Explain the 4% withdrawal rate

[free4now]

One thing that I don't see mentioned often is that the SWR studies don't apply if your investments underperform the market.  They assume that you will earn returns just as good as the stock market, and if you don't, your SWR is lowered by approximately the amount that you underperform.

Most people (just like most mutual funds) do underperform the market.  There are many reasons, but the most common reason is paying loads, costs, fees and other overhead.    If you pay 1% extra per year in fees or costs, your SWR drops from 4% to 3%.  If you pay 2% extra your SWR drops from 4% to 2%.

Another way that many people end up underperforming the market is by making emotional decisions, like pulling out of the market during a dip.  In order for the SWR to apply to you personally, you have to know yourself well enough to be sure that you could stick to your investment plans even when the going to rough.  There's no judgement here... many people sleep better pulling out of the stock market when it dips and those people should not count on the SWRs from these studies.   Making such emotional decisions that seem rational at the time can easily knock out a large percentage of your capital at the moment when you need it most, lowering your SWR significantly.

 

[dory36]

fireme is correct.

From the "How it works" section in Firecalc:

Important: The model is only valid to the extent that your stock portfolio tracks the overall stock market, such as with Vanguard's Total Market Index.

 

[wstu32]

i am not clear again...what if you put 20% stocks in firecalc... doesnt that mean only 20% has to track the market

or are we back to the 4% rule

 

[dory36]

i am not clear again...what if you put 20% stocks in firecalc... doesnt that mean only 20% has to track the market

or are we back to the 4% rule 

Yes, only 20% needs to track the market in that case.

Your results may not be 4% in that case though. Using the default settings in Firecalc but changing the stock allocation to 20% gets a safe rate of only 2.73%, versus 4.19% when it's 75% stocks.

"4% rule" is just a shortcut for saying "assuming 30-35 years in restirement, stocks tracking the market and comprising 75% of your portfolio, under 0.2% expenses, etc etc etc, you can safely withdraw 4%." When you make changes to any of the assumptions, the safe rate changes as well.

 

[Sheryl]

This has been a great thread. I'm happy to see a lot of the things I've been thinking about being posted, without me having to type them.

Personally I feel a lot more comfortable with the option of taking 4% of the current portfolio at whatever it happens to be that year - essentially, as Dory said, "starting over" with a current plan each year. This is more intuitive and more interactive - the 4% of original + inflation adjustment seems too robotic and possibly counter to logic.

If I get to a year where the 4% of existing is not enough to live on, I know I have a problem and better find alternate income sources. If my investments do great my 4% will give me a more comfortable life, and if I don't need it all I may not spend it or may save it for a major purchase if things continue to go well.

As many on this forum have often said, you must use some common sense with the formulas!

 

[wstu32]

A great thread...thank you all!!

 

[brewer12345]

This has been a great thread.  I'm happy to see a lot of the things I've been thinking about being posted, without me having to type them.   

Personally I feel a lot more comfortable with the option of taking 4% of the current portfolio at whatever it happens to be that year -  essentially, as Dory said,  "starting over" with a current plan each year.   This is more intuitive and more interactive  - the 4% of original + inflation adjustment seems too robotic and possibly counter to logic.

If I get to a year where the 4% of existing is not enough to live on, I know I have a problem and better find alternate income sources.   If my investments do great my 4% will give me a more comfortable life, and if I don't need it all I may not spend it or may save it for a major purchase if things continue to go well.

As many on this forum have often said, you must use some common sense with the formulas!
 

I particularly like the approach ESRBob outlined, the 4%/95% method. Seems more appropriate to me for very early retirees who perhaps maintain a small side business or do a little paid work now and then.

 

[SteveR]

Thanks Dory,

Excellent thread. A lot of good discussion in this one and very helpful for those not sure about the whole 4% SWR thing.


At the end of the day, how much you take out is determined by:

1. Current market conditions--an up market allows a larger income while a down market should make you re-evaluate your situation to see if you need to cut back or stay the same. It all depends on your individual situation and where you are in your life.

2. The amount of other income sources you may have. FIRECalc uses ALL of your nest egg, which includes both pre and post tax accounts. It also takes into account pensions and other income streams from SS etc. If you have significant (relative to your income needs) sources of income other than retirement accounts then your nest egg can be smaller or you can take more of it each year than a person without these other sources.

3. The volitility of your personal expenses plays a major part too. If you can adjust your expenses down in a down market then your SWR can adjust up or down to reflect the market. A static and top heavy expense profile without addtional income streams will require the greatest amount of withdraw from your retirement accounts and will need to be monitored closely and rebalanced frequently to assure you don't run out before your life does.

4. Your investment mix play a huge part in SWR. The more fixed income you have the less you can take out over time since, on average, the return rate will be lower than if you were heavier into equities. However, an extended down market with a high equities holdings percent can hurt you; maybe even more since the loss could be much higher than the loss due to inflation with fixed income investments. You math wizards can figure this one out.

Not trying to be redundant; just thought it might be helpful to have a summary of the basics up to now.

 

[Sheryl]

Great summary Steve.

This thread has been a real help in my thinking through our personal situation -  Making the transition from "young dreamer" to ESR in the next year or so.

Number 3 on your summary is a big concern to me right now -  "volitility of personal expenses."  What happens when we need/want a new car, or that $20,000 trip to Antarctica?  Those things can't be part of an annual budget but have to be considered.    My current plan allows for setting $5,000 of each year's SWR into a capital replacement fund - which has to cover cars, roofs, etc.   Things like water heaters and dishwashers can fit into a "miscellaneous" catagory without blowing the budget.  I'm also budgeting $15,000 per year for travel - which some may find outrageous, but to me it's the REASON for ESR.

I doubt I will put that $5k or $15k into some special account. I'll just sort of note in the back of my mind that it wasn't withdrawn that year, and then when it comes to buying a $20k item, it's still going to feel like a big hit to the nest egg. 

I guess we just have to make the leap of faith and trust that the details will work out.

 

[brewer12345]

I guess we just have to make the leap of faith and trust that the details will work out.

I think that's the bottom line. We can sit around and play with firecalc and other tools all day, but ultimately you pays your money and you takes your chances.

 

[Sheryl]

I think that's the bottom line.  We can sit around and play with firecalc and other tools all day, but ultimately you pays your money and you takes your chances.

Yup! I went through a phase of obseesing playing with FIRECalc - couldn't stay away from it. Now I'm getting sort of bored with fiddling - I have dozens of scenarios, but all are between 85 and 100% success rate... I'm ready to "just do it."

Actually SO is going to "just do it" I am going to join the likes of TH and JG's spouses and keep working, maybe two more years. Mostly for the health insurance.

 

[unclemick]

Lucky me - launched into ER via lay off in 1993 and long before I ever heard of ER.

Handgrenades are (I believe) a no no for most civilians - so I putz along in ER and use FireCalc as a 'keep me in the ballpark' gut check. Like a flu shot it helps prevent periodic 'brilliant investment idea' attacks.

This be a good thread.

heh heh heh

 

[jerryo]

This has been a great thread.  I'm happy to see a lot of the things I've been thinking about being posted, without me having to type them.   

Personally I feel a lot more comfortable with the option of taking 4% of the current portfolio at whatever it happens to be that year -  essentially, as Dory said,  "starting over" with a current plan each year.   This is more intuitive and more interactive  - the 4% of original + inflation adjustment seems too robotic and possibly counter to logic.

If I get to a year where the 4% of existing is not enough to live on, I know I have a problem and better find alternate income sources.   If my investments do great my 4% will give me a more comfortable life, and if I don't need it all I may not spend it or may save it for a major purchase if things continue to go well.

As many on this forum have often said, you must use some common sense with the formulas!
 

I think that Sheryl has it exactly right....at least in terms of MY comfort level....

 

[dory36]

"Until one is committed, there is hesitancy, the chance to draw back-- Concerning all acts of initiative (and creation), there is one elementary truth that ignorance of which kills countless ideas and splendid plans: that the moment one definitely commits oneself, then Providence moves too. All sorts of things occur to help one that would never otherwise have occurred. A whole stream of events issues from the decision, raising in one's favor all manner of unforeseen incidents and meetings and material assistance, which no man could have dreamed would have come his way. Whatever you can do, or dream you can do, begin it. Boldness has genius, power, and magic in it. Begin it now."

Attributed (perhaps incorrectly) to Johann Wolfgang von Goethe​

 

[brewer12345]

"Find out what brand of whiskey he drinks and distribute it to the other generals."

- Abraham Lincoln, after being informed that Gen. US Grant was a drunk.

 

[cute fuzzy bunny]

I guess we just have to make the leap of faith and trust that the details will work out.

If you consider the range of details that you cant control in your working life (that can have wide ranging effects on your life) vs the ones in an ER life, I think you'll find that the latter can be a lot more comfortable...for example, my porfolio cant lay me off or fire me or go out of business, and I cant get a new manager who is an idiot and makes my life miserable...

Actually SO is going to "just do it" I am going to join the likes of TH and JG's spouses and keep working, maybe two more years. Mostly for the health insurance.

Thats a good transition. Consider what we do, where we get the health care (huge), then use pre-tax plans (her 403b) to severely reduce the taxable ordinary income, then fund Roths for both of us, then use the residual to pay the regular monthly bills, reducing our withdrawal rate. Then she cut her hours to the point where we're skimming along just atop the amount we need to fund all of that, which is almost half what she worked when she was single.

She was going to quit in 5-7-10 years, but now she says she'll probably always work for a day or two a week. With the qualifier that if any nationalization or statewide "all in" healthcare plan materializes where we can be covered for free or for low cost, she'll probably bail.

Methinks she enjoys the "vacation" from me and Gabe a few days a week

 

[Sheryl]

Thats a good transition.  Consider what we do, where we get the health care (huge), then use pre-tax plans (her 403b) to severely reduce the taxable ordinary income, then fund Roths for both of us, then use the residual to pay the regular monthly bills, reducing our withdrawal rate.  Then she cut her hours to the point where we're skimming along just atop the amount we need to fund all of that, which is almost half what she worked when she was single.

Sounds about right. As Goethe, or maybe Nike said, we need to Just Do It!

 

[Jane_Doe]

Dory,
Thanks for all your coherent explanations. This really is a subject that tho it has been previously discussed, needs to be thoroughly understood. Those of us not yet drawing down on our portfolios need to better understand the ins and outs. This is very helpful.

All of us have different situations, and I tend to be a WEE bit conservatiive. Think belt and suspenders! So, I am planning for more of a 20% stock/80% fixed portfolio, with more like a 3% SWR. I also figure I'm gonna live forever, and if I end up with money at the end more power to our kids! If you figure a high budget vs. low (bad year) budget, don't pull the "max" SWR all the time, have some sort of back up (SS, pension, real estate to sell, etc.), I think that is the prudent way to go. Again, I know I'm a chicken little, but I will sleep better with this plan (100% FireCalc survival). Before you pull the plug, have your bases covered, or as per ESR Bob's advise, be ready to work part-time if the going gets rough. Just my view - YMMV.

An aside to Sheryl, if you are just working for insurance, I assume you have looked into premiums and were unhappy with cost. We were fortunate to get individual policies for our family of 4 for Blue Cross/Blue Shield all basically healthy, DH is 52 and costs about $133/mo with $2500 deductable, mine is about $100/mo (I'm 44). Just hate to think of you sweating away working when you could be diving!!! [BTW your current avatar always makes me think it's Martha's - they look similar out of the corner of your eye!]

TTFN, Jane

 

[free4now]

An aside to Sheryl, if you are just working for insurance, I assume you have looked into premiums and were unhappy with cost.  We were fortunate to get individual policies for our family of 4 for  Blue Cross/Blue Shield all basically healthy, DH is 52 and costs about $133/mo with $2500 deductable, mine is about $100/mo (I'm 44). 

That sounds like a great deal if it offers decent coverage. How are the yearly max out of pocket, copays, and percent covered?

As I research health care it seems like the yearly max out of pocket is in some ways the most important attribute of plans but is rarely mentioned.

 

[virginia]

Oh my - I've been moving for the past few days and noticed about 4 more pages of responses. Dory lost me somewhere on page 3, I'm gonna have to go back and read everything.

 

[Sheryl]

Do go back and read, Virginia. This has been one of the best threads on this board, for those of us still puzzling through how to implement a withdrawal.

Jane, I KWYM about about the blue avatar - I thought the same thing - it's probably time for a change.

I'm not just working for the health insurance - I want to hord up another year or two of 401k contributions, "just to be safe," and it is going to take me a couple years to extricate myself from my current possition without burning bridges. I have projects I need to see through to completion, for my own sense of closure.

Plus - S.O. is going to ESR in July and he's very insecure about both of us quitting all at once. Whether he's going to ER or ESR isn't clear yet - He will be looking around to see what sort of project interests him, but won't NEED to work.

 

[rmark]

The early withdrawal studies generally centered on – constant 60/40 market weight portfolios, 25 year withdrawal periods, using U.S. market returns and volatility

Resulting in 4% of initial portfolio value + annual inflation withdrawals, no resetting

Lower starting withdrawals or overweighting of equities for longer withdrawal periods
------------------------------------------------------------------------------------------------------------
In short, you divide your money over your initial life expectancy while keeping a market weight portfolio, assuming the higher stock mix will offset lower returns due to volatility.

Using the above formulation, a 33 year withdrawal starts at 3%, a 20 year at 5%. Or you
overweight equities, praying (not planning) that irregular capital gains pay regular bills.

But two weaknesses arise – the small sample size used plus investor costs and actions
- Almost all other countries had lower returns, higher volatility, longer bad runs
- Ever more conservative retirees, investing costs, lower dollar weighted returns

This suggests that the offsetting growth needed for the ‘automatic’ inflation adjustment is rarely achieved in real life, leaving only the initial life expectancy equivalent withdrawal rate – you’re likely just dividing your money over your remaining life expectancy.

(taking “Triumph of the Optimists” as a proxy for market data, the 1926 – 2000 U.S. period commonly used is only 5% of the years in their sample, or 6.7% of 15 countries)

Dividing your money yearly over your remaining life expectancy, in essence assuming 0% real returns, results in some interesting features – after tax fixed pensions can be discounted using life expectancy, advancing life expectancy stretches portfolio, annual division resets withdrawal amount, allocation can be set using withdrawals and portfolio cash flow, can crudely adjust pension for joint & survivor option, works with a wider range of allocations, and the ever increasing withdrawal rate may adjust for inflation if you are invested to do so, otherwise you are spending your portfolio down.

Divide after tax fixed pensions and mixed portfolios annually over IRS life expectancy.

Calculate withdrawals annually, spending the lesser of the new divisions or the previous yearly + inflation. Average together to reduce annual spending change. Portfolio unused for draws used as retirees savings. Maintain insurance to protect against personal losses.

More complicated withdrawal rules are likely spurious patterns due to small sample size.

Replacement = net income – mortgage – investing + replaced benefits
Stock, reit expected real return = (1/pe) – cost
Bond, bill expected real return = yield – inflation – cost
SS draw = [(payment – med b) – tax] x (age/life)
Fixed pension withdrawal = (payment – tax) x (age/life)
J & S pension = expected payment x (single/joint life)
Tax deferred fund withdrawal = balance/life/12 - tax
Taxable fund withdrawal = balance/life/12
Bond percentage = (draws – cash) x 12/bond %
Estimated savings = (total draws – replacement) x 12 x life
IRS publication 590 standard withdrawal life expectancies

(SS after Medicare b deduction treated as a fixed pension due to rising healthcare costs)

Cooley, Hubbard, Walz “Sustainable withdrawals from your retirement portfolio” paper
1999 reprise of their 1998 paper, with short synopsis of other work.
Dichev “What were stock investors actual historical returns?” paper
Dimson, Marsh, Staunton “Irrational optimism” paper
Dimson, Marsh, Staunton “Triumph of the optimists” book
Ervin “Shortfall risk, asset allocation, and over funding a retirement account” paper
Frazzini “Dumb money: mutual fund flows and the cross-section of stock returns” paper
Hebeler “The simplest retirement plan for retirees” (analyzenow.com)
Jorion “Long term risks of global stock markets” paper
Jorion, Goetzmann “Global stock markets of the 20th century” paper