The Money Mustache Community
Learning, Sharing, and Teaching => Investor Alley => Topic started by: Runge on April 12, 2014, 08:53:27 AM
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https://www.betterment.com/blog/2014/04/11/why-the-4-percent-rule-is-broken/
Interesting post about the 4% rule from Betterment's perspective. Since I'm young and am just a year into my Path to FIRE journey, I'd like to get the MMM Community's thoughts on it.
They also mention a new program they're pushed out for those in retirement who are trying to follow the 4% rule.
Note: Betterment's blog posts typically can read as an advertisement for their service, so feel free to look past that aspect without fully dismissing everything they say. And no I'm not trying to push their product on you. It's sad that I feel like I need to say that..
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I'm having a hard time reading through their sales material to see what they are actually suggesting other than using their product that has a different asset allocation.
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I don't take issue with the source, I take issue with the fact that they take one of the fundamental assumptions that makes the 4% rule a good guideline (yes, it's not a rule, you still need to be flexible), discard it, and then write an extensive blog post about the simulation results. Specifically, the one and only scenario they ran was a 30% stock allocation-- well of course it failed more times than one would be comfortable with! Now let's see them re-run the simulation and be nearly as compelling with a 75% stock allocation.
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Read the #1 foot note. They are arguing that their 30% portfolio is going to have the same volatility and returns as a 50% s&p 500 fund so it is the same as doing 50% as in the trinity study. If you look at the porfolios they spit out they have a huge value bias (basically 50/50 total market and value indexes) so I wouldn't be shocked to learn they slightly outperform the total market
They are biasing their returns by using current market conditions. I have no idea how accurate that is. I am also not sure how accurate assuming 3% inflation is. Yes that is roughly what the inflation has been since 1930 or so. However part of the reason current interest rates are so low is because inflation is more like 1.5% lately.
They don't give a ton details about their product but the fact they need to reduce the withdrawal rate below 2% 10% isn't exactly inspiring. There sample also has the wonder example of having no cash in your 60-70s and a ton when you 85+. That income doesn't really match most peoples spending patterns.
I don't want to really rag on Betterment because it does provide some value. However this is the type of thing that fidelity or vanguard should be providing for free. You tell them how you want your assets allocated and they should use divs and new money to maintain it. Tell them how much money you want over a year (and how much taxable income you want) and they should be able to generate spending plans. But it shouldn't cost you a cost you 2500+/yr for those services that you can do for 12/hrs year of work.
I don't take issue with the source, I take issue with the fact that they take one of the fundamental assumptions that makes the 4% rule a good guideline (yes, it's not a rule, you still need to be flexible), discard it, and then write an extensive blog post about the simulation results. Specifically, the one and only scenario they ran was a 30% stock allocation-- well of course it failed more times than one would be comfortable with! Now let's see them re-run the simulation and be nearly as compelling with a 75% stock allocation.
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I don't want to really rag on Betterment because it does provide some value. However this is the type of thing that fidelity or vanguard should be providing for free.
They do offer it, unfortunately it's not free... From the recent NY Times article:
Vanguard’s full-service offering, called Personal Advisor Services, costs 0.3 percent annually of the assets it’s managing. For now, customers need $100,000 in accounts there to join, but the company plans to drop the minimum to $50,000 at some point soon. An existing Vanguard service that resembles the new one costs 0.7 percent annually on the first $1 million and requires at least $500,000 on balance.
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The whole point is that paying 3k for 1s of computer time is ridiculously overpriced and it isn't like we are talking some crazy hard programming either. It is basic grade school math. It might look good compared to the old days of paying 10k but it still doesn't mean it isn't overpriced by 10x+.
I don't want to really rag on Betterment because it does provide some value. However this is the type of thing that fidelity or vanguard should be providing for free.
They do offer it, unfortunately it's not free... From the recent NY Times article:
Vanguard’s full-service offering, called Personal Advisor Services, costs 0.3 percent annually of the assets it’s managing. For now, customers need $100,000 in accounts there to join, but the company plans to drop the minimum to $50,000 at some point soon. An existing Vanguard service that resembles the new one costs 0.7 percent annually on the first $1 million and requires at least $500,000 on balance.
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The whole point is that paying 3k for 1s of computer time is ridiculously overpriced and it isn't like we are talking some crazy hard programming either. It is basic grade school math. It might look good compared to the old days of paying 10k but it still doesn't mean it isn't overpriced by 10x+.
You aren't paying for computer time, you're paying for the service. How much it costs them to produce the service has absolutely no bearing on how much value it has in the marketplace, which is a common rookie mistake to make. I happen to think their price is very reasonable. If you don't, roll your own. But I'm pretty certain Betterment is still losing money, so perhaps the cost to provide this service is a lot higher than you think?
And there's nothing "grade school" about building this sort of software platform, either. It's not like you could sit down and do it in a week yourself. It is a sophisticated platform.
I don't want to really rag on Betterment because it does provide some value. However this is the type of thing that fidelity or vanguard should be providing for free.
This kind of service is very costly to provide. I can see Fidelity doing it at some point in the future as a loss leader but not really Vanguard.
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The article makes a good point:
Twenty years ago, the yield on a three-month Treasury bill was 6%. So while Bengen’s model called for a 50/50 stock allocation, even those with a more conservative asset allocation could still draw down 4% annually adjusted for inflation, and reasonably expect to preserve their capital. Even in 2002, the 5-year US Treasury yield was still 4.5%. That’s no longer the case—today a three-month Treasury is .04% and a 5-year is around 1.67%.
Which is why it's puzzling that they decided to use a 70% bond allocation to then determine that the 4% rule is "broken". The current low yields in bonds means that you're going to want to be closer to a stock/bond split of 75/25 rather than a 30/70 allocation. And their own system starts with a 56/44 allocation. Again, strange that they're using 30/70 instead of 56/44 to claim an issue with the 4% rule.
But their "fly in the ointment" section doesn't really hold a lot of water, or at least, everyone should be well aware of these issues:
The 4% rule is based on the portfolio’s initial balance; subsequent market performance isn’t dynamically factored into the withdrawal rate—even though it can dramatically affect the portfolio’s balance. Flat-rate withdrawals that ignore dramatic market changes can lead to premature portfolio depletion.
In particular, an unfavorable market climate in the early years of retirement, coupled with a rigid withdrawal formula, increases the risk of asset depletion, because capital preservation during those early years is critical to the portfolio’s ongoing growth.
These two are essentially the same thing. Build in some flexibility, whether that's earning a little side income or planning for some non-essential expenses that can be cut if necessary. If the markets drop 30% right after you FIRE, you'll probably have to do both or maybe go back to work for a (hopefully short) while.
Likewise, a flat withdrawal rate doesn’t take into account personal changes in health or lifestyle that naturally occur with age. Many retirees need more flexibility in their cash flow to handle the inevitable ups and downs of life.
So, have some flexibility again? If your health declines, you can probably allocate that vacation money towards healthcare. Likewise, if you want to pick up a new hobby, figure out a way to pay for it.
Conversely, if returns are higher than expected in the early phase of retirement, but your withdrawals are static, you run the risk leaving money on the table at the end of your life that could have been used for greater enjoyment in previous years.
Assumes that spending more money leads to more happiness. The retiree can combat this issue by reading more MMM.
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I agree with Eric's main point- flexibility. To misquote Pirates of the Carribean, the 4% rule is "more of a guideline, than an actual rule". Any long-term plan is doomed to failure if you refuse to alter course to meet unexpected obstacles.
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And maybe the market has voted that they don't bring enough value to the table and hence the reason they are losing money?:) If I had to guess they are losing money today because they are building a company to handle 50 billion AUM while today they have 500 million. The fixed costs will stay the same as the AUM grow. And if you think I am exaggerating about operating this as a free service, trowe price offers it for IRAs. The tweaks required to do it for taxable accounts are not huge. If it is a competitive advantage, someone will offer it.
As I said I like betterment and the like. If you have zero interest in investing they are a decent choice along with the various lifecycle type funds. But they don't offer 3k+ of value to some one who knows roughly what AA they want and who is willing to spend 1 hour a month figuring out how to split up the incoming money.
The whole point is that paying 3k for 1s of computer time is ridiculously overpriced and it isn't like we are talking some crazy hard programming either. It is basic grade school math. It might look good compared to the old days of paying 10k but it still doesn't mean it isn't overpriced by 10x+.
You aren't paying for computer time, you're paying for the service. How much it costs them to produce the service has absolutely no bearing on how much value it has in the marketplace, which is a common rookie mistake to make. I happen to think their price is very reasonable. If you don't, roll your own. But I'm pretty certain Betterment is still losing money, so perhaps the cost to provide this service is a lot higher than you think?
And there's nothing "grade school" about building this sort of software platform, either. It's not like you could sit down and do it in a week yourself. It is a sophisticated platform.
I don't want to really rag on Betterment because it does provide some value. However this is the type of thing that fidelity or vanguard should be providing for free.
This kind of service is very costly to provide. I can see Fidelity doing it at some point in the future as a loss leader but not really Vanguard.
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Hello, Alex here from the Betterment product team that launched this income solution. Hopefully I can help shed some light on the research we did and how our model works.
I'm having a hard time reading through their sales material to see what they are actually suggesting other than using their product that has a different asset allocation.
@Joel, there are two parts to providing income - 1. managing the allocation of the portfolio. 2. deciding how much is safe to withdraw. This product helps you do both. The first part is customization on top of our current allocation advice that's specific for retirees. The second part is brand new. Both can be tweaked according to however you want to use them.
@Eric, you make a number of good points, it might help if I walk through our thinking and methodology a bit:
The article makes a good point:
Twenty years ago, the yield on a three-month Treasury bill was 6%. So while Bengen’s model called for a 50/50 stock allocation, even those with a more conservative asset allocation could still draw down 4% annually adjusted for inflation, and reasonably expect to preserve their capital. Even in 2002, the 5-year US Treasury yield was still 4.5%. That’s no longer the case—today a three-month Treasury is .04% and a 5-year is around 1.67%.
Which is why it's puzzling that they decided to use a 70% bond allocation to then determine that the 4% rule is "broken". The current low yields in bonds means that you're going to want to be closer to a stock/bond split of 75/25 rather than a 30/70 allocation. And their own system starts with a 56/44 allocation. Again, strange that they're using 30/70 instead of 56/44 to claim an issue with the 4% rule.
Our allocation advice is tailored for our specific portfolio of ETFs. "75/25" can mean lots of things depending on what you put in it. So you can't compare your 75/25 to ours. Our 30% stock / 70% bond allocation has an expected excess return of 2.98% on top of the risk free rate. Our risk free rate assumption starts near 0 like it is today, but increases to a max of 3% over the next 5 years, since we expect rates to rise. This time-varying rate is what is used in our forward looking projections and withdrawal calculations. The risk-free rate max at 3% is admittedly conservative, given history, and we will adjust it based on actual risk free rates. We also assume a 7.78% standard deviation for this allocation. Our allocation advice for retirement income goals is tailored for older retirees who are quite risk adverse, so very high levels of stocks are not desirable. Of course you can always choose an allocation that makes sense for you - we just provide guidance, you make the choice. We auto-rebalance and auto-reinvest according to what you explicitly set.
Regarding the 4% rule using the portfolio of 30% stocks for this post, we did run a number of other fixed-withdrawal scenarios. Here are the other results:
50% stocks: 22.5% failure
70% stocks: 21.8% failure
90% stocks: 22.9% failure
As you and others have pointed out, the reason for this failure is the lack of flexibility in withdrawals. Yes this seems obvious to those who have thought deeply about it. MMM readers are different than the pack. Many people, even advisors, follow the 4% rule blindly. If you adjust, you will get better results. And that is the whole point. Our model simply helps those who need guidance on how much to adjust, and let's them do that very easily, and with automation.
Likewise, a flat withdrawal rate doesn’t take into account personal changes in health or lifestyle that naturally occur with age. Many retirees need more flexibility in their cash flow to handle the inevitable ups and downs of life.
So, have some flexibility again? If your health declines, you can probably allocate that vacation money towards healthcare. Likewise, if you want to pick up a new hobby, figure out a way to pay for it.
Regarding this kind of flexibility, here it is more about liquidity. Some retirement income products limit what you can do with your money in order to provide guaranteed income.
Conversely, if returns are higher than expected in the early phase of retirement, but your withdrawals are static, you run the risk leaving money on the table at the end of your life that could have been used for greater enjoyment in previous years.
Assumes that spending more money leads to more happiness. The retiree can combat this issue by reading more MMM.
I don't think this blindly implies we think 'more money leads to more happiness'. A key part of the MMM philosophy is eliminating waste. A corollary is making the most of what you have. If you end up with more money than you planned for, no one is saying that 'enjoyment' of it doesn't include giving it all to charity, or some other higher-than-material use.
A parting word... if you believe in passive investing, and are able to stick to the plan and avoid behavioral biases that derail so many individual investors, you can do it yourself or use a service like Betterment. It all comes down to how you value your time. Someone with 500k may be thrilled to pay $62.50 a month to not have to worry about investing it. Others feel that's way too much, so they do it themselves and effectively earn $62.50/month.
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Alex - welcome to the forums! Thanks for taking the time to explain some of your thinking.
You may be asked some direct questions at points, but we appreciate your willingness to engage positively with the MMM forum community. :)
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Alex - welcome to the forums! Thanks for taking the time to explain some of your thinking.
You may be asked some direct questions at points, but we appreciate your willingness to engage positively with the MMM forum community. :)
Yeah, what a more positive way to engage. Certainly greatly appreciated compared to the shadier, non-attributed posts, or threatening frivolous legal actions. A company that's willing to engage like Alex gets a vote of approval.
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Alex - welcome to the forums! Thanks for taking the time to explain some of your thinking.
You may be asked some direct questions at points, but we appreciate your willingness to engage positively with the MMM forum community. :)
Yeah, what a more positive way to engage. Certainly greatly appreciated compared to the shadier, non-attributed posts, or threatening frivolous legal actions. A company that's willing to engage like Alex gets a vote of approval.
+1
Thank you for engaging and explaining your reasoning behind everything. I found it very interesting :)
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Alex,
I made the post below the dashed line in another thread, and arebelspy was kind enough to note the discussion occurring in this thread. As I read comments here, I'm not saying anything that others haven't already. In particular, your reply:
Regarding the 4% rule using the portfolio of 30% stocks for this post, we did run a number of other fixed-withdrawal scenarios. Here are the other results:
50% stocks: 22.5% failure
70% stocks: 21.8% failure
90% stocks: 22.9% failure
is very much on point.
So the question may be more for your advertising firm than for your programmers and analysts: why not highlight the Monte Carlo results from the Trinity scenario in your advertising blurbs? I'd guess it's because "30% failure" seems more alarming than "21% failure", and maybe the target audience isn't wont to dig into the details...? Thanks for your willingness to discuss.
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Betterment may (or may not) be more reputable than your average indexed annuity sales firm, but when their article...
1) Portrays a 4% WR failing 30% of the time with a portfolio containing 30% stocks, then
2) Notes that to follow Betterment's suggestion, the "initial portfolio starts with a 56% stock allocation"
...it looks like so much smoke and mirrors.
Near the bottom of the Betterment article they do acknowledge "we are highlighting the Monte Carlo results using a 30% stock Betterment portfolio. Notably, we found that applying the 4% rule even to a 50% stock Betterment portfolio is expected to fail 21% of the time under modern market conditions."
They may have a good point (and a good product) but I'm always leery when the bold proclamations at the top say one thing, while the fine print at the bottom provides a different perspective.