Author Topic: How does the 4% rule actually work?  (Read 4165 times)

investonoob

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How does the 4% rule actually work?
« on: June 24, 2015, 09:28:34 AM »
Hi!

I am a bit confused about how does the 4% rule actually work? If say I have 100 000 to invest. That means I can annually cash out 4000 for expenses.
Do I have to wait exactly one year from date of investing or wait for it to increase to 104 000 or more? When do I know when I can withdraw my 4%?

Let’s look at a real world example. I live in Europe, so I will be investing in VANGUARD FTSE AW ETF.

1.   If I would invest 100 000 euro in June 24, 2014 I would buy 1912 shares for 52.28 = 99959.36. Exactly one year later the share price is 64.79, so my investment would be worth 123878.48. That is an annual increase of 23.9%. Therefore, to extract 4% of the original sum I would sell 61 shares to get 3952.19.
2.   If I would just wait for the original sum to increase to 4%, I would have to sell already on 30/10/2014 when the share price was 54.39. I would sell 74 shares for 4022.64.
3.   If the share price dropped below my original buy price of 64.79 up to for example 60 on June 24, 2015. I would sell 66 shares to get 3960.

Is my logic correct in the above examples?

And if I keep selling shares all the time, wouldn’t I run out of shares completely at one point?

Thanks for your input!

StockBeard

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Re: How does the 4% rule actually work?
« Reply #1 on: June 24, 2015, 09:44:19 AM »
My take on it:

The average 7% increase is 4% + 3% of inflation in general. Which is why the rule of thumb is that you can take "4%" every year.
Of course, the increase is progressive throughout the year. For the same reason you don't have to wait for an entire year to see the "+7%" in your account (it grows progressively - and chaotically - throughout the year(s)), you don't have to wait until the end of the year to withdraw 4%. I'd assume most people withdraw on a monthly basis.

But the "chaotically" here is very important. The 4% rule is a rule of thumbs, it is much more appropriate to withdraw more on "good" months, and less on "bad" months. Does that make sense?

And if I keep selling shares all the time, wouldn’t I run out of shares completely at one point?
No, the individual value of the shares increases with time, so in theory as time goes by, you have to sell less and less of them, in a way that (theoretically) you never reach 0. Pluse, with dividends reinvestment, your account probably keeps buying new shares?

protostache

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Re: How does the 4% rule actually work?
« Reply #2 on: June 24, 2015, 09:45:47 AM »
I haven't put a lot of thought into it, but I believe a lot of people who have ER'd and do the 4% rule do it as one chunk in the beginning of the year into a cash management account of some sort, something they can write checks from and/or has a debit card.

I'm don't think your 4% rule interpretation is correct. I believe the 4% is actually 4% of the current balance, not the original balance. For example, on step 1, if the account is at 123,878 when you withdraw, you actually sell 4% of that, which would be 4,955 (or as close as you can get in whole shares). In good years you'll pull out more, in bad years you'll pull out less.

Edit: I'm totally wrong.
« Last Edit: June 24, 2015, 12:09:40 PM by protostache »

Financial.Velociraptor

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Re: How does the 4% rule actually work?
« Reply #3 on: June 24, 2015, 09:48:44 AM »
If you RE with a stache of 100k E, you withdraw 4k E a year.  Presumably you'd take out 4k/12 a month to make your personal budgeting easier.  Your actual percentage withdrawn will not likely equal 4% exactly.  You would then give yourself a 3% annual inflation raise each year 4,000*1.03 = 4,120 E withdrawn in Year 2 and so on.

You only get to "zero" or close if your returns are consistently below average.  You should have years (decades?) to adjust something in response.

dandarc

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Re: How does the 4% rule actually work?
« Reply #4 on: June 24, 2015, 09:54:25 AM »
And if I keep selling shares all the time, wouldn’t I run out of shares completely at one point?
No, the individual value of the shares increases with time, so in theory as time goes by, you have to sell less and less of them, in a way that (theoretically) you never reach 0. Pluse, with dividends reinvestment, your account probably keeps buying new shares?
Exactly.  Also note that you don't have to buy / sell whole shares necessarily.  If you're in mutual funds or on a platform that supports trading fractional shares (Sharebuilder, for example), the only way you get to 0 is if you're unfortunate to have retired at a time when the 4% rule was not sustainable. 

Even without the ability to trade fractional shares, most stocks and funds will split when the price is too high for convenience sake.  So it is unlikely you'll find yourself in a situation where you have 1 share worth 100K - more likely that the fund or stock has split it shares many times before it reaches that point.  Unless you're 100% in BRK.A, of course.

investonoob

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Re: How does the 4% rule actually work?
« Reply #5 on: June 24, 2015, 09:59:55 AM »
Of course, the increase is progressive throughout the year. For the same reason you don't have to wait for an entire year to see the "+7%" in your account (it grows progressively - and chaotically - throughout the year(s)), you don't have to wait until the end of the year to withdraw 4%. I'd assume most people withdraw on a monthly basis.

But if I withdraw on a monthly basis, how will I know when to start? I mean if I invest today do I start selling in Jully? Or wait untill it goes up in price?

I'm don't think your 4% rule interpretation is correct. I believe the 4% is actually 4% of the current balance, not the original balance.

I always thought it was from the original sum, that way you will still have enough capital to weather the bad times.

dandarc

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Re: How does the 4% rule actually work?
« Reply #6 on: June 24, 2015, 10:17:23 AM »
4% rule is just a guideline to help you know when you have enough.  Once you have enough and retire, you'll draw money as you need it for retirement.  Getting too mixed up on the specifics.

What the research the 4% rule is based on says is that for 95% of 30-year periods on record and a 50-50 stock-bond portfolio, if you initially draw 4%, then increase your withdrawal by inflation every year, you'll have not run out of money at the end of 30-years.  This is also a US-specific number. 

plainjane

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Re: How does the 4% rule actually work?
« Reply #7 on: June 24, 2015, 10:23:58 AM »
Of course, the increase is progressive throughout the year. For the same reason you don't have to wait for an entire year to see the "+7%" in your account (it grows progressively - and chaotically - throughout the year(s)), you don't have to wait until the end of the year to withdraw 4%. I'd assume most people withdraw on a monthly basis.
But if I withdraw on a monthly basis, how will I know when to start? I mean if I invest today do I start selling in Jully? Or wait untill it goes up in price?

Generally you don't start withdrawing until you've stopped investing.  So if you are planning to retire today, then yes, you may start selling in July.  If you aren't going to retire for another 5 years, you wait to sell until you need the money then.  (If you invest and sell within a month you'll probably end up with hefty fees.)

skyrefuge

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Re: How does the 4% rule actually work?
« Reply #8 on: June 24, 2015, 10:41:48 AM »
The average 7% increase is 4% + 3% of inflation in general. Which is why the rule of thumb is that you can take "4%" every year.

No. This is absolutely not how the 4% Safe Withdrawal Rate became a rule of thumb. The "4%" number does not come from averages or estimates or anything like that. It came from looking at specific history and discovering that withdrawing an inflation-adjusted 4% allowed most historical portfolios to survive for 30 years. "7%" and "3% inflation" have nothing to do with the 4% SWR.

I'm don't think your 4% rule interpretation is correct. I believe the 4% is actually 4% of the current balance, not the original balance.

You are wrong. The research that discovered the "4% SWR" assumed that you would withdraw an inflation-adjusted 4% of your original balance each year.

Anyway, like dandarc said, the research that discovered the "4% SWR" was never intended to be a mechanical prescription for how to withdraw money in retirement. It was simply trying to discover what idealized withdrawal rate might be "safe". As such, it's much more useful as a "do I have enough to retire? (25x expenses)" rule-of-thumb than a "how do I withdraw money in retirement?" prescription. The variability of real life will never match the idealized withdrawal method that the SWR researchers used simply to make their math easier.

Essentially, if your expenses over the last 10 years have averaged "X", and you expect them to continue to average about "X", you just need to make sure you have about 25 * X in your stash. Then you'll know that you can just withdraw money from it as needed and have a decent chance of it lasting 30 years.

Eric

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Re: How does the 4% rule actually work?
« Reply #9 on: June 24, 2015, 10:44:47 AM »
Listen to skyrefuge.  He's correct, as usual.  It would behoove some of you to actually read the Updated Trinity Study to understand the methodology.  There is no TL:DR for this one folks.  Read it and understand it.

StockBeard

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Re: How does the 4% rule actually work?
« Reply #10 on: June 24, 2015, 11:01:29 AM »
As such, it's much more useful as a "do I have enough to retire? (25x expenses)" rule-of-thumb than a "how do I withdraw money in retirement?" prescription.
Well, at least we agree on that :)

protostache

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Re: How does the 4% rule actually work?
« Reply #11 on: June 24, 2015, 12:09:04 PM »
I'm don't think your 4% rule interpretation is correct. I believe the 4% is actually 4% of the current balance, not the original balance.

You are wrong. The research that discovered the "4% SWR" assumed that you would withdraw an inflation-adjusted 4% of your original balance each year.

Thanks for the correction! Sorry to confuse the issue.

investonoob

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Re: How does the 4% rule actually work?
« Reply #12 on: June 24, 2015, 12:51:23 PM »
Thanks everyone!