Stop worrying about the 4% rule

[Padonak]

I'll just leave it here...

[nereo]

... i lol'd

[tooqk4u22]

but they gloss over the fact that simply having a mortgage increases sequence of returns risk.

No it doesn't.  SORR is the risk that more unfavorable returns occur earlier in retirement.  Having a mortgage does not affect market returns, so you must be talking about some other type of risk.

You are technically correct.   

This is what I think is being considered by the OP.  I'm sure they'll correct me if I'm wrong!

Having a mortgage increases your minimum monthly costs.  It's typically one of the bigger monthly costs.  A higher minimum monthly cost means it's harder to cut costs, and therefore it's more likely you'll need to withdraw while the market is low.  So it didn't increase the odds of having a SORR problem, it just increased the odds of that problem causing financial issues.

He is technically correct... the best kind of correct. But you also have to factor in paying off a house vs having more liquid cash in investments/emergency funds etc. which may be more beneficial in case of "financial issues" than a paid off house.

This issue was definitively answered by the following:
https://earlyretirementnow.com/2017/10/11/the-ultimate-guide-to-safe-withdrawal-rates-part-21-mortgage-in-retirement/

Actually, after thinking about this issue a lot I think this is one of the few ERN analyses that I disagree with.

Karsten's analysis assumes a fixed 2% inflation rate, so the mortgage payment effectively decreases by 2% every year. But some of the greatest SORR eras in history were driven by high inflation, so this one assumption makes his conclusion unnecessarily conservative. I suspect that his calculations being done in CPI-adjusted terms, rather than nominal terms, made modeling historical inflation difficult, so he simply made a convenient assumption to make things easier to model.

Try this: use cFireSIM to model paying down a mortgage.

Take a $1M portfolio, and a $1M mortgage, excluding taxes and insurance. That works out to $57,000 per year at 4%. Select the option for withdrawals to not be CPI adjusted.

CFireSIM suggests that the above scenario fails 4% of the time over 30 years - roughly the same as the "4% rule". Ergo, funding a 30 year fixed rate loan at 4% is as risky as the "4% Rule", despite the actual withdrawal rate being 5.7% at the beginning. The non-CPI adjusted payments make up the difference.

So in contrast to the ERN analysis, I'd deduce that if you're comfortable with the failure rates of the "4% Rule" then you should be entirely comfortable funding a 4% or below mortgage off a 100% stock portfolio. Adjust to suit your risk tolerance as appropriate.

A 3% mortgage fails 2% of the time. If your loan term is shorter than 30 years it's even lower. Of course the lowest possible risk is always paying off the loan, but at some point I start worrying more about optimizing for the median end of life portfolio value than the worst case portfolio failure risk.

Cliff notes: if you have a cheap mortgage (4% or lower) then don't worry about paying it down - you just need a portfolio big enough to live off + enough to cover the mortgage balance.

Because you show 4% failure at 4% rate and 2% failure at 3% rate, then the 20% failure at 5% probably should be shown as well in the spirit of showing both sides of the coin.   Rates sub-4% are unlikely going forward and if the 30-year rate does go below that then there other economic issues at hand.  So yes, i agree that if there is a sub-4% mortgage then paying it off doesn't make sense and is a positive force on the SWR analysis.  Unfortunately I already had a paid off house and didn't see the need or hassle to take out a mortgage.

[Must_ache]

Morningstar Inc. has lowered what the investment research firm considers a safe retirement savings withdrawal rate for new retirees based on a 30-year outlook, according to the firm’s annual “State of Retirement Income” report released Wednesday.

To decide on the recommended withdrawal rate, Morningstar researchers considered forward-looking asset class returns and inflation assumptions for new retirees, excluding what they may be getting from Social Security or other nonportfolio income sources such as a company pension.

In that forward-looking analysis, the authors concluded that higher equity valuations and lower fixed-income yields will likely lead to lower return assumptions for stocks, bonds and cash. That outlook led them to reduce their safe withdrawal rate for the average retiree to 3.7% in 2024, down from the 4.0% it recommended in 2023.

[nereo]

Morningstar Inc. has lowered what the investment research firm considers a safe retirement savings withdrawal rate for new retirees based on a 30-year outlook, according to the firm’s annual “State of Retirement Income” report released Wednesday.
(snip)

FWIW, Morningstar Inc has had a sub-par record on its track record of ranking fund performance (i.e. forward-looking). Given their track record I'm not inclined to give prediction much weight.

Most of the "Morningstar Effect" seems to be entirely attributable to people rushing into newly recommended funds, but those funds frequently fall short of benchmarks a few years later despite being tagged with their "Five Star Rating".

https://www.investopedia.com/articles/investing/013016/are-morningstars-best-mutual-funds-really-best-morn.asp

[Telecaster]

In that forward-looking analysis, the authors concluded that higher equity valuations and lower fixed-income yields will likely lead to lower return assumptions for stocks, bonds and cash. That outlook led them to reduce their safe withdrawal rate for the average retiree to 3.7% in 2024, down from the 4.0% it recommended in 2023.

Yawn.   In a couple years it will be 4.2%.   These guys are implying a precision that doesn't exist.   

[lifeanon269]

In that forward-looking analysis, the authors concluded that higher equity valuations and lower fixed-income yields will likely lead to lower return assumptions for stocks, bonds and cash. That outlook led them to reduce their safe withdrawal rate for the average retiree to 3.7% in 2024, down from the 4.0% it recommended in 2023.

Yawn.   In a couple years it will be 4.2%.   These guys are implying a precision that doesn't exist.

Exactly. Not only that, but their change in outlook took place over just the last year. Why didn't their prediction from 2023 predict they'd need to adjust their outlook just a year from then?

If their outlook for a 30-year period needs to be adjusted annually, then maybe something is wrong with their "foward-looking analysis"...

[waltworks]

Re: Morningstar

This seems like a good time to segue into a Bayesian vs. Frequentist argument...

In all seriousness, Morningstar is attempting to predict the future (and thinks it will be less profitable than the past). The 4% rule looks at the past and assumes the future will closely resemble it.

Given the track record of active investors/hedge funds/mutual funds, I'm in the Frequentist camp on this one. But I could see the argument for arguing for a poorer future based on demographics and to a lesser extent politics.

-W

[Telecaster]

In all seriousness, Morningstar is attempting to predict the future (and thinks it will be less profitable than the past). The 4% rule looks at the past and assumes the future will closely resemble it.

I think you might be giving Morningstar too much credit.   If the future SWR is only 3.8%, that means Morningstar thinks the future will be simply awful.    Like 1929 awful.  I doubt their model is good enough to predict conditions like that.

I don't know for sure, but I strongly suspect they have a Bayesian model that spits out some number which is well above 4%.  Then they panic and go full Frequentist by adding in a fudge factor to bring the SWR down to what would have worked in the past. 

[grantmeaname]

I think you might be giving Morningstar too much credit.   If the future SWR is only 3.8%, that means Morningstar thinks the future will be simply awful.    Like 1929 awful.  I doubt their model is good enough to predict conditions like that.

3.8% is much less "simply awful" than 1929. The failsafe rate for a 1929 early retiree is 3.26% (from ERN SWR toolbox).

[Must_ache]

Re: Morningstar
This seems like a good time to segue into a Bayesian vs. Frequentist argument...
In all seriousness, Morningstar is attempting to predict the future (and thinks it will be less profitable than the past). The 4% rule looks at the past and assumes the future will closely resemble it.

That is way too simplistic.  The 4% rule looks at all the past scenarios and tells you what percentage of them would have failed/succeeded.  If in fact valuations are stretched, a number of those past scenarios won't resemble our present condition and will be irrelevant.  Higher current valuations lead to lower future returns.  If the Shiller CAPE is sitting at 30 we should anticipate 5% returns for the next ten years, considerably less than the 4% rule contemplates, resulting in lower safe withdrawal rates.

[rab-bit]

In that forward-looking analysis, the authors concluded that higher equity valuations and lower fixed-income yields will likely lead to lower return assumptions for stocks, bonds and cash. That outlook led them to reduce their safe withdrawal rate for the average retiree to 3.7% in 2024, down from the 4.0% it recommended in 2023.

Yawn.   In a couple years it will be 4.2%.   These guys are implying a precision that doesn't exist.

Exactly. Not only that, but their change in outlook took place over just the last year. Why didn't their prediction from 2023 predict they'd need to adjust their outlook just a year from then?

If their outlook for a 30-year period needs to be adjusted annually, then maybe something is wrong with their "foward-looking analysis"...

If a person believed that Morningstar was right, they could build a 30-year TIPS ladder today that would guarantee a 4.52% withdrawal rate: https://www.tipsladder.com/

[ChpBstrd]

Re: Morningstar
This seems like a good time to segue into a Bayesian vs. Frequentist argument...
In all seriousness, Morningstar is attempting to predict the future (and thinks it will be less profitable than the past). The 4% rule looks at the past and assumes the future will closely resemble it.

That is way too simplistic.  The 4% rule looks at all the past scenarios and tells you what percentage of them would have failed/succeeded.  If in fact valuations are stretched, a number of those past scenarios won't resemble our present condition and will be irrelevant.  Higher current valuations lead to lower future returns.  If the Shiller CAPE is sitting at 30 we should anticipate 5% returns for the next ten years, considerably less than the 4% rule contemplates, resulting in lower safe withdrawal rates.

If a person believed that Morningstar was right, they could build a 30-year TIPS ladder today that would guarantee a 4.52% withdrawal rate: https://www.tipsladder.com/

Putting these ideas together...

Any 10-year period that averages out to 5% per year returns, or only involves a 3.8% SWR, will probably involve a very large dip. We're talking GFC or dot-com-sized dip. Extreme valuations (PE, Shiller PE, stock market concentration, over-investment in the U.S.) only make it more likely that a massive and rapid re-valuation event happens, as it did within 0-2 years of each of the last times Shiller PE exceeded 30 (1929, 1999, 2018, 2021).

So why shouldn't retirees take the deal if they can cover their cash flow needs with a bond ladder?

They could essentially lie in wait for a point in the future when stock valuations and forward SWR estimates are better. If rate cuts accompany the revaluation event, then bond appreciation might provide a nice bonus for their bargain shopping. They wouldn't necessarily have to time the bottom perfectly. If they could just avoid some significant amount of the damage it should significantly affect the sustainability of their WR. If they then switch to a stock-heavy AA right after a major SORR event, their odds become excellent.

My own strategy uses options to hedge against major portfolio damage, but I am watching for the opportunity to drop my hedges in the event of a SORR event. My strategy has more upside and downside than the "bond ladder and ready to pivot" strategy, but I may soon start taking more risk off the table by rolling up my puts.