Learning, Sharing, and Teaching > Investor Alley
Stop worrying about the 4% rule
forummm:
A collection of posts about why you should not worry about the 4% rule. Please add others that you find useful.
forummm:
From Nords: http://forum.mrmoneymustache.com/post-fire/what-has-workednot-worked-for-you-guys-who-have-been-fire-for-10-yrs/msg700740/#msg700740
(worth reading more in the thread)
--- Quote from: Nords on June 18, 2015, 12:21:03 AM ---
--- Quote from: Dawg Fan on June 17, 2015, 05:40:38 AM ---Nords - great web site! The Real Life Retire Investment Returns was most interesting to me. The only points which I wasn't clear on in the various portfolios... 1) were all portfolios rebalanced once a yr or just those noted? 2) Was the 4% harvested equally amongst the individual portfolio mixes or was there some sort of order (I.e. Interest, dividends, cash, bonds, last stock sales)?
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Thanks!
I don't think that those differences are significant. If they were relevant then Greaney would've taken the time to highlight them.
Those questions might not be relevant for any retirees, especially if the advice isn't suited for the retiree. For example, some are firm believers in rebalancing every 1 January while others just do it when their asset allocation gets too far out of whack (I'm in the latter camp). Some research says annual rebalancing is better, other research says every 2-3 years. You have to pick the system with which you're most likely to stick.
You'll harvest your 4% with cash first, then the annual cap gains & dividends & interest, and then you'll sell off the assets that are farthest out of whack from your asset allocation. So it doesn't matter what the study did-- your real-life practice is pretty close to the study, so minor differences won't be significant.
--- Quote from: Dawg Fan on June 17, 2015, 05:40:38 AM ---As a 4 yrs from FIRE guy, here is my takeaway so far for someone who is planning for 40+ yrs RE...
- Understand your risk temperment and don't kid yourself if your a 60/40 guy and going with a 100% stock portfolio
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Absolutely. It's the investor behavioral psychology aspect of investing, where you have to be able to sleep comfortably at night.
--- Quote from: Dawg Fan on June 17, 2015, 05:40:38 AM ---- After taking into account any other income sources, 3 - 3.5% may be a safer withdrawal rate
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Um, no. By that logic 0.0% would be even safer.
Consider the assumptions in the 4% SWR studies:
no annuitized income (not even Social Security),
1% account expense ratios,
constant withdrawals (adjusted for inflation),
no extra cash beyond one year of expenses (just stocks/bonds).
Those are all simplifying assumptions for the benefit of the computer programming. Nobody lives like that!
Imagine that some of your income was annuitized (even if it was "just" Social Security). If you encounter one of the failure scenarios where you blithely spend all of your assets at a 4% SWR, then you'll still have your annuity income. In other words, your failure rate is actually zero because you have longevity insurance. Yet the SWR studies never include this reality.
You're going to pay much less in fund expenses. If you get your expense ratios down to 0.5% instead of 1% then the real SWR becomes 4.5%. If you're thinking that you'll maintain a 3%-3.5% SWR then just cut your expense ratios and add the savings. Now you're at 3.5%-4%.
But wait, there's more: variable spending. You'll spend more when the markets are up ("wealth effect") and cut back your spending during recessions ("loss aversion"). Some years you'll have a big fantasy vacation or a roof replacement, other years you'll hang out at home most of the year. During the first five years of ER you'll be particularly sensitive to a recession and you'll probably cut your spending way back when it happens. Even just using Bob Clyatt's variable spending scheme of 4%/95% in "Work Less, Live More" raises the 4% SWR to about 4.5%. So variable spending is probably worth another 0.5% added to your more conservative version of the SWR.
Now if you keep two years of expenses in a money market or CD (instead of just one) then your asset allocation is more like 60/36/4. Yet starting the year with two years' expenses in cash means that you can outlast almost any recession by just spending down your cash (which you're trying to conserve anyway) and letting your stocks recover.
Just by addressing some of those simplifying assumptions, we've taken your 3%-3.5% SWR right back up over 4%.
If you retire on a 4% SWR then you'll have a success ratio of 80%-100%, depending on your personal willingness to work longer to boost it past 80%. (Anything over 80% is meaningless precision, but it'll help you sleep better at night.) Your annuitized income (for a bare-bones budget) will guarantee that you'll avoid the failure rates of 0%-20%, so already your actual success ratio is at 100%. In other words then you'll have more money than you need.
If you cut your spending to 3%-3.5% then you won't be any happier, although you might sleep better at night. But eventually you'll realize that you have more money than you have health & mobility to enjoy it. Your great-grandchildren will be happy with your legacy, but you'll have missed a lot of life-enhancing opportunities because you were too conservative with your spending.
Here's another way to look at it: reducing your SWR from 4% to 3-3.5% is the same effect as cutting your current spending by 12%-25%. Try that test now. Cut your spending by that much for the next couple of years, while you're still working, and see how you feel about it.
I think you're good with a 4% SWR and behavioral psychology. Don't over-think it.
--- Quote from: Dawg Fan on June 17, 2015, 05:40:38 AM ---- Using common sense and making sure you have flexibility to lower your annual expenses when needed (market tanks)
- 1 - 2 yr cash/CD/short term bond acct not a bad way to cushion a heavier stock portfolio mix
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Yep, as mentioned in my previous paragraphs.
--- Quote from: Dawg Fan on June 17, 2015, 05:40:38 AM ---- Be sensitive to stock valuations when you launch and adjust your SWR accordingly if needed
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Whatever the heck "valuation" means. Trailing earnings? Projected earnings? EBIDTA? Free cash flow? One of the Internet's most notorious personal-finance trolls claims that he's been in cash since 1996 because valuations are still "too high". Even 2009 wasn't good enough for him because future earnings were projected to be zero, and when a zero is in the denominator of P/E then valuations will always be too high.
A more concrete approach would be to start your ER at your personal conservative asset allocation, say at 60%/40% equities/bonds. (I would not be more conservative than that.) If a recession occurs during the first few years of ER then you'll cut your spending. You'll spend your cash. You'll spend some of your bonds. Just by your spending, even though it's reduced, your AA will begin to drift up to 65%/35% or even 70/30. At the end of the recession you'll resume your 4% SWR, your portfolio will have survived a recession and assumed a more aggressive AA, and it'll recover its value more quickly because you held on to your equities. You'll have also endured the dreaded "sequence of returns" risk which is critical to portfolio survival during the first 5-10 years of ER. Once you've survived that then your portfolio is nearly bulletproof.
--- Quote from: Dawg Fan on June 17, 2015, 05:40:38 AM ---- Maybe give consideration to a more aggressive SWR in yrs prior to age say 75 with a reduced SWR there after (This is basically my own research/observations as the theory is while you are younger/healthier, you will want to do more that may cost more $$ and as you get in your golden yrs you may be a little less active. Yes, exceptions everywhere, but I see this/hear this from people in my life)
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One of the earliest mentions of this was a 1990s book by Michael Stein "The Prosperous Retirement." The anecdotal evidence is strong, but the research is mixed. Are people spending less because they have to (running out of assets), or because they can't spend it? (Poor health, limited mobility.) What about medical expenses or end-of-life care? In any case, I'm going to agree with the anecdotal data because it closely matches my personal experience.
I think your instincts are correct. You could start your ER at a 4% SWR, and as you get into your 70s you might find out that your new 30-year SWR is really 5% or even 6%.
I'm 54 years old, so it'll be interesting to see whether the actuarial analysis reaches a firm conclusion over the next decade. However I'll still spend a little more now out of concern that I won't be able to spend it later.
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forummm:
From Sol: http://forum.mrmoneymustache.com/investor-alley/bogle-projects-'nominal-to-zero'-real-returns-over-the-next-decade/msg702331/#msg702331
(worth reading more in the thread)
--- Quote from: sol on June 19, 2015, 11:41:50 AM ---
--- Quote from: sabertooth3 on June 19, 2015, 11:27:59 AM ---this is why I'm not a fan of FIRE = 25x annual expenses. As
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Keep in mind that the 25x rule and 4% rule already account for 95 percent of scenarios, so you would only have a one in 20 chance of needing to ever reduce your expenses.
To extend your hotel analogy, the correct plan would be to take the average expectation, which in this case is a 6% withdrawal rate (has a 50/50 chance of success over 30 years) and then add a 10% safety buffer (another 0.6%) and still plan on a withdrawal rate over 5 percent. Your plan of going with 40x expenses is like planning for every party that makes a reservation to need the entire hotel, just to be safe, even though that has never happened before in all of history.
Yes, it is safer. No, it's not a very efficient way to make plans.
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forummm:
From Eric:
--- Quote from: Eric on June 19, 2015, 11:58:34 AM ---
--- Quote from: sabertooth3 on June 19, 2015, 11:27:59 AM ---Jumping in here, this is why I'm not a fan of FIRE = 25x annual expenses. As brooklynguy stated a few posts back, none of us really know what the future will hold for the market. Instead of skirting by on 25x expenses, I think it's more prudent to go for 30 or 40x expenses. Because if your adaptation alternative is going back to work, you aren't FIRE anymore.
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That's totally cool if that's your comfort level, but realize the trade off. You're talking many extra years of guaranteed work, probably 5-10 years to get to 40x, versus a possible but unlikely part time work here and there if your 25x takes a big hit initially (and you choose to do that instead of implement other safety margins). So if you go back to work "you aren't FIRE anymore", that still sounds better to a lot of us than never being FIRE to begin with until many years after 25x.
Sol touched on it above, but that 4% is already a pretty worse case scenario. To add some numbers, the average portfolio balance at the end of 30 years using the 4% rule is over twice of what you started with (in real terms, not nominal).
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forummm:
From Brooklynguy:
--- Quote from: brooklynguy on June 19, 2015, 12:15:39 PM ---To second (third?) Sol's and Eric's point, take a look at this excellent recent post by Nords highlighting the ridiculous amount of safety built into the 4% rule (in that, besides having an excessively high historical success rate to begin with, it deliberately ignores various external levels of safety margin which, in reality, will inure to the benefit of most retirees) -- and he's one of our more conservative early retirement planners!
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