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Explain the 4% withdrawal rate
Old 01-16-2006, 08:12 PM   #1
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Explain the 4% withdrawal rate

I have a question for the board.

Why do most retirement counselors suggest that you have enough money so that you can withdraw 4% per year during retirement?

If you RE, let's say at 50 - wouldn't you be able to, for example, live off the interest alone of $1 million (possibly 50-100k per year), and use all of the left over interest to add back to your retirement money?

I'm trying to figure out how much I need to invest to retire early, and can't really understand why I would possibly need more than $1 million to have a comfortable lifestyle - and not only comfortable, but have plenty left over to be reinvested. I can understand that as you get older, you would want to move the money into safer investments that might only return around 5%, but still don't see how the principal would ever be touched.

Which really leads me to the BIG question - is anything near $1 million even necessary? Now - I'm not talking about bare bones retirement. I want to have during retirement, what I make now - about 50K - which would really be a raise, since I wouldn't have a mortgage.* I still want to take vacations and have some of the extras that I have now. 500K is a realistic number for me to achieve in the next 10-15 years, but $1 million is going to take about 20, and I'll be 54 by then. I want to be at least free to make the decision to semi-retire by 50.* I wouldn't really call it retirement though - I just want to start working on the other things that I want to do - not necessarily the things that get me paid a good salary.

Also - I'm in the military, so in 10 years I'll have a nice retirement.

I'm just really afraid that I'm oversaving right now.* I save about 30% of my after tax salary - but I make a good salary - I could save more.* Before this past year, my salary was ok, but I was saving at least the same percentage of a lot less money - so when I was promoted, I decided to let the purse strings loose and live a little more.*

Thanks for your comments in advance.

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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 08:20 PM   #2
 
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Re: Explain the 4% withdrawal rate

The biggest answer to your question is INFLATION.

You have a pension, so you may not need $1 Million. - But even if you have a Million you should withdraw about 4% or $25K [$40K] per year. Inflation will make the Million smaller and market downturns could eat into it. Everyone should re-access the withdrawal rate yearly, so that it makes sense.

I have maintained aiming for 4%, But backing off after a down year in investments and maybe increasing after an up year in the markets.
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 08:25 PM   #3
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Re: Explain the 4% withdrawal rate

A couple of questions for you:
Do you understand the effects of inflation?
What interest rate would you expect to get? *You wrote 5%.
Did you know that the safest investments in the last few years did not even pay 5% interest? *And if you subtract the inflation rate, then you would not even come close to a "real" 5% a year.


The more you save now, the earlier you can probably retire.

Oh, the 4% per year safe withdrawal rate is from studies published in learned magazines. *It accounts for the historical investment return on a well-diversified portfolio after the ravages of historical inflation.
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 08:27 PM   #4
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Re: Explain the 4% withdrawal rate

Yep...inflation will kill ya. You need enough to live off of 4% and invest it in a manner that provides an offset to inflation.

I ran a handful of scenario calculations this morning for the first time in a long time. We're 44 now. Presuming a 45 year lifespan, the lifestyle we live on now will cost 5x that much when we're 90, inflation adjusted. The i-orp calculator also pointed out that we'll probably spend something in the ten and a half million dollar range between now and when my plan expires at 90 years old.

A stunning number...
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 08:41 PM   #5
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Re: Explain the 4% withdrawal rate

As you've heard, the 4% rule is based in part on staying ahead of inflation.

Quote:
Originally Posted by virginia
Why do most retirement counselors suggest that you have enough money so that you can withdraw 4% per year during retirement?

If you RE, let's say at 50 - wouldn't you be able to, for example, live off the interest alone of $1 million (possibly 50-100k per year), and use all of the left over interest to add back to your retirement money?
The key question here is can you live off the interest for the rest of your life (30-40+ years) as inflation eats away at the buying power of your interest over time? Not to mention the impact of painfully low interest rates the past few years for those attempting to live off interest returns.

If you are in the military and will have as you say, a "nice retirement" (I'm assuming you mean you will have a pension), then I would say you may not need more than a million or so to have what you describe as a "comfortable lifestyle". But if you spend any time at all on this forum you will learn one person's "comfortable lifestyle" is another persons idea of deprivation and poverty.

Take a look at FIREcalc (http://www.fireseeker.com/), run some numbers there and be sure you feel OK with the results.


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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 08:52 PM   #6
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Re: Explain the 4% withdrawal rate

Well - I THINK I understand inflation. My reasoning was this -
- I start with $1 million.
- The first year in retirement, my money earns 5-10% (keep in mind, I will still have my money invested mostly in stocks, since I will still be young - I'm not sure if that's a good idea or not, but that's my assumption here). So, let's say it earns 10%. I take my cut - 5%, inflation takes it's cut 3%, and there's still 2% left over for reinvestment, right? If my money only earns 5%, then I take the 5%, or a little less, say 3%, and my money gets eaten by 1-2%
I guess I was figuring mostly that there's no way that my money would earn less than 5-10% during those earlier years of retirement, although it would be possible. At any rate, it seems like the years should balance out between 50 and 65 the number of years that inflation would eat my money with the number of years that my return would eat the inflation.
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 09:08 PM   #7
 
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Re: Explain the 4% withdrawal rate

Virginia,

You also have to understand, that there are periods of investing such as the 1966-1982 period that stocks had no return at all. And Inflation was raging at 10%+ - Can you imagine what taking just 4% coupled with 10% inflation would do to a portfolio?
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 09:11 PM   #8
 
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Re: Explain the 4% withdrawal rate

Quote:
Originally Posted by ()
Yep...inflation will kill ya. You need enough to live off of 4% and invest it in a manner that provides an offset to inflation.

I ran a handful of scenario calculations this morning for the first time in a long time. We're 44 now. Presuming a 45 year lifespan, the lifestyle we live on now will cost 5x that much when we're 90, inflation adjusted. The i-orp calculator also pointed out that we'll probably spend something in the ten and a half million dollar range between now and when my plan expires at 90 years old.

A stunning number...

And just think, spending all that money at age 90 won't be any fun! - Instead of New Corvette, you be getting a new bedpan!
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 09:20 PM   #9
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Re: Explain the 4% withdrawal rate

Quote:
And just think, spending all that money at age 90 won't be any fun! - Instead of New Corvette, you be getting a new bedpan!
Maybe, maybe not. My FIL who is now 93, bought a new Boxster for his 90th b'day. I'm told he is enjoying it. I think what keeps him spry is a strong desire to get the max out of a military pension plus a Maryland state pension. He can't die; he is making too much money just by staying alive.

Ha
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 09:22 PM   #10
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Re: Explain the 4% withdrawal rate

Quote:
Originally Posted by Cut-Throat
And just think, spending all that money at age 90 won't be any fun! - Instead of New Corvette, you be getting a new bedpan!
I was going to make a comment about "buring rubber" and "leaving skidmarks", but maybe not...
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 09:25 PM   #11
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Re: Explain the 4% withdrawal rate

Quote:
Originally Posted by HaHa
Maybe, maybe not. My FIL who is now 93, bought a new Boxster for his 90th b'day. I'm told he is enjoying it.
Until he gets in sight of a fruit stand or a farmers market. Then all bets are off...
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 09:36 PM   #12
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Re: Explain the 4% withdrawal rate

In addition to inflation, the 4% rule attempts to take into account "worst case" scenarios so that you have a high (but not 100%) probability of meeting your long term income requirements.

You mention that you will be heavily invested in stocks at the start of retirement and assume that they will go up about 10%. *That maybe true on the average but it may also go down 10% or 20% or even 30% that first year and a couple of years of subpar performance can deplete your portfolio to the point where you can't recover. *

For example if you happened to retire at the start of the depression or at the start of the 70s stagflation era your returns will be much worse than if you retired say at the start of the bull market in '82.

Do some FIREcalc runs and you will find that for a 4% WR for most historical starting points you end up with a significantly larger portfolio than when you start but there are a few of those "worst case" years where you run out of money. *Of couse as the % goes up the probability of failure goes up. *

I think that 4% is a good rule of thumb based on the work that has been done because it gives you a probability of success that most people would find acceptable but you should maintain some flexibility just in case you happen to retire into a severe bear market.

MB
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 10:10 PM   #13
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Re: Explain the 4% withdrawal rate

You wanna understand inflation.* I remember when gasoline was .25/per gallon.* Just what do you think gasoline will cost in 20/30 years?* Or whatever replaces gasoline?* You are planning to live that long, right?* So by acknowledging that the price of gasoline today is lower (inflation adjusted) to that quarter per gallon I paid so long ago, inflation is sharply illustrated.* 4% withdrawal seems reasonable, but might not be completely successful.* Be vigilant and adjust as required.*
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 10:12 PM   #14
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Re: Explain the 4% withdrawal rate

Another way to understand inflation. Look at your heating bill for 2004. Look at it for 2005.

To add to mb's post. Suppose you start with $1 million when you retire and the market has a bad couple of years like 2000-2002. Now your $1 million is worth $600,000. What would you do?

So much for the earning 10% or 5% a year. You have just lost 40% of your retirement stash in 2 years. What would you do? What did you do between 2000 and 2002?
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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 10:30 PM   #15
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Re: Explain the 4% withdrawal rate

To clarify, the 4% rule states you'll take 4% of your initial portfolio, and next year take 4% of the initial portfolio adjusted for inflation, and the next year 4% adjusted again etc. etc.

If you have a military pension and no mortgage, you could go a different route:

Say you need 50k to live the life you imagined, and your pension will pay you 25k and adjust for inflation (we'll leave the CPI=inflation debate out of this for now).

So now you look at what you absolutely need to live, no frills, just survival. If you can keep that number around 25k, then you could simply choose to take whatever your portfolio returns you that year minus inflation and put that in your "fun" account. Once it's spent, you have to wait until next year! Now my hope is that in the fat years you won't spend it all so that you have leftovers in the lean years. You said 500k is a realistic goal? Here's a scenario:

2015, 9% return, 3% inflation, 6% real return, equals 30k in fun account
2016, 3% return, 4% inflation, -1% real return, equals none in fun account
2017, 7% return, 3% inflation, 4% real return minus 1% kick back for last year, equals 15k in fun account (adjusted to 2015 dollars, of course)

Or you could just take 4% of your starting portfolio balance every year and not worry about it, since historically you'll survive 99% of the time.

If 45k (pension plus 4% of your portfolio) is going to cut it close, why not work part time for a couple of years to let your portfolio grow? Get a civilian contractor gig and exert minimal effort since you aren't making a career of it anyway?

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Re: Explain the 4% withdrawal rate
Old 01-16-2006, 11:31 PM   #16
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Re: Explain the 4% withdrawal rate

Quote:
Originally Posted by REWahoo!
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Re: Explain the 4% withdrawal rate
Old 01-17-2006, 06:25 AM   #17
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Re: Explain the 4% withdrawal rate

I'm sure that's what I'd do - live off the pension and use the extra as fun money most of the time.
Thanks for your comments. I've been working for about 17 years, so during my working years, the market has had good returns, and I was thinking too much along what I've seen myself.
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Re: Explain the 4% withdrawal rate
Old 01-17-2006, 07:51 AM   #18
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Re: Explain the 4% withdrawal rate

Don't forget volatility. That factor can force your nest egg to dip dangerously low, perhaps too low to recover when you are taking fixed withdrawals, even absent any inflation.

Say you retired at $1 million after several great years in the market, and planned to take $60,000 a year. Well below your 15% returns for recent years. Seems safe.

If you were unlucky enough to retire at the end of a string of great years and just before several lousy years in a row, you might have had $500,000 by the end of year 3, take your $60,000, and then get zero return for the 4th year.

So for the next year, you are starting with 440,000, and taking $60,000. After just 5 years, you are down to nearly a third of your starting nest egg. Continuing to draw that 6% of the starting balance will obviously wipe you out.

This is where the 4% figure comes in. Historically, about 4% would have survived ~30 years even if a retirement began just as a downturn started. This is based on the longest and worst downturns we've had in our history.

If you retire into an UPturn, and your nest egg doubles in the first few years, then following the 4% rule for the next few decades will insure your descendants remember you fondly!

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Re: Explain the 4% withdrawal rate
Old 01-17-2006, 11:38 AM   #19
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Re: Explain the 4% withdrawal rate

Also, just keep in mind that some things will shoot up faster than the general inflation rate. For example, as others have said, just look at how much more some things like fuel are now. Here are a few examples of things I've had shoot up in price over the past few years...

Home heating oil: $1.74/gal last year, $2.54/gal this year (and it could go up, as I have a $3.19 cap)...46% increase
Property taxes: $2356 last year, ~$2550 this year...8.2% increase
Car insurance: $700 last year for primary car, $800 this year...14.3% increase
Health insurance: used to be $13 every 2 weeks, then went to $20 every two weeks for 2005. Still the same for 2006, but then the Co-pay went up this year, from $20 to $30. So each doctor's visit now costs 50% more than last year.

I'm sure there are other things too, that have gone up faster than the rate of inflation. Depending on where you live, real estate has really shot up, although that bubble may be bursting. But still, the same condo that I sold for $185K back in November 2004 would probably go for $220-230K today...a 19-24% increase.
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Re: Explain the 4% withdrawal rate
Old 01-17-2006, 01:40 PM   #20
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Re: Explain the 4% withdrawal rate

Quote:
Originally Posted by Andre1969
Also, just keep in mind that some things will shoot up faster than the general inflation rate.* For example, as others have said, just look at how much more some things like fuel are now.* Here are a few examples of things I've had shoot up in price over the past few years...

Home heating oil:* $1.74/gal last year, $2.54/gal this year (and it could go up, as I have a $3.19 cap)...46% increase
Property taxes:* $2356 last year, ~$2550 this year...8.2% increase
Car insurance: $700 last year for primary car, $800 this year...14.3% increase
Health insurance:* used to be $13 every 2 weeks, then went to $20 every two weeks for 2005.* Still the same for 2006, but then the Co-pay went up this year, from $20 to $30. So each doctor's visit now costs 50% more than last year.

I'm sure there are other things too, that have gone up faster than the rate of inflation.* Depending on where you live, real estate has really shot up, although that bubble may be bursting.* But still, the same condo that I sold for $185K back in November 2004 would probably go for $220-230K today...a 19-24% increase.*
Re. costs shooting up, I try to shop just about everything
recurring as much as possible, insurance especially.
Then if I need to cut more, I go even higher on deductibles,
etc. One thing I have found is that there is always
someone cheaper (not necessarily better). Property
taxes is a tough nut, but you can always sell and move.

JG
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