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4% Rule
Old 09-25-2003, 10:31 AM   #1
 
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4% Rule

When the 4% rule is applied does your principle get used up at the end?
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Re: 4% Rule
Old 09-25-2003, 10:57 AM   #2
 
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Re: 4% Rule

The answer is - No one knows for sure ! And no one also knows when the 'end' is.

I can paint you a scenario where the principal gets used up and I can paint you a scenario where your heirs are very wealthy.

I think a fixed withdrawal rate is kind of silly anyway. If you think that spending a lot of money at age 85 is going to be as much fun as spending money when your 55, a fixed withdrawal rate is probably for you.

I use the financial planner from Quicken and schedule withdrawels much higher from 50-80 and ratchet down after that. I plan on traveling a lot until age 75 or so. I also plan on the last check I write to bounce.
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Re: 4% Rule
Old 09-25-2003, 11:33 AM   #3
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Re: 4% Rule

I am not a numbers person, but isn't the idea behind the 4% rule basically to live as much as possible on ones interest? Since 4% is not unreasonable given a conservative mix of investments, it would seem reasonable to figure out whether 4% of whatever you have is a reasonable amount to live on and go on from there.

Or is there something that I am missing?
If this is really a numbers-heavy concept, I probably won't get it. So KISS (keep it simple, stupid) answers will be really helpful.

thirdage
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Re: 4% Rule
Old 09-25-2003, 01:31 PM   #4
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Re: 4% Rule

Quote:
I am not a numbers person, but isn't the idea behind the 4% rule basically to live as much as possible on ones interest? Since 4% is not unreasonable given a conservative mix of investments, it would seem reasonable to figure out whether 4% of whatever you have is a reasonable amount to live on and go on from there.

Or is there something that I am missing?
If this is really a numbers-heavy concept, I probably won't get it. So KISS (keep it simple, stupid) answers will be really helpful.

thirdage
Hi ThirdAge

I started to choose a quote from your post, and I realized that every word was necessary to convey your question.

In fact the 4% rule is a numbers heavy concept, and it is also a contentious one, at least among people who are willing to contend over such matters. The idea is that there is some number, called the safe withdrawal rate (SWR), which will give you a very high probability of being able make that SWR each and every year, in real terms, for a long time-like 30 to 40 years. There are calculators like FireCalc made by Dory who started this board, which will take your assumptions about returns, expenses, investment mix, and make many runs of your chosen number of years over successive historical periods I think beginning in 1871, then 1872, etc. It tells you how many times you made it, and how many times you didn't. Four percent of a mixed portfolio is likely enough, and not too dispiriting, that it has become a shorthand answer to the question, how much can I withdraw, and stay even with inflation, and not go broke?

The hazard to a portfolio made up mostly of fixed income is that real interest rates are rarely 4%- so a 4% real withdrawal will eventually wipe you out. (Real rates are market rates less CPI inflation.) The hazard of an equity heavy portfolio is that returns, in addition to being unknowable going forward, are also very volatile. A bad few years early on can put you down so far it is hard or impossible to recover, since your portfolio will be suffering attack from two directions- your need to withdraw money, and the falling market quotations.

If you have a strong preference for fixed income, a good guess at the actual sustainable, real SWR is the coupon yield on TIPs, not the blended yield of coupon and inflation adjustment.

I believe the truth is that if inflation returns in a big way, it is hard to make out without becoming something of a speculator, or finding a way to get wages or earned income, or find some way outside of one's investments to fund life.

There is a New Yorker cartoon where the guy is explaining to his wife, "Sorry darling, it appears that we are on the live cheap and die early plan."

Mikey
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Re: 4% Rule
Old 09-25-2003, 02:13 PM   #5
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Re: 4% Rule

Thanks for your straight and simplified answer.

I guess a little bit of ignorance goes a long way towards bliss. Am torn between educating myself more or just jumping into the water in my usual fashion. (Haven't drowned yet.) Also, since I'm older than most early retirees, I don't have to go so far out in my planning. Good thing!

You bring up some interesting ideas.

Life, after all, is more fun if it isn't predictable. If things turn out a little funny moneywise, funding a life outside of investments could turn into a creative endeavor putting you on a path that you would never have dreamed of in your ordinary worklife. If health allows, I could imagine a second career chosen for rewards that have less to do with money than personal satisfaction.

I am beginning to understand through reading the posts here that risk averse means different things to different people, as does safety.

Thanks for the enlightenment.

thirdage

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Re: 4% Rule
Old 10-03-2003, 11:42 AM   #6
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Re: 4% Rule

To more directly answer your question - yes, it is possible with a 4% withdrawal (inflation adjusted) to go broke over historical time periods. The condition placed on the withdrawal calculators is that you won't go broke over a set period of time (30 years usually) but it is allowable to go broke in the year after the period of interest (i.e. year 31). The odds of this are low but not non-existent. Dropping the withdrawal rate to reduce this chance might be possible for some but it can make early retirement impossible for some.

The better option, IMHO, is to consider the idea of fallbacks in your planning. For the very early retiree (30's or 40's) SS will likely be small and may be best to not be counted on as regular retirement income but as a fallback in case of bad portfolio returns. Variable withdrawal schemes that take more in good years and less in bad years could also limit the chances of going broke.

As you suggest, work of some kind could also be used as a backup. The amount of work would likely not need to be large and it could be of the non-stressful kind (part-time barrista, tour guide for rich Westerners through countries you've spent retirement travelling/living in, stereotypical greeter at Walmart, etc.). The most dangerous years for the portfolio are actually the early years and if you have a sequence of bad returns at that time you should still be young enough to get some work and reduce your withdrawal. Even a small amount should be enough to tip you over from a losing portfolio scenario into a winning one.

Hyperborea
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Re: 4% Rule Discussion
Old 10-04-2003, 12:37 PM   #7
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Re: 4% Rule Discussion

Any thoughts appreciated on this issue. just wondering

If you start withdrawal in 2003, can you use the high point of 2000 as your asset withdrawal amount?
Based upon a 4 % withdrawal, can you use the high value (i.e. before March 2000) of your asset as your base amount to calculate the 4% withdrawal and adding that number of years ( in this case 3 years) to your end point? Instead of 30 years it is now 33 years , etc. This would give a higher dollar withdrawal.

Does this make sense or is there something missing?

Thanks

earlyout

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Re: 4% Rule
Old 10-04-2003, 01:49 PM   #8
 
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Re: 4% Rule

Sure, this would work. -

But you've got to realize all you're doing is formulating a plan - which may be totally different from the actual experience.

There really is no safe withdrawal rate, as you can always come up with a scenario where you will go totally broke.
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Re: 4% Rule Discussion
Old 10-04-2003, 02:04 PM   #9
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Re: 4% Rule Discussion

Quote:
If you start withdrawal in 2003, can you use the high point of 2000 as your asset withdrawal amount?... This would give a higher dollar withdrawal. Does this make sense or is there something missing?
Well, it makes sense if you stay within the artificial confines of SWR thinking. But does it make sense in the real world? Of course not! How could it? Valuing a portfolio in 2000, at an alltime high PE ratio didn't make sense then, or now. What counts is not where the hyper-emtional Mr. Market happens to value your portfolio on a given date, but the underlying long term earning power of your shares in the companies represented in that portfolio, and the interest rate of your fixed income investments. And of course, the size and timing of your withdrawals.

Speaking of withdrawals, after seeing the price of veggies on my last couple of trips to the grocery, I am planning a Victory Garden for next spring.

Mikey
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Re: 4% Rule
Old 10-04-2003, 03:52 PM   #10
 
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Re: 4% Rule

Quote:
Valuing a portfolio in 2000, at an alltime high PE ratio didn't make sense then, or now.
You are absolutely correct Mikey and I am starting to look at today's Market Value in the same light. Maybe even worse, since the economy is in the tank and not creating enough jobs.

I see a major correction in the next couple of years unless we start producing great jobs (In the U.S., not India) at a rate that I have not seen in my lifetime!
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Re: 4% Rule Discussion
Old 10-04-2003, 09:48 PM   #11
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Re: 4% Rule Discussion

Quote:
If you start withdrawal in 2003, can you use the high point of 2000 as your asset withdrawal amount?
Based upon a 4 % withdrawal, can you use the high value (i.e. before March 2000) of your asset as your base amount to calculate the 4% withdrawal and adding that number of years ( in this case 3 years) to your end point? Instead of 30 years it is now 33 years , etc. This would give a higher dollar withdrawal.

Does this make sense or is there something missing?
A lot of REs don't feel comfortable with the real answer to your question, but if you believe in the validity of the historical analysis that the 4% rule is derived from . . . then the answer is "yes".

Think of it this way . . . If a person had retired on March 1, 2000, they could have safely retired (assuming the validity of the 4% SWR) on 4% initial withdrawal rate of their nest egg value on that date. Today, they would be living off of an inflation adjusted version of that initial rate after already withdrawing living expenses in 2000, 2001 and 2002. And as long as the economic climate over the the next 30 years is not worse than that faced by retirees in the 1930s and the mid-1960s, they would be safe.

If you didn't retire in March 2000, then your nest egg has not been diminished by spending in 2000, 2001, 2002 or the first part of 2003. So if you had held the same portfolio as the person who did retire in March 2000, you have more funds now than they do. Clearly if the 4% SWR analysis is valid for them, then you are even safer than they are. In fact, you can use a greater than 4% initial withdrawal to account for the inflation since your nest egg high and still be safer than the March 2000 retiree. If you have added funds to your investments since March 2000, then you can add 4% of the current value of those new funds to 4% of your March 2000 funds to come up with your new SWR.

The objection most REs have to this analysis is that the nest egg you had in March 2000 was overvalued, so you shouldn't use that amount. But, of course, the high value of the starting funds is already accounted for in the 4% rule analysis. Investments were overvalued in 1929 and the mid-60s too. If you are going to ignore the historical analysis whenever starting investment values were overvalued, then then we would end up with a 4.5% rule or a 5% rule. If you use the worst case analysis of historical data to derive a 4% rule but then throw out the value or your portfolio in March 2000 because it represents a worst case, you are accounting for the overvaluation problem twice.

Caution: Remember that the 4% rule makes certain assumptions about your investment portfolio (equity/fixed balance ratios, rebalance once per year, etc.)and is based on a 30 year investment lifetime. Also, there are plenty of reasons to question the validity of any historical analysis as it applies to the future. Tomorrow could always be worse than anything that ever happened in the past. That doesn't change regardless of how you choose to pick your SWR.
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Re: 4% Rule
Old 10-05-2003, 06:20 AM   #12
 
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Re: 4% Rule

Very well said Salaryguru! You are right on the money.

And also remember plans are just plans.
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Re: 4% Rule
Old 10-05-2003, 09:36 AM   #13
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Re: 4% Rule

The ultimate 'safe withdrawal rate' is dividends and interest, reinvesting cap. gains. Thats what they used to do before computers, spreadsheets and all that stuff. BTY 1958 I think, is when stock div. yields fell below bond yields. A 60/40 stock/bond index is probably below 2.5% - historically a pretty 'chewy' period to endure.
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Re: 4% Rule Discussion
Old 10-05-2003, 02:19 PM   #14
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Re: 4% Rule Discussion

Quote:
Think of it this way . . . If a person had retired on March 1, 2000, they could have safely retired (assuming the validity of the 4% SWR) on 4% initial withdrawal rate of their nest egg value on that date.
Salaryguru, your analysis couldn't be better put. You exactly and clearly explain that once the SWR concept and method of calculation is accepted as valid, it wouldn't matter if the S&P had been 2500 or 3000 in 2000, or any other year. Just multiply ones portfolio by 4%-and surely we all would have had $3,000,000 portfolios at least-and move to Nice. Hey, "providing the future is like the past."

It's just that there is a very big ? regarding the phrase "assuming the validity of the 4% SWR". For various reasons, I believe that is an unwarranted assumption. First reason is that using several metrics, PE_10 of Shiller, Tobin's Q, etc- the market in the late 1990's and 2000 was much more overvalued than during 1929, and of course even more than during the mid 60's. So we have an out of sample condition. The existence of Year 2000 valuations proves beyond doubt that the past did not adequately encompass the year 2000. We experienced an upside outlier.

The second reason has to do with the statistical significance of the underlying process by which SWR is calculated. Since 1871 there are 4 non-overlapping 30 year periods! 4! That means that you have 4 independent runs, not >100 as is often advanced. Then there is the problem of stationarity. For statistical sampling to mean anything at all, there must be some reason to believe that there is not an overall drift in the data- ie. that data points from many years ago are drawn from the same universe as more recent ones. I see no reason that this would likely be true, and many reasons why it is likely not true.

This analysis shows only a few of the most glaring problems with SWR as it has been advanced. In reality, the situation is quite a bit worse.

I am afraid that Emperor SWR has no clothes.

Mikey

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Re: 4% Rule
Old 10-05-2003, 03:21 PM   #15
 
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Re: 4% Rule

Quote:
This analysis shows only a few of the most glaring problems with SWR as it has been advanced. In reality, the situation is quite a bit worse.

I am afraid that Emperor SWR has no clothes.
Yup, I think you are right on this Mikey.

The biggest issue that I see with a constant withdrawal rate is that you cannot spend your withdrawal after age 80! - I have many, many friends that are over 70 and their biggest issue is time. A lot are going blind, most have diabetes. They never worry about money!

This often seems to be neglected when discussing SWR.

To rig up a retirement plan with a constant withdrawal amount until age 95, is not realistic. At age 80 you cannot travel as well as you can at age 60. To hoard money for age 85 will only insure that your heirs will enjoy it.

A retirement plan needs to have more money withdrawn in the 50-75 years where you can enjoy it.

Live Rich ! - Don't die Rich!
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Re: 4% Rule Discussion
Old 10-05-2003, 07:21 PM   #16
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Re: 4% Rule Discussion

Quote:

The second reason has to do with the statistical significance of the underlying process by which SWR is calculated. Since 1871 there are 4 non-overlapping 30 year periods! 4! That means that you have 4 independent runs, not >100 as is often advanced.
I'm lost.

Did the quote above refer to a historical calculator like FIRECalc, or to some 4% hypothesis (I can't get myself to call it a "4% rule", as that means with great, maybe absolute, certainty!).

If it refers to FIRECalc... If the latest data in FIRECalc is through the year 2001, and the term is set to 30 years, then 2001 - 30 = 1971, then 1871 to 1971 = 101 years (inclusive). So a 30 year-wide bar can be slid across the data year by year from 1871 until it includes 1971. Any progression beyond that means truncating the data period to a year less for each year the bar is advanced.

So how is this wrong? A historical calculator like this is looking at CONTIGUOUS years data (30, in this example).

Granted, the data from each year in the historical record is not diced year by year, thrown into a big pile, and then someone says "let's try to assemble something completely on a whim, let's take data from year 1875, then put data from 1943 behind it, followed by data from 1906, etc. etc."
Although if someone really wanted to do that, I guess the data exists to create such a calculator. In that case, include data through 2001 also. But it would NOT truly be a historical calculator. The worst-case selections would be very grim. Example, line up every down year available in a serial string of 30 years, then put the poor fool's nest egg into it. Failure for sure! And that result would be be representative of, what?

I'm comfortable with FIRECalc, as far as understanding the statement attached to it, no worse than the past for which data is available. To me, that is not a 100% certainty of the future, nor to I think it purports itself to be so.

But for that matter, are any of the Monte Carlo calculators any better? Someone had to make their own assumptions about what was "plausible" in setting up their model. Were they exceedingly, or ridiculously pessimistic in the bounds they set? I sure don't know. And what would be "too pessimistic"? What a quagmire!

I hope I'm making sense here with all this, maybe I just misunderstood something
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Re: 4% Rule Discussion
Old 10-05-2003, 10:41 PM   #17
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Re: 4% Rule Discussion

Quote:
Did the quote above refer to a historical calculator like FIRECalc, or to some 4% hypothesis.
Hi Telly,

I am not really dissing the historical calculators. As you point out, there are problems with Monte Carlo also. In fact many of the same problems. What I am trying to say is that one has to be careful in taking the result of any of these calculators and blindly applying it in the real world. In particular, I was referring to the idea that one can take the year 2000 peak value of a portfolio, run the calculator, and set a "maximum safe withdrawal" from this process.

With regard to how many independent (non-overlapping) 30 year periods there are between 1871 and present, I get 1871-1900; 1901-1930; 1931-1960; and 1961 1990. In 2020 we'll have another! I realize that many runs can be achieved by starting in 1871 and incrementing one year, thus adding 1 new data point, and dropping one old one. You correctly point out that this gives many more trials. However, they are not independent.

Which does not suggest that they are useless; just that one should probably be careful in deciding how much confidence to give to the result. Especially when it seems to go against common sense-as when it is suggested that S&P valuation at the time of setting the portfolio value for SWR purposes doesn't matter.

To me, a useful way to think about this problem is to focus on the sustainable cash generated by the portfolio. Imagine that one is going to live on a private business. Not the salary of a manager, but the real (inflation adjusted) dividend that could safely be paid out, without neglecting capital spending, or drawing down emergency reserves. Your son, an honest manager, will run the business prudently, and with an eye to cash generation. Absent selling the business, or re-capitalizing it, would the amount of cash you could take out have anything to do with what valuation was put on the business?

I realize that many prefer a more abstract form of modeling it, but I think that some of the reality can be lost in the abstracting.

Mikey
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[i][/i]Re: 4% Rule Discussion
Old 10-05-2003, 11:04 PM   #18
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[i][/i]Re: 4% Rule Discussion

Quote:
It's just that there is a very big ? regarding the phrase "assuming the validity of the 4% SWR". For various reasons, I believe that is an unwarranted assumption. First reason is that using several metrics, PE_10 of Shiller, Tobin's Q, etc- the market in the late 1990's and 2000 was much more overvalued than during 1929, and of course even more than during the mid 60's. So we have an out of sample condition. The existence of Year 2000 valuations proves beyond doubt that the past did not adequately encompass the year 2000. We experienced an upside outlier.
As I stated in my original post, I agree that there are plenty of reasons to question the validity of the 4% rule. Past performance is no guarantee of future results. That simple statement can be used to condemn any historical based analysis.

Quote:
The second reason has to do with the statistical significance of the underlying process by which SWR is calculated. Since 1871 there are 4 non-overlapping 30 year periods! 4! That means that you have 4 independent runs, not >100 as is often advanced.
I'm not aware of any mathematical reason that the number of "non-overlapping" periods is important to validity of the analysis. Think of it this way . . . if you wanted to determine empirically the worst case of how many times a flipped coin would turn up heads out of 30 flips, you don't need to consider non-overlapping events. You can flip the coin 100 times and look at all the strings of 30 flips in a row to estimate the worst case. In fact, if you don't do that, you are throwing out a lot of valid and important data.

Of course, the real answer to the coin toss problem is 0 and the odds that you actually experience that situation using 100 flips is incredibly small.

This is very analogous to the historical analysis that yields the 4% rule. The real SWR is zero. The government could colapse and all your funds siezed overnight. The historical analysis gives you an estimate of the most probable worst case you might face in the future much like the 100 coin tosses estimates the most probable smallest number of heads you will experience out of 30 tosses.

Quote:
Then there is the problem of stationarity. For statistical sampling to mean anything at all, there must be some reason to believe that there is not an overall drift in the data- ie. that data points from many years ago are drawn from the same universe as more recent ones. I see no reason that this would likely be true, and many reasons why it is likely not true.
I'm not familiar with the term "stationarity", but I am familiar with statistcal analysis, and you are correct that the 4% analysis won't be valid if tomorrow bears no resemblance to yesterday. The performance of the economy from 1871 to today may have nothing to do with the performance of the economy over the next 30 years. Investors, equity traders, bond traders and governments may change so much that the forces that formed our economic environment since 1871 are no longer valid. Past performance is no guarantee of future results.

Quote:
This analysis shows only a few of the most glaring problems with SWR as it has been advanced. In reality, the situation is quite a bit worse.


I am afraid that Emperor SWR has no clothes.

Mikey
I'm not quite that pessomistic. In fact, I think there are quite a few reasons to believe that our economic systems have actually improved since 1929. I don't expect investment returns over the next decade to be as high as they were during the 90's, but I am not going to lose any sleep worrying that we are facing times as hard as those who retired in 1929 either. It may happen that times really get worse than the Great Depression, but it could happen that I die tommorrow too. I'm going to plan both my financial future and my life like those events are long shots that do not deserve a significant amount of my attention.

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Re: [i][/i]4% Rule Discussion
Old 10-06-2003, 07:27 AM   #19
 
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Re: [i][/i]4% Rule Discussion

Quote:

I'm not aware of any mathematical reason that the number of "non-overlapping" periods is important to validity of the analysis. *Think of it this way . . . if you wanted to determine empirically the worst case of how many times a flipped coin would turn up heads out of 30 flips, you don't need to consider non-overlapping events. *You can flip the coin 100 times and look at all the strings of 30 flips in a row to estimate the worst case. *In fact, if you don't do that, you are throwing out a lot of valid and important data. *

Can't be said any more clearly. What we as REs are interested in are the periods of successive years, not the raddom sample of 30 unrelated years.
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Re: 4% Rule
Old 10-06-2003, 06:15 PM   #20
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Re: 4% Rule

Another significant variable in the SWR equation has to do with the makeup of the portfolio. The individual with 70% in TIPS and 30% in stocks can be far more certain about his/her SWR than the person with 30% TIPS and 70% stocks, for example. So while there is certainly no safe withdrawal rate of 4% going forward, one can actually come close to a true SWR of about 2.5% (until 2032) by investing 100% in TIPS. The pursuit of that additional one and a half percent (or whatever) is where the risk comes into play.
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