Beware the 4% rule

[REWahoo]

I think it is our loss when we dismiss a person or concept just because they say something that is incorrect once, when further reading would show that it is NOT what they meant.

I'm quick to dismiss a person or a concept when the "news release" regarding the article/study makes an incorrect statement (4% rule definition) and chooses to quote something from the article/study which is also incorrect (purchase of surpluses).

First impressions are difficult to overcome.

 

[Texas Proud]

Ok here is a simple yes / no queswtion

Did you read the actual original article before making your comment ?
Or did you only read the news story

If you read the article and not merely the news story no problem
but if you only read the news story it is your problem

original article at
http://www.stanford.edu/~wfsharpe/retecon/4percent.pdf

Thanks for the article... it will be interesting to read...

But, my concern is still the same..... that the 4% is a hard number... I do not think anybody has a 4% hard number.... here is a quote from the abstract..

"Further, we argue that even if retirees were to recoup these costs, the 4% rule’s spending plan often remains wasteful, since many retirees may actually prefer a different, cheaper spending plan"

​

So, right off the bat they have this as a hard and fast rule...

Also in the article and I am not that far in

A typical rule of thumb recommends that a retiree annually spend a fixed, real amount
equal to 4% of his initial wealth, and rebalance the remainder of his money in a 60%-​

40% mix of stocks and bonds throughout a 30-year retirement period.


I agree... it is a rule of thumb... but not mandatory spending...

The goal of this paper is to price these inefficiencies—we want to know how much money a retiree wastes by adopting a 4% rule.

THIS could be interesting...

OK... quickly read the whole thing.... and I think I read something like this before...

They seem to say that you can 'buy' your retirement cheaper than with the variable portfolio... but they do not seem to show what would happen if EVERYBODY went this way... the stock market has a huge value... the amount of TIPS is not that large... if everybody went to buy the least cost item... then the costs are sure to go up..

So I do not see that the 4% rule is dead... just that it might not be the 'optimal' way to do things... a very different view of the article..​

​

 

[ERD50]

Thanks for the article... it will be interesting to read...

I didn't read every word, I got mildly frustrated that his examples and terminology are not as clear as they could be. After a nice lunch out on a sunny day, I just didn't feel like putting forth the effort...

However, if I use my decoder ring and provide another example (not his example - I don't want to appear to be quoting him on this), I think I get his drift from what I did read.

A) If you look at the output of FIRCALC for the 4% & 30 year portfolio, many cases result in more money than you started with, while 5% fail. If your stated goal is to be able to WD 4% for 30 years, you were 'inefficient'. You are 'paying too much' (in the form of failures) for the surplus years (that you don't 'need').

B) So a really simple example (that I am making up) is, if you could invest 100% in something that was guaranteed to do nothing but keep up with inflation, you could WD 3.33% per year, and meet your stated goal, and have no 'wasted' surplus. Year 31 you deplete your portfolio, no ifs, and or buts. It is 'efficient' by one measure.

So I think he is saying to invest in something safe that pays a bit more than inflation, so you can kick that back up to 4%.

The problem I see is:

A) Can we always expect to be able to find 'safe' investments at slightly more than inflation (TIPS?)?

B) If you want to plan for a possible long life, and say stretch that to a 45 year portfolio, you are down to a 2.2% WR (plus your real returns). From what I've seen in FIRECALC, getting down to ~ 2.5% is a 'forever' portfolio with a 50-75% equity AA. No failures and a huge upside for heirs and/or your favorite charities.

I think I'll stick with some equities, a lower than 4% WR, and I'll let you know on my 95th birthday how I'm doing


-ERD50

 

[ERD50]

I just thought of another 'risk' we talk about. What if your 'personal rate of inflation' was higher than CPI?

If you take out a higher amount with the fixed income example - you *will* run out of money early. 100% of the time. There is no chance of a surplus.

But if I bump FIRECALC up to a 5% WR, I still succeed >70% of the time. Cross your fingers?

-ERD50

 

[ejman]

Incidentally, it may be a long time coming, but I believe plenty who retired in 1999 or 2000 and stick to 4% annually adjusted with the usually recommended allocations will eventually be up a financing creek of one sort or another. We've put in 10 years and counting from there, perhaps enough to conclude that something fundamental has changed?

Ha

If I understand the theoretical basis of the 4% withdrawal rule correctly, it basically says that a 4% withdrawal over 30 years with a 60/40 split will result in portfolio survival 95% of the time based on the historical record of all such periods going back 100+ years. Your statement above implies that you think that times worse than the Great Depression and two World Wars are ahead. Perhaps am not understanding correctly?

 

[clifp]

Hate to be odd man out, but this is an article about a position, not a white paper. Why should we expect it to be a complete explication of the Sharp et al position?

Also, to me at least it appears that the main thrust of the article is that there is a basic incompatibility in financing a fixed real outflow with gradual liquidation of varying assets. I really don’t think that this should be too controversial, and the next time we have a big downdraft there will be a lot of agreement with this position, even here.

Cavils such as "one doesn't have to spend 4%" are beside the point. Of course if you are well supported by a secure real value pension, you could invest in chicken futures and you still would succeed. If a sub-optimal plan is hugely over financed, it is still very likely to work, and it is for most people still suboptimal. Though not I would assume with ER.orgers.

A mind numbing review of years of threads on the 4% rules, and SWRs in general should show that people’s main question is not “will this cause me to become a mega-consumer trying to spend at least 4% every year”, but "will I never go broke spending what I feel that I want to spend within the upper limit of 4% of initial amount adjusted for inflation.? To say, well my 4% SWR allows me withdraw $60,000 real, but if things really get tight I could live on $22,000, or $12,000, or whatever, do not address the real world problem faced by most people.

Incidentally, it may be a long time coming, but I believe plenty who retired in 1999 or 2000 and stick to 4% annually adjusted with the usually recommended allocations will eventually be up a financing creek of one sort or another. We've put in 10 years and counting from there, perhaps enough to conclude that something fundamental has changed?

Ha

I am with HA on this . The article's conclusion seems pretty obvious: "If people are going to invest in risky assets after they retire, they will need to choose a strategy that adjusts their spending as the value of their savings changes. And that's quite a leap from the inflexible 4 percent rule. " Or as I have said the 4% SWR isn't a rule it is a guideline and it needs to be adjusted based on today conditions.

However, Professor Sharpe larger point is the (I read the original a year or two ago so I am a bit fuzzy) there are some real inefficiencies with the religious adoption of the 4% rule. Given recent events the talk has switched from is the 4% rule too conservative to is it too aggressive. I'll admit I am guilty of this also.

The 4% SWR is useful because it provide a reason to avoid panic during bad times. I found this exchange on the BogleHeads Wiki interesting.

Limitations of the Trinity study ...

The authors of the paper, however, did not mean for their scenarios to be applied rigidly or uncritically. The article makes this very important statement:

The word planning is emphasized because of the great uncertainties in the stock and bond markets. Mid-course corrections likely will be required, with the actual dollar amounts withdrawn adjusted downward or upward relative to the plan. The investor needs to keep in mind that selection of a withdrawal rate is not a matter of contract but rather a matter of planning.​

Nisiprius requested clarification from Professor Philip L. Cooley, senior author of the Trinity study:[3]

What the "4% SWR" means is not that you can treat a portfolio as if it were a guaranteed annuity. I think all the [Trinity] authors meant is that if it is late 2008 and your stocks halve in value, you don't need to halve your spending instantly. It's OK to cross your fingers and continue spending according to the 4%-then-COLAed plan, even though it means dipping into capital, and it's OK to go on doing that for a while.​

Professor Cooley's response:
You have hit the nail on the head! I've tried to explain that thought to journalists but they don't seem to get it. You've got it. Stay flexible my friend!, which is the advice we should give to retirees.

As a Class of 99 very early retiree, HaHa point is exactly right. I just went and recalculated what an inflation adjusted 4% SWR would mean for me today. A withdrawal of 168,000 a year. In truth with a paid off house I'd have trouble spending that much. My actually spending is less than 1/2 that amount. If I had spend that much my I estimate my withdrawal rate would be around 10%, pretty clearly unsustainable for a 50 year old.

The reality is I never should have looked at 4% SWR for a variety of reason. First, I was to young 50 years was a better planning horizon. Second and probably equally important my portfolio was not very close to the Trinity Study. Now my AA was probably 85%/15% in 1999 but 40% was in Intel and 25% was in NASDAQ stocks. Fortunately I made good/lucky adjustments and by Jan 2000 it was 75%/25% but still heavily weighted NASDAQ weighted and that was cut in 1/2 in short period of time.

On the other hand at the beginning of 2009, when I looked at my portfolio and realize that probably for the first time I was going to be spending near 4% of my portfolio current value, it was helpful to remember that over long periods of time spending less than 4% survived even the worst economic crisises.

 

[Rich_by_the_Bay]

Just a reminder of why some of us prefer Clyatt's approach of a 4.3% total portfolio per year, the amount variable as the porfolio fluctuates annually. Throw in a "5% less than last year's total" as a safety net or "floor" and you have a back-tested, sensible plan for those of us who can handle some fluctuation of income.

Not for everyone but it fits nicely for us.

 

[dex]

I am with HA on this . The article's conclusion seems pretty obvious: "If people are going to invest in risky assets after they retire, they will need to choose a strategy that adjusts their spending as the value of their savings changes. And that's quite a leap from the inflexible 4 percent rule. " Or as I have said the 4% SWR isn't a rule it is a guideline and it needs to be adjusted based on today conditions.

When I read the OP; I then read the link from which I made my comment. My reading of the link was wrong. I think my comment about the Rule of Thumb and customization is correct.

The 4% withdrawal rate is only one factor. We have had threads discussing cash flow i.e. several years of expenses in cash equivalents (or short term bond funds) to ride out the downturns. Also, the mix of stocks, bonds and the dividends/interest they generate is important.

After glancing over the original paper I still think there isn't much value to those contemplating retirement. It is over thought and overly complicated. I get the sense they were trying to work in aspects of Freakeconics into their analysis.

 

[NW-Bound]

...by Jan 2000 it was 75%/25% but still heavily weighted NASDAQ weighted and that was cut in 1/2 in short period of time.

My story is almost like that, except my high-water mark was on March 2000, and my lowest point after the tech bubble burst was on Oct 2002, nearly 2-1/2 years later. Between those two points, I lost 44%. That could have been worse, if I did not have a part-time income and had to draw on the savings to live.

Just a reminder of why some of us prefer Clyatt's approach of a 4.3% total portfolio per year, the amount variable as the porfolio fluctuates annually. Throw in a "5% less than last year's total" as a safety net or "floor" and you have a back-tested, sensible plan for those of us who can handle some fluctuation of income...

I am aiming to do the same, meaning spending a percentage of this year's portfolio value. And I try also not to put a cap on the yearly reduction, like R-i-T's 5% per year. It means really tightening the belt in extreme bad years, like we had in 2008-2009. One must lower the fixed cost of living to perhaps 60% or less of the "usual" expenses, in order to have the other 40% as fat to be cut in lean years. It is tough, but we have done it. Why 60%? It's because I have lost 30-40% of portfolio in 2007-2009. I have reclaimed more than 1/2 of that loss.

As an aside, I cannot see two consecutive 40% yearly cuts though. It would mean that Year 3's expenses would be only 0.6*0.6 = 36% of Year 1's expenses. And Year 4's expenses would be 0.6*0.6*0.6 = 21.6% of Year 1's expenses.

I shudder when thinking of 7 years of famine!

 

[FIREd]

And I try also not to put a cap on the yearly reduction, like R-i-T's 5% per year. It means really tightening the belt in extreme bad years, like we had in 2008-2009.

I was thinking about doing the same, but now that I have come up with a retirement budget, I think that abruptly cutting our expenses by 25-30% in bad years would be way too depressing. Basically, one year we'd be cruising around the world and the next we'd be sitting at home watching TV. The plan now is to withdraw 3-3.5% of portfolio value each year with an expense reduction cap of 10% in bad years (we reduced our expenses by roughly 15% in 2008 without suffering too much, so I think it's doable). Even then, FIREcalc shows a number of scenarios where our expenses would still have be cut by as much as 50% over a period of several years. That's a pretty scary thought.

 

[NW-Bound]

Did I scare anybody about the vision of the incredible shrinking portfolio that gets cut 30% per year, and 2 or 3 years in a row? I can have a dark sense of humor, in case you have not noticed.

Just joking around. I cannot fathom the scenario above. If the world economy gets that bad, all bets are off. We wouldn't be too far from Mad Max situation then.

Just now looking at Uncle Mick's beloved Wellesley as a benchmark, I saw that it dropped around 25% in the 2007-2009 time frame. Perhaps it is more reasonable to tweak your living expenses so that around 25% of it is for icing-on-the-cake pleasures. It is still a pretty hefty variation, I know.

My big portfolio variation is due to an aggressive AA, and high-beta stocks on top of that. That makes for an exciting ride, heh heh heh...

We never have a real budget. As long as we underspent our income, we thought we would be OK. I kind of cheat and allow myself a lot of leeway because I still have part-time income. Not until seeing how people here are a lot more serious about budgeting, I went back and found out that over the last 10 years, our annual expenses varied from the $40K to $110K+. The difference was due to a lot of travel and home improvements in good years. I am not sure we can go back to that $40K level anymore, because we have two houses now on top of higher medical insurance. But the point is that I am used to seeing my portfolio and lifestyle going up and down like yo yo.

What are the good shows on TV nowadays? Oops, forgot that we may not have TV while RV boondocking. I will just pack some Tolstoy and Dostoevsky.

 

[haha]

the

If I understand the theoretical basis of the 4% withdrawal rule correctly, it basically says that a 4% withdrawal over 30 years with a 60/40 split will result in portfolio survival 95% of the time based on the historical record of all such periods going back 100+ years. Your statement above implies that you think that times worse than the Great Depression and two World Wars are ahead. Perhaps am not understanding correctly?

Actually, I do not think that, although I certainly cannot rule it out. The US was a young capitalist country coming into its own with no huge baggage of entitlements, or government spending, and with no lower cost industrial competition.

What I based my statement on was since valuations (PE10) were at all time highs in 1999 and 2000- much higher than the top in 1929- there is no good reason that I can see to be certain or even put a high probability on the idea that the Depression and our wars represent the worse that might befall the stock market. This is not a popular idea, so I am not really prepared to defend it, but it is my working hypothesis. Also, remember that there are not many 30 year periods in the database, and fewer than five thirty year periods with no overlap.

We have the idea that government can pull us out of anything, but IMO it is at least equally possible that their reponses are just digging a deeper hole. My idea is that over an intermediate timespan, inflation is likely to be a bigger problem than deflation. But they are basically Scylla and Charybdis.

Ha

 

[NW-Bound]

In mathematical terms, what Ha said was that the working assumption of the economic model in Firecalc is that the stock and bond markets are stochastic stationary processes. We really have no proof of that, just a belief or a hope. On the other hand, before the American empire, we all know of the rise and fall of other empires. My thinking is that the change will be gradual enough that we will have time to adapt ourselves to it.

I observe that many posters have significant foreign equities in their AA. It's my way to hedge too.

 

[Texas Proud]

In mathematical terms, what Ha said was that the working assumption of the economic model in Firecalc is that the stock and bond markets are stochastic stationary processes. We really have no proof of that, just a belief or a hope. On the other hand, before the American empire, we all know of the rise and fall of other empires. My thinking is that the change will be gradual enough that we will have time to adapt ourselves to it.

I observe that many posters have significant foreign equities in their AA. It's my way to hedge too.

I agree on the rise and fall of empires... how long did it take for the Roman empire to fall??

And like I tell my boss.... WHO is going to take over Sure, the world economy might take a dive for the next 10 years... but how much does that really change our living standards?

Almost everybody how is worried seems to think that we go from where we are today to "Mad Max"... with nothing in between...

Also, even if we DID lose the top spot... we would still be second or third... not much farther down... there are a LOT of countries where things would be a lot worse...

 

[Spanky]

First impressions are difficult to overcome.

Yes, we human beings have a tendency to form judgment and refuse to change it while still insisting that we have an open mind.

 

[REWahoo]

Yes, we human beings have a tendency to form judgment and refuse to change it while still insisting that we have an open mind.

I refuse to insist I have an open mind.

 

[chinaco]

This has been discussed in other threads.

There are other papers that also point out misconceptions about the 4% WR approach as well as alternative approaches to a 60/40 mix for funding retirement income.

I thought Sharpes paper was thought provoking and made a good point. Don't follow a concept blindly, identify your real goals, look into your options for achieving those goals. If it can be done for less money and less risk... a rational person would/should choose that course of action.

 

[Spanky]

I observe that many posters have significant foreign equities in their AA. It's my way to hedge too.

The correlation between foreign equities and that of U.S. is getting higher, however. Adding other asset classes such as precious metals or commodities may help.

 

[chinaco]

Just a reminder of why some of us prefer Clyatt's approach of a 4.3% total portfolio per year, the amount variable as the porfolio fluctuates annually. Throw in a "5% less than last year's total" as a safety net or "floor" and you have a back-tested, sensible plan for those of us who can handle some fluctuation of income.

Not for everyone but it fits nicely for us.

Hey Doc... could you elaborate on the "5% less" part of the approach.

 

[Spanky]

Don't follow a concept blindly, identify your real goals, look into your options for achieving those goals. If it can be done for less money and less risk... a rational person would/should choose that course of action.

Agreed if we were rational.

 

[Independent]

To the contrary, in the article you linked, Sharpe does indeed propose a solution. If the Treasury were to issue TIPS with the maturity payment stripped-off so that you could purchase the coupon stream at auction, you could very easily implement Sharpe's proposal. Sharpe is talking about what is basically a 2-bucket approach, where one bucket (the stripped TIPS coupon stream) would fund your 4% inflation adjusted withdrawal for 30 years. The present value of the stripped-off maturity payment (approximately 9% of your portfolio's current value) would be invested in risky assets (e.g. the S&P 500), and would be left untouched for 30 years. Presumably, over such a long time period the stock market would return close to it's long-term historical average of about 6.5% per year real; and at your horizon, would have grown to a large enough value so as to fund the rest of your retirement years. IMO, the beauty of this approach is that you would never have to cut back from your 4% spending rule out of fear that you would run out of money, only to end up with a large surplus on your dying day.

I'll agree that your strategy, if I understand it correctly, is an excellent alternative. (In fact, I'm very heavily weighted in TIPS for that stability.) But, I can't find it in the paper. Maybe it's the financial equivalent of Sharpe's "Least Cost Spending Strategy" on page 11, but I can't make the connection.

My complaint about Sharpe's approach is that he seems to treat 30 years as a perfectly fixed number. Any amount left at the end of 30 years becomes a "surplus", and a source of inefficiency to be squeezed out. But, if he eliminates the possibility of a surplus, then it seems to me he has 100% chance of running out of money if he lives 31 years.

Your approach is better. By my understanding, you say that pure TIPS would allow a 4.46% flat income. If you're willing to move (.46/4.46) of your total portfolio into something with a higher risk/higher reward category, then wait 30 years for the short term volatility to partially cancel out, you'll have some funds for the possibility of a very long life.

 

[Rich_by_the_Bay]

Hey Doc... could you elaborate on the "5% less" part of the approach.

You have $1mm on Jan 1, 2000. You take $43k in income, leaving $957k.

Bad year ensues, market down 15%, leaving you with $813k by year's end. According to the basic rule, you would end up taking 4.3% of that $813k for the upcoming year's income = $35k. That's a huge hit.

However the "floor rule" allows you to take no less than 95% of what you took the prior year. 95% of $43k = $40,850. You can that amount rather than $35k and still do well long-term at least as far as back-testing shows.

BTW, following a really good market year, you may wish to withdraw less than the allotted 4.3% if you don't need it all, further enhancing the flexibility of this system - kind of a poor man's value cost averaging.

Hope that helps.

 

[ERD50]

(RE: great depression, etc)
Actually, I do not think that, although I certainly cannot rule it out. The US was a young capitalist country coming into its own with no huge baggage of entitlements, or government spending, and with no lower cost industrial competition.

For a period of time, we were the 'lower cost industrial competition'. So it isn't just that we lost an advantage, it's worse than that - the tables have been turned on us. It might not spell disaster, but I don't think it bodes well for us maintaining our standard of living. But as others have said, if it means a relatively modest decline in our standards, we can still be very happy indeed.

My complaint about Sharpe's approach is that he seems to treat 30 years as a perfectly fixed number. Any amount left at the end of 30 years becomes a "surplus", and a source of inefficiency to be squeezed out. But, if he eliminates the possibility of a surplus, then it seems to me he has 100% chance of running out of money if he lives 31 years.

That was my take on it also. To me, it makes his whole example a mere academic discussion - it becomes one data point from which you formulate a plan. And in that regard, that is all the '4% rule' is anyhow. So without investing too many brain cells on this, and still working on my caffeine consumption for the morning, I'll hazard the guess that some blend of the two makes the most sense for most people. I feel like I'm stating the obvious.

-ERD50

 

[Rustic23]

Rich,
Your post confused me a little. Are you applying the initial 4.3%, then applying a 4.3% to the remaining balance each succeeding year? If so, that is not how I thought how a 4% swr was applied. I thought you started with one million, applied the 4% or in your case 4.3% and arrived at $43,000. You then took $43,000, adjusted for inflation, out of your remaining balance, which in down years would be greater than 4.3% and less in good years.

 

[FIREd]

You have $1mm on Jan 1, 2000. You take $43k in income, leaving $957k.

Bad year ensues, market down 15%, leaving you with $813k by year's end. According to the basic rule, you would end up taking 4.3% of that $813k for the upcoming year's income = $35k. That's a huge hit.

However the "floor rule" allows you to take no less than 95% of what you took the prior year. 95% of $43k = $40,850. You can that amount rather than $35k and still do well long-term at least as far as back-testing shows.

BTW, following a really good market year, you may wish to withdraw less than the allotted 4.3% if you don't need it all, further enhancing the flexibility of this system - kind of a poor man's value cost averaging.

Hope that helps.

When I plug in the 4.3%/95% scenario in FIREcalc, I find an uncomfortably large number of cycles where the annual income would still have to be progressively cut from $43,000 down to roughly $20,000 at one point or another during a 30-year period. Does it sound right? By the way, I get somewhat similar results using my proposed 3%/90% scenario.

I don't know whether I am allowed to screen capture the FIREcalc results and post them here...