Explain the 4% withdrawal rate

[haha]

My Bad! Bad! Bad!     - Yup I scrwed up!  -- I think Hoc*s did it to me. Tried to get me to spend only $25 K per Mil instead of $40K

That's OK Cutt, even at that lower rate you can still live like a Russian Count out of War and Peace.

Ha

 

[wstu32]

trying to follow this...
so if you had a $1million portfolio, you should expect to take out 4% or
$40k per year?

 

[dory36]

trying to follow this...
so if you had a $1million portfolio, you should expect to take out 4% or
$40k per year?

Yes. That is the rate that would have been safe in the worst we have ever seen, so the 4% number, or $40,000, adjusted each year for inflation, is the commonly discussed safe withdrawal amount. That's what we mean by "safe".

Bonuses or raises? Now, there is another factor that doesn't get discussed all that much in calculations, although it probably gets implemented all the time when we use common sense in deciding how much to spend during our retirement. Let me try to give a logical description.

We are saying that 4% of the starting balance is safe, meaning that starting from any arbitrary point in time, we can initiate a series of ~30 annual withdrawals of 4% of the portfolio balance at that point in time, with adjustments for inflation.

We usually talk about this in the situation when the portfolio goes way down -- and the whole purpose of the safe rate discussions is to give us some comfort that if we stop our paychecks early, we can reasonably count on at least 4% of the balance at that point for the next ~30 years.

But look at the positive side. Let's say that in 5 years, the portfolio is at 1.2 million, after starting at 1 million. (Assume these are all inflation-adjusted dollars for this discussion.) 

What has happened?

One thing that has happened is that we have "lucked out", as the scenario that is worst for the survival of a portfolio is a large and lengthy market decline starting immediately after we decide to begin the withdrawals. Except for that scenario, the rate would be a good bit higher.

Another thing that has happened is passage of time. So now, instead of needing a $1 million portfolio to last for 30 years, we need it to last for only 25 years.

We can take advantage of our good fortune (timing retirement when we don't have an immediate bear market afterwards) and our new circumstances (more money and a shorter time to spend it) in a couple of different ways.

One -- we can start over. Just designate this new moment as the start of the withdrawal program, and take 4% of 1.2 million, or $48,000 instead of $40,000, for the next 30 years (or you could take ~4.2%, since you are now looking at 25 years instead of 30...), or,

Two -- we can take a $200,000 "bonus" to get the portfolio back down to $1 million, and continue drawing 40,000 for 30 years (or 42,000 for 25 years).

(This seems counterintuitive, but all that is happening is that we are reducing the amount that would have been left over at the end of the 30 year period, since we didn't get the bear market in the first 5 years.)

So... 4% sets your minimum withdrawal even in bad times, but you can adjust upwards following good years.

Hope this helps -- dory36

 

[azanon]

So... 4% sets your minimum withdrawal even in bad times, but you can adjust upwards following good years.

Hope this helps -- dory36

Is that the way the study was designed to work? I thought the method and chances for failure included all the probabilities of "good fortune", so therefore you weren't supposed to readjust if you were strictly interpreting and applying intercst's study. Said another way, maybe that extra 200K is supposed to be there for that 10-year depression that is just around the corner.

 

[virginia]

This has been a really good discussion. I never really considered that you might lose so much money so close to ER, although it happened with plenty of people a couple of years ago.

 

[REWahoo]

This has been a really good discussion. I never really considered that you might lose so much money so close to ER, although it happened with plenty of people a couple of years ago.

Yes Virginia, you can run out of ER money. (Sorry, couldn't resist. )

There are many examples out there of those who failed financially very quickly in ER. An old friend of mine amassed a very nice nest egg and retired at the age of 51. It was 1999, and his financial advisor told him he was "set for life" and would never have to work again.

His ER lasted less than a year. The bottom fell out of the tech-heavy investments his financial advisor had set up for him and he lost 60% of his nest egg. After six years of full time work he says he still hasn't fully recovered. And even if he had, I think he's now so gun shy of retiring that he may work until he can draw full SS benefits.

 

[TromboneAl]

So... 4% sets your minimum withdrawal even in bad times, but you can adjust upwards following good years.

I understand the logic in this, but I'm with Azanon, if you're going to readjust when you have good times, you can through the originally calculated probability of success out the window.

 

[Nords]

I understand the logic in this, but I'm with Azanon, if you're going to readjust when you have good times, you can through the originally calculated probability of success out the window.

Two thoughts:
- If the new probability of success is higher than the old, then please open that window for me.
- Bernstein points out in his "Retirement Calculator from Hell" series that anything over an 80% probability of success is meaningless.

So now we're gonna have to find a way to spend that extra money? Geez, we already have enough "green waste" around here!

 

[azanon]

Two thoughts:
- If the new probability of success is higher than the old, then please open that window for me.

You meant lower right? If you adjust up, or take a 200K bonus, your chance of success over the remaining 25 years or whatever is lower now since the original probability of success estimation included the possibily of having strong years those first few years. You know, maybe in hindsight, "our" 30 year period (or whatever) is going to be composed of 7-8 killer years in a row at first, then a net loss for the remainin 22 years!

Also, since the market gravitates towards an average return over-time, it stands to reason, all other things being equal, the market is more likely to go down the next year if its gone up disportionately the previous years. Again, the way that whole 4% thing works is so that you capitalizes on the good years and reinvest the returns for bad years that are likely to follow.

Imagine if one readjusted using dory's suggestion right up to year 2000, ....... then just got slammed big time. I'd rather have a steady 4% + inflation payout, than have to adjust for losing half my portfolio in 2000 because i "readjusted" every year preceeding that.

 

[dory36]

Is that the way the study was designed to work?  I thought the method and chances for failure included all the probabilities of "good fortune", so therefore you weren't supposed to readjust if you were strictly interpreting and applying intercst's study.    Said another way, maybe that extra 200K is supposed to be there for that 10-year depression that is just around the corner.

I understand the logic in this, but I'm with Azanon, if you're going to readjust when you have good times, you can through the originally calculated probability of success out the window.

Nope. Here's another way of looking at it, boiled down to a simple case:

Say a buddy retired at the end of 2004 with $1.2 mil. We would all agree that the 4% rule says he can take $48k/year.

If you retired in 2000 with $1 mil and it grew to $1.2 mil in 2004 as of the same time that your buddy retired, then you are both starting 2005 with $1.2 mil, so your withdrawals can be the same. The fact that you had some prior history doesn't somehow taint your returns for the same investments that pay 4% of $1.2 mil for your buddy.

Intercst calls this the "Pay Out Reset Method" or something like that, and published spreadsheets with that model as well.

 

[brewer12345]

Imagine if one readjusted using dory's suggestion right up to year 2000, .......   then just got slammed big time.    I'd rather have a steady 4% + inflation payout, than have to adjust for losing half my portfolio in 2000 because i "readjusted" every year preceeding that.

You think so?  I don't think that someone with a diversified, annually rebalanced portfolio taking 4% withdrawals is down much at all.  IIRC, there was a poster on the TMF boards that indicated that she retired around the peak and was down maybe 10%.  That's after a market bubble bursting and taking withdrawals.  The last few years have been much less stressful on portfolios than, say, the 5 to 10 years after 1966.

 

[azanon]

You think so?  I don't think that someone with a diversified, annually rebalanced portfolio taking 4% withdrawals is down much at all.  IIRC, there was a poster on the TMF boards that indicated that she retired around the peak and was down maybe 10%.  That's after a market bubble bursting and taking withdrawals.  The last few years have been much less stressful on portfolios than, say, the 5 to 10 years after 1966.

That comment wasnt for the JG's and others who like to loan other people their money so that the person you're loaning your money to makes the real $$$.    Of course you guys are safe from a year 2000, and also safe from any outstanding returns too.

I was talking to the Peter Lynches and others who realize the superiority of stocks.  Glad we got that cleared up!

Azanon

(edit)

The last few years have been much less stressful on portfolios than, say, the 5 to 10 years after 1966.

Since i was 0-5 years old then, i'll just take your word on that, chief.

 

[brewer12345]

Az, just look at the historical record: 1966 was about the worst time to ER since real returns were low/negative for years and inflation was historcially high.

And keep your 'tude to yourself.

 

[azanon]

Step outside the box brewer. If my 'tude makes just one person take a closer look at stocks, do a little research, becomes educated, and as a result have an end portfolio of 2 million instead of 1 million, was it worth it? I think so.

.....

2000 was extremely harsh for someone fully invested in the stock market. Realize i have first-hand experience of this truth. But dont go feeling sorry for me, because of course ive been in the market for a while now, and like anyone that has, i'm not exactly hurting.

I could not care less about year-to-year, or even more-so day-to day volatility (like you posted about earlier today) with a 20 year+ investment horizon.

 

[TomSimpsonAZ]

Does anyone plan to use up their nest egg?

Like....I have 1 million....I'll make a % on it, but I'm going to spend 100k a year and eventually end up at zero, right as I croke.

Just wondering because I'd like to hear the reasons for not using it, pass on inheritance, living longer than expected, etc etc.

 

[SteveR]

Does anyone plan to use up their nest egg?

Like....I have 1 million....I'll make a % on it, but I'm going to spend 100k a year and eventually end up at zero, right as I croke.

Just wondering because I'd like to hear the reasons for not using it, pass on inheritance, living longer than expected, etc etc.

My spreadsheet says I will croak with a nice chunk of change to pass on to whoever outlives me. My SWR will be higher in the early years but lower in the later years. This still makes my "final" numbers much larger than the current stash.

My spending the first 8 years will be 35% higher than in year 9 and 50% higher than in year 15. This is due to planned expenses in these early years without SS income. I plan on spending very close to current income levels for a few years and then cut back. My spending will still allow a nice inheritance to my family. If I live longer, I will have that much more I can either spend or give away. In fact, one reason I want a higher early income is to spend down one of my IRAs so the RMDs will be lower when I hit 70.5 years of age. It is my plan on lower taxes later in life; both income and estate.

 

[wstu32]

thanks dory

 

[MasterBlaster]

If you retired in 2000 with $1 mil and it grew to $1.2 mil in 2004 as of the same time that your buddy retired, then you are both starting 2005 with $1.2 mil, so your withdrawals can be the same. The fact that you had some prior history doesn't somehow taint your returns for the same investments that pay 4% of $1.2 mil for your buddy.

Intercst calls this the "Pay Out Reset Method" or something like that, and published spreadsheets with that model as well.

The twin paradox ?

Does the reverse of that work too ? You retire with $1 mil taking $40k/year out. Several years later it is worth $700k due to down markets. But your buddy retires now with $700k and will take out only $28k. Could your buddy then look at past peaks and take out the same $40k/year as you.

 

[dory36]

The twin paradox ?

Does the reverse of that work too ? You retire with $1 mil taking $40k/year out. Several years later it is worth $700k due to down markets. But your buddy retires now with $700k and will take out only $28k. Could your buddy then look at past peaks and take out the same $40k/year as you.

Yes, other than the fact that the later retiree will have to assume a shorter withdrawal period, to match the earlier retiree's remaining years.

Again, step back and look at the reasoning.

If Bob has $300k in long term treasuries and $400k in the S&P 500 index, and Joe has exactly the same thing at the same time, and both do exactly the same things with these funds, then there is no way that their future results can differ. It doesn't matter that one of them used to have a lot more money, and the other is perhaps starting from a lump sum payout of a retirement plan -- the future results have to be the same for them.

This seems even more counter-intuitive than the original example, but I see, after looking at the historical numbers, the reason this seemingly anomalous situation works is that historically, we haven't had extended bear markets that exceeded 5 years, and very few that exceeded even 2 years. So the fact that the first guy was unlucky enough to retire into a serious long term bear market means that it is behind him -- and if so, then it is behind the other guy as well -- he just didn't have to deal with it.

Since 1871, we have only had two 5-year periods when each year-end stock market value was lower than the previous year-end, and that was back in the pre-depression days. (This is adjusted for inflation -- there was only one such period when I ignore inflation). There were only three periods with consecutive 4 year downturns, and only five 3 year downturns.

Had this not been the case, then we would be talking about the 2% rule, or maybe the 1% rule I suspect.

So... the best time to retire is after a bunch of crappy years. If history is any guide, it will only get better.


dory36

(Can you see people watching the market, waiting to retire, saying "Oh crap - another good year -- now I have to postpone my retirement again!")

PS - if you want to look at numbers, see the original source data for Irrational Exuberance and for a good part of what Firecalc and the REHP spreadsheets use, at http://www.econ.yale.edu/~shiller/data/ie_data.htm. I used the start-of-year figures for the above.

 

[REWahoo]

(Can you see people watching the market, waiting to retire, saying "Oh crap - another good year -- now I have to postpone my retirement again!")

Maybe you need to change FIREcalc to start with the question "Were market returns positive or negative in the year before you retire?". If the answer is "positive", post an appropriate warning that they are taking on unnecessary risk and should consider delaying retirement until the market goes south.

 

[wstu32]

quick question:

inflation is gauged on cpi ?? why use ppi?
i understand it is more conservative, but using cpi data seems pretty safe?

any thoughts?

 

[dory36]

quick question:

inflation is gauged on cpi ??  why use ppi?
i understand it is more conservative, but using cpi data seems pretty safe?

any thoughts?

No good reason -- both were available, so I offered both.

Our own individual inflation rates will vary anyway -- those with interest rate exposure (adjustable rate mortgages etc) will see one inflation rate, those paying medical bills out of theor own pockets (shudder!) will see another. So I just wanted to give a couple of options.

 

[F M All]

OK I'm confused. The OP asked for an explanation of the 4% withdrawal rate. What I read here is two interpretations of the rule:-

1) each year take 4% of the portfolio. As the portfolio fluctuates spending is adjusted accordingly. Portfolio will survive a bad run but retiree will switch from eating caviar to catfood.

2) each year take an amount equal to 4% of the original portfolio, adjusted for inflation. Spending stays at the same "real" level. Portfolio could get wiped out in a bad run. Retiree may need to move to Oregon.

ESRBOB appears to offer a version of 1) that says spending will never be less than 95% of previous year.

What is the rule?

 

[wstu32]

i see. thank you...
can you explain the 2.5 in the tips area and how, why , when , what to adjust it too?

 

[dory36]

OK I'm confused. The OP asked for an explanation of the 4% withdrawal rate. What I read here is two interpretations of the rule:-

1) each year take 4% of the portfolio. As the portfolio fluctuates spending is adjusted accordingly. Portfolio will survive a bad run but retiree will switch from eating caviar to catfood.

2) each year take an amount equal to 4% of the original portfolio, adjusted for inflation. Spending stays at the same "real" level. Portfolio could get wiped out in a bad run. Retiree may need to move to Oregon.

ESRBOB appears to offer a version of 1) that says spending will never be less than 95% of previous year.

What is the rule?

The 4% rule we talk about here is based on the starting balance of your portfolio, with inflation adjustments as you go.

So presumably, when you take that risky step to pull the paycheck plug based on being able to live on 4% of the portfolio at that moment, your spending ability will stay the same from then on.

So in year 7, instead of $40,000 from a $1 mil portfolio, you are perhaps taking $45,000 because inflation has make you increase your withdrawals. According to the 4% rule, it doesn't matter what your portfolio is at that point -- your withdrawals are always 4%, with inflation adjustments, of the starting portfolio.


So your #2 explanation is the correct description of the rule -- except for the portfolio to be wiped out, the future would have to be worse than we've ever seen, including the Great Depression. (Well, we could have a great future and you can put all your money into lousy investments. "The 4% rule" is shorthand for the approximate results of investing with something like a 75/25 split between S&P total market and bonds -- see the Firecalc calculator or similar calculators in Excel at the REHP to try different mixes. )

I don't think many people slavishly follow this rule after they retire -- that's not what it is for. It is a test of the feasability of retiring with a given portfolio and an expected level of expenses. We will all react to the conditions we encounter as we go, and the more flexible your budget, the better you will be able to do so. Perhaps you are debt free and have low fixed costs and can follow your #1 description with caviar, or you have a heavy mortgage, 3 cars on loan from the bank, college loans, etc., and have to fight off the cat.