the end-of-life that is the reality for many. I had a client mention this website to me after commenting that I reminded him of MMM himself during our meeting (I work as a Financial Planner).

I've repeatedly told many of my clients about the reality of lifestyle inflation, the lack of frugality in today's culture, and the disillusion of over consumption being recognized as success.

Anyway, given this forum consists of what I feel to be a very financially savvy bunch; I can't help but question why the retirement calculation baseline is 25x expenses for everyone? Don't get me wrong, this is a phenomenal goal and solid way to work towards an early retirement. Yet, I don't see much discussion surrounding the individualism of each and every retirement scenario which could very well allow you to retire with much less than 25x expenses.

To better explain, consider the following example:

Client A is seeking to retire at age 40 with a $40,000 annual income indefinitely. He therefore aims to save $1,000,000 (i.e. $40,000 x 25). Very simple math.

Client B is also seeking to retire at age 40 with a $40,000 annual income indefinitely. Believing in the 4% SWR theory, he therefore calculates the present value dollar amount required to fund this income stream: approximately $859,000.
He then incorporates a small pension he is entitled to at 55, and government assistance payments as well.
He now requires even less

The only explanation I can predict is that we are focusing on capital preservation throughout our retirement; albeit based on my reading I'd imagine more here are focused on a happy and healthy retirement moreso than leaving a large inheritance.

This is just a genuine observation, and I'm hoping to hear some thoughts or insights from this community!

Thanks everyone.

forummm

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It's a rule of thumb. We talk about the nuances of it here and there. For those of us looking to retire in our 30s, we can't rely on pensions to reduce our savings needs in the short term. And many of us have different SWR rates we are shooting for. There are a lot of threads talking about that. Or adjusting based on the current market valuation, etc. cFIREsim is a tool that many of us use to see how comfortable we are with different spending levels and their historical outcomes.

beltim

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What assumptions are you using for client B that results in that present value dollar amount?

As for the larger question, the reason you see 25x expenses equated with a 4% withdrawal rate is that many people here aren't counting on other income streams, or they are explicitly including them, figuring that they need a stash of 25x expenses not funded through other sources (pension, SS, etc.).

For very early retirees, the difference between 25x expenses now and including future income streams (pension, SS) is very small because of that long time period.

arebelspy

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Client B is also seeking to retire at age 40 with a $40,000 annual income indefinitely. Believing in the 4% SWR theory, he therefore calculates the present value dollar amount required to fund this income stream: approximately $859,000.

I'm not following the calculation, unless it's future dollars (40k he'll need in several years), not today, in which case the 859k should still come to 25x today's spending, if he is using the 4% SWR.. and then he inflates it to a 40k spending, 1mm ER based on when he can hit that number,

Either way, calculating the PV of what is required to fund one's ER doesn't change the amount, if it's based on a 4% SWR, as is mentioned.

4% of a stach means you'll need 25x your assets, because 1/25 (each year you withdraw your assets, out of your whole portfolio, which is 25x that, so 1/25) = 0.04.

So
Quote
Why do the majority of Mustachians equate "25x Expenses" with "4% SWR" ?

Because they are mathematically equal.

If you are asking why do so many of us talk about a 4% SWR and why that's a fairly ideal rule of thumb for ER, you'll have to look more into the trinity study and subsequent research on retirement income and spending.  There are many, many threads, and you can run your own scenarios on tools like www.cfiresim.com. MMM has an article on the 4% rule as well you can read.
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Frugancial Advisor

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Thanks for the responses so far!

I should have given further clarification on the calculation:

At a withdrawal rate of 4%, and a life expectancy of age 90 - a client would require $859k to produce an income of $40k/year. This is a simple present value calculation done on a regular financial planning calculator, and not incorporating any other income sources.

dandarc

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Yep.  The 4% rule is a conservative strategy.  5% (Client B) is less conservative, but even absent pension / social security should last 30 years about 3 out of 4 times according to CfireSim.

MMM himself says he can get behind a 5% withdrawal rate in his 4% rule article.  http://www.mrmoneymustache.com/2012/05/29/how-much-do-i-need-for-retirement/

People think we're a bunch of renegade mavericks running around here, but in truth we're very careful.

4alpacas

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Thanks for the responses so far!

I should have given further clarification on the calculation:

At a withdrawal rate of 4%, and a life expectancy of age 90 - a client would require $859k to produce an income of $40k/year. This is a simple present value calculation done on a regular financial planning calculator, and not incorporating any other income sources.
I'm confused.  $859k could spit off $40k/year assuming a higher return rate than the Trinity Study uses, but I don't understand how it could be a 4% withdrawal. 

0.04*$859,000=$34,360


Frugancial Advisor

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Thanks for the responses so far!

I should have given further clarification on the calculation:

At a withdrawal rate of 4%, and a life expectancy of age 90 - a client would require $859k to produce an income of $40k/year. This is a simple present value calculation done on a regular financial planning calculator, and not incorporating any other income sources.
I'm confused.  $859k could spit off $40k/year assuming a higher return rate than the Trinity Study uses, but I don't understand how it could be a 4% withdrawal. 

0.04*$859,000=$34,360

Ah, thank you 4alpacas for pointing this out. It seems my terminology is misleading and I apologize for that.

I should have said "assuming a real return of 4% on investment, $859k would be required to produce an income stream of $40k/year from age 40 to age 90".

arebelspy

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Yes, a 4% real return is different than a 4% SWR.

Here is the article I referenced early, which may answer many of your questions: http://www.mrmoneymustache.com/2012/05/29/how-much-do-i-need-for-retirement/
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Mr. Green

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Personally, I'd rather have the million and know my 40k per year was based on that alone, rather than bank on Social Security or a pension. I certainly expect SS to be there in some form when I reach "retirement age" but I consider that an added safety net if my portfolio would do worse than the historical average between now and then. If I was comfortable with the possibility of being forced to go back to work in old age I might walk that fine line that reduced the required net worth to account for future income sources. But for me that's too risky, particularly when my earning power is high now and the extra time it takes to bridge the desired net worth, assuming future benefits, vs. the desired net worth alone is only a year or two. A shortage late in life might very well be a "work until death" type problem if not caught early. To me the price of an extra year or two wins hands down compared to "75 until I die."
« Last Edit: May 27, 2015, 09:07:43 AM by Sir Hikes-A-Lot »

nereo

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Ah, thank you 4alpacas for pointing this out. It seems my terminology is misleading and I apologize for that.

I should have said "assuming a real return of 4% on investment, $859k would be required to produce an income stream of $40k/year from age 40 to age 90".
I worry that you are getting caught up with the differences between a real rate of return and an inflation-adjusted withdrawal rate.
The subtleties in why a 4% WR has worked in ~80% of historical periods over various 40 year time periods are a bit more complex.  On average the real-adjusted rate of return sits closer to 8% for most 30 year time periods. At first glance that might suggest that you could use a 6 or even 7% WR (and this is exactly what many recommended prior to 1994).  However, individual years vary from about -40% to ~+40%, and in order to maximize your chances that you survive several down years - particularly near the start of retirement - you need a lesser WR.

It's worth noting that many around here want a much higher rate of success and shoot for WR at or below 3%.  Others (like myself) see a 5% WR as being a good balance between safety and working longer than necessary (historically >50% of scenarios resulted in an increase of money after 40 years), and our plan is to keep expenses flexible and part-time work on the table, particularly in the first decade of retirement.  Everyone has to find their own balance of security and flexibility.

forummm

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Thanks for the responses so far!

I should have given further clarification on the calculation:

At a withdrawal rate of 4%, and a life expectancy of age 90 - a client would require $859k to produce an income of $40k/year. This is a simple present value calculation done on a regular financial planning calculator, and not incorporating any other income sources.

Sounds like the missing factor might be the fact that the returns are not uniform, guaranteed, annual returns. The variation in returns, including frequent negative returns, makes it impossible to use the average rate of return as the withdrawal rate for many scenarios historically.

NoraLenderbee

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Client A and Client B have different assumptions. Client B expects a pension and govt assistance, so he can save less. Client A has no such expectations (or doesn't include them in his calculations). So of course Client A wants to save more. The comparison is not apples to apples.

In general, though, the 4% or 25x "rule" is more of a guideline. It is simple, straightforward, and provides a safety margin (as far as we know) for life's contingencies.  But you're right that with more information, each person can figure their individual needs more precisely.

Alternatepriorities

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The only explanation I can predict is that we are focusing on capital preservation throughout our retirement; albeit based on my reading I'd imagine more here are focused on a happy and healthy retirement moreso than leaving a large inheritance.

As I understand the 4% SWR rule, it is based of preserving capital which is why its also expressed as 25x expenses. As dandarc pointed out Mustachians are really more cautious than typical consumers. Personally I'll sleep better knowing my stash will continue to grow a little though the decades of retirement than I would if it were calculated down to the dollar and year of expected death. It's a little less efficient financially, but it also means I created more wealth than I consumed and made the world a little bit richer place.

MDM

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As I understand the 4% SWR rule, it is based of preserving capital which is why its also expressed as 25x expenses.
If that were true then your conclusions would be valid.  Unfortunately that understanding is not correct.  In addition to good links given above, consider https://www.kitces.com/blog/what-returns-are-safe-withdrawal-rates-really-based-upon/.

Alternatepriorities

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As I understand the 4% SWR rule, it is based of preserving capital which is why its also expressed as 25x expenses.
If that were true then your conclusions would be valid.  Unfortunately that understanding is not correct.  In addition to good links given above, consider https://www.kitces.com/blog/what-returns-are-safe-withdrawal-rates-really-based-upon/.

Sorry, maybe I missed something. From the link "And of course, if a 4.5% withdrawal rate is used in virtually any other environment, the client will simply have funds left over, or can raise spending along the way; in point of fact, the safe withdrawal rate actually has a 96% probability of leaving more than 100% of the original starting principal!" That sounds like preserving capital to me.

shelivesthedream

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Client A and Client B have different assumptions. Client B expects a pension and govt assistance, so he can save less. Client A has no such expectations (or doesn't include them in his calculations). So of course Client A wants to save more. The comparison is not apples to apples.

In general, though, the 4% or 25x "rule" is more of a guideline. It is simple, straightforward, and provides a safety margin (as far as we know) for life's contingencies.  But you're right that with more information, each person can figure their individual needs more precisely.

The differing assumptions I see here is that when Client A dies at age 90, he expects to still have $1m in the bank, whereas Client B expects to have just spent his last penny.

MDM

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As I understand the 4% SWR rule, it is based of preserving capital which is why its also expressed as 25x expenses.
If that were true then your conclusions would be valid.  Unfortunately that understanding is not correct.  In addition to good links given above, consider https://www.kitces.com/blog/what-returns-are-safe-withdrawal-rates-really-based-upon/.

Sorry, maybe I missed something. From the link "And of course, if a 4.5% withdrawal rate is used in virtually any other environment, the client will simply have funds left over, or can raise spending along the way; in point of fact, the safe withdrawal rate actually has a 96% probability of leaving more than 100% of the original starting principal!" That sounds like preserving capital to me.
It may at times preserve capital, but that is a side effect.  The 4% SWR "rule" is based on not running out of money if the worst historical scenario recurs.

The reason why a 4% SWR is also expressed as 25x expenses is simply that 4% = 1/25.
« Last Edit: May 27, 2015, 03:05:03 PM by MDM »

seattlecyclone

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The 4% rule is based on having at least $1 left in 30 years, provided that the next 30 years aren't worse than the worst 30 years in recorded history. It's not preserving capital per se, because you still could end up with $1 (which is less than you started with). By planning to have something left even in the worst known scenario, good or average or even most below average scenarios will result in you preserving and usually even increasing your capital.

Eric

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As I understand the 4% SWR rule, it is based of preserving capital which is why its also expressed as 25x expenses.
If that were true then your conclusions would be valid.  Unfortunately that understanding is not correct.  In addition to good links given above, consider https://www.kitces.com/blog/what-returns-are-safe-withdrawal-rates-really-based-upon/.

Sorry, maybe I missed something. From the link "And of course, if a 4.5% withdrawal rate is used in virtually any other environment, the client will simply have funds left over, or can raise spending along the way; in point of fact, the safe withdrawal rate actually has a 96% probability of leaving more than 100% of the original starting principal!" That sounds like preserving capital to me.

You should play around with www.cFIREsim.com and you can see all the results for different past scenarios.  For instance, even with a portfolio with a 100% chance of success (say $1MM portfolio with $30k withdrawal, all else default) that portfolio value dropped 40% or more below it's initial value 30% of the time.  And this is with a 100% chance of success based on past results.  So if a $1MM portfolio can drop to $600K and still have a 100% chance of success, would you consider that as preserving capital?

Chances are that yes, you will have more money after 30 years, as the median ending portfolio is more than twice your starting amount.  However, that doesn't mean that you shouldn't expect to dip below your initial point (and sometimes well below) along the way.

Woodshark

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The 4% rule tends to be confusing. Perhaps because of preconceived assumptions.
It really comes down to the results of the Trinity study.  The results of the study basically say that, in a worst case scenario based on past history, you still could have withdrawn 4% of your 50/50 portfolio a year; each year adjusted for inflation, for 30 years and still have at least $1 left. 

It’s a maximum withdrawal rate, accounting for inflation, for a worst case 30 year period based on historical market returns. No more. No less.

If things ever get worse than in history past (worse than the great depression etc.) then you “might” run out on $$ sooner than 30 years. However, it being a worst case study, the chances are you will end up with much, much more. 

Alternatepriorities

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You should play around with www.cFIREsim.com and you can see all the results for different past scenarios.  For instance, even with a portfolio with a 100% chance of success (say $1MM portfolio with $30k withdrawal, all else default) that portfolio value dropped 40% or more below it's initial value 30% of the time.  And this is with a 100% chance of success based on past results.  So if a $1MM portfolio can drop to $600K and still have a 100% chance of success, would you consider that as preserving capital?

Chances are that yes, you will have more money after 30 years, as the median ending portfolio is more than twice your starting amount.  However, that doesn't mean that you shouldn't expect to dip below your initial point (and sometimes well below) along the way.

Thanks, cFIREsim does look really useful. I think I used the term "preserving capital" wrong. It's not really the goal, but it's the most likely result that the stash grows. Preservation of capital would just prevent it from being eroded by inflation while taking as little risk as practical?

nereo

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Thanks, cFIREsim does look really useful. I think I used the term "preserving capital" wrong. It's not really the goal, but it's the most likely result that the stash grows. Preservation of capital would just prevent it from being eroded by inflation while taking as little risk as practical?
cFIREsim and FireCALC all have inflation built in to their simulation.  The assumptions of the 4% WR are that you adjust upward for inflation each year.
FWIW over 30 year periods the majority of portfolios tend to do one of two things; go to $0 or increase exponentially.  A few hover around the initial amount, but not many.  At  4% a few will go towards $0, a few will hover, and the majority will end up increasing.  Even at 5% WR the median ending value is ~= to the starting value.

aschmidt2930

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I see what you're trying to say, but predicting how long you're going to live is just another form of gambling.  If the person in your example got to 1,000,000, they would be set til life, not an unknown date in their 90s.

nereo

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I see what you're trying to say, but predicting how long you're going to live is just another form of gambling.  If the person in your example got to 1,000,000, they would be set til life, not an unknown date in their 90s.
You are the very first person I've heard refer to predicting one's lifespan as "gambling".
I'm not sure anyone is advocating trying to run out of money in their 90s and hoping they are dead before then....

There's just an acceptance that your assets can drop below the initial amount and you still have a decent chance of it recovering with a 4% WR.  This is actually quite common on fireCALC simulations and the majority of 4% scenarios recover.  That's what the markets do...
of course flexibility is still key.

aschmidt2930

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I see what you're trying to say, but predicting how long you're going to live is just another form of gambling.  If the person in your example got to 1,000,000, they would be set til life, not an unknown date in their 90s.
You are the very first person I've heard refer to predicting one's lifespan as "gambling".
I'm not sure anyone is advocating trying to run out of money in their 90s and hoping they are dead before then....

There's just an acceptance that your assets can drop below the initial amount and you still have a decent chance of it recovering with a 4% WR.  This is actually quite common on fireCALC simulations and the majority of 4% scenarios recover.  That's what the markets do...
of course flexibility is still key.

I think you misunderstood my post. The OP suggested that his example only needed 859k because it got them to a set age in their 90s, which at a 40k withdrawal rate is well below the 4 swr.  I'm saying THAT is gambling, not a 4℅ swr.