Question on applying the 4%

[JimLy]

I see the 4% tossed around a lot and understand it's fundamentals, almost. Let's say you've got $1M 4% is $40k. Does that mean I'll take $40k (increased a bit by inflation) each year? Or does that mean I get 4% of what's left at the end of each year? Or something else?

Thanks,
Jim.

 

[Cut-Throat]

Yup, if you had a Million then

The 4% rule is that you take 40K each year adjusted for inflation.

 

[renferme]

if you have 1,000,000 dollars that earns 5.1% per year and inflation is 3% per year - you can withdraw $3331 per month for the 1st year, give yourself a 3% 'pay' increase each year, AND your money will last 478 months or 39 years 10 months.

 

[Mr._johngalt]

If I had a million dollars, living as I do, I wouldn't need
to know how much I could withdraw, nor what
FIRECALC projected as doable. My stubby no. 10 pencil
would be more than sufficient.

 

[Ian]

If I was getting 5.1% interest, I would be in heaven. Try 2.7%!!!

 

[JWR1945]

The 4% rule refers to 4% of the initial balance of a retirement portfolio to provide a minimum of 30 years of income. Withdrawals are increased each year to match inflation. (There are qualifiers. They are far from trivial.)

If you look at the current balance, the equivalent number is 5%. It is not guaranteed to keep up with inflation, but it is guaranteed to last. The income is almost always very close to that of the 4% plus inflation approach. The one exception is during times of stress. Withdrawing based upon your current balance forces you to cut back (mildly) if your portfolio is headed toward disaster.

You mentioned 2.7%, which sounds like TIPS. I wrote a detailed article about that on the SWR Research Group discussion board at www.nofeeboards.com . Here is part of the introduction. The title is 3% SWR for 56 Years.

Many people have been dismayed at stock returns since 2000 and what they mean in terms of retirement portfolios....We have been successful in restoring the safety at a 4% withdrawal rate....But what if someone remains unconvinced? Some people talk about reducing their withdrawals. Some people talk in terms of a 2% withdrawal rate.

That is entirely unnecessary. Even if you reject the idea of switching outright, you can still withdraw 3% of your initial balance (plus inflation) for 56 years in today's market. That sets a floor on safe withdrawal rates for most of us.

If you have long-term TIPS at 2.5% (yield to maturity, lasting almost thirty years), you do not have to dip very deeply into your capital (by selling some TIPS to boost income) to support withdrawals of 3% plus inflation. After that, the principal that remains will last another 26 years, even if you invest at zero percent (real) interest, just so long as it matches inflation.

2.7% TIPS are even better.

Have fun.

John R.

 

[unclemick]

2.7% is within hand grenade distance of our Vandgard lifestragety funds moderate and conservative plus some vanguard high yield corporate and REIT index - I haven't calculated the combined SEC yield but 2.7% is ballpark.

The advent of TIPS and I bonds helps capture the effects of inflation. I view the 2.7 as the bottom range - to paraphrase Frank Armstrong's "the rich live off dividends" and the 4% as defining as the safe upper bound based on historical bound. Oh and BTY we add the unspent portion of 4% up each year(area under the curve) each year as mental mad money to spend if some opportunity arises. Also my sense of humor requires that I DD at 84.3 - my IRS life expentancy back in 1993 when we ER'd - but thats only planning wise - living longer won't upset me.

 

[Ted]

A lot of you apparently don't appreciate the way that TIPs work and are not giving them sufficient credit.

At present, the "current yield" on long-term TIPs is about 2.4%. That means that the annual interest payments amount to 2.4% of the current market price of the bonds. The current market price is closely related to the par value, and the important thing to understand is that the par value gets "bumped up" at the end of each year in proportion to the actual inflation that occurred.

This "bump up" represents a return that is in addition to the interest payment for the year. (For tax purposes, it is reported separately but also subject to being taxed as ordinary income on the federal return but not on the state return.) Thus, if inflation for this year turns out to be, say, 1.6%, the total (annualized) return on long-term TIPs purchased now would be 2.4% + 1.6% = 4.0%.

If you go to FIRECalc, you find that a portfolio of 100%TIPs yielding 2.4% (with no expense charge) would have sustained a 4% withdrawal, inflation-adjusted, for 30 years in 100% of the trials.

While I think that most early retirees can do better than a 4% withdrawal by having some stocks, high yield bonds, etc., it is hard to beat the safety of TIPs, and the return that they will sustain is not all that bad. For an older retiree who wants complete safety, it would make sense to have 100% of their assets (other than some cash for immediate spending) in TIPs.

 

[unclemick]

Looks to me like you have defined a beautiful annuity - no management fees and any remaining principle goes to the heirs.

 

[Cut-Throat]

Ted,

If you go to FIRECalc, you find that a portfolio of 100%TIPs yielding 2.4% (with no expense charge) would have sustained a 4% withdrawal, inflation-adjusted, for 30 years in 100% of the trials.

Interesting - This may cause me to take a very conservative path down the road when my wife's retires.

I plugged in $1 Million into the starting portfolio. Took out $40 K annually. I also set it for CPI Inflation, no Expenses. I got 99.2% - Which is close enough for me. Just curious - How did you come with 100%

 

[JWR1945]

GDER

Interesting... Excuse my naivety as a non-firecalc user, but why wouldn't the max SWR for your 100% 2.4% TIPs portfolio (w/o expenses) be ~5.7% for 30 years. To deplete the principle to 0 over 30 years requires 1/30 per year or 3.333...% + the 2.4% yield + inflation rate.

The mathematics is identical to that of a mortgage, where you are the lender (and where you ignore inflation since your TIPS match inflation). As the loan gets paid off, you receive a greater and greater return of capital since the amount of the payment remains constant (in real dollars).

Specifically, you have to sell some TIPS along the way. Your principal decreases over the years.

For 2.4% and 30 years, the withdrawal rate to have an ending balance of exactly zero dollars is 4.714%.

In my example, you would have had enough principal left over to last another 26 years (continuing with 3% withdrawals but now at zero real interest). I have posted the mathematics along with the post that I referenced. It is probably better just to plug the numbers into FIRECalc.

Have fun.

John R.

 

[Ted]

Cut-Throat,

You're right -- I get 99.2% now too. Specifically, if a person had started their 4% withdrawal in 1894, the money would have run out in 1923, a year early. Perhaps I was using a return on TIPs equal to 2.5%, since that will give 100% success with FIRECalc.

JWR 1945,

You are close to being right but not quite. Somehow the effect of inflation prevents TIPs from acting just like a mortgage. According to FIRECalc, your calculated withdrawal rate of 4.714% would have lasted 30 years in only 41% of the 30 year periods. This illustrates your point that it is important to preserve the pricipal in the TIPs very carefully, because it will provide important compounding benefits in the future.

 

[Ted]

JWR 1945,

Another possibility is that you are right in your calculation and that FIRECalc has some minor glitch. Intuitively, it seems that you should be right -- that a given interest rate on TIPs should sustain a given withdrawal rate for a determinate number of years, regardless of inflation.

One exception to this is that the value of TIPs is not reduced if there are years of deflation. This would tend to work in favor of the investor and make their withdrawals last somewhat longer. FIRECalc is probably not programmed to account for this, but that would tend to make the FIRECalc results a bit too conservative, but the same would apply to your calculation that inherently assumes that TIPs could drop in par value if deflation occurred. Whatever the reason for the discrepancy, I don't think that it is too significant as a practical matter. As with all asset liquidation plans, the most important parameter that is highly uncertain is how long a person will live.

 

[JWR1945]

Ted

Another possibility is that you are right in your calculation and that FIRECalc has some minor glitch.

I think that there is a slight mismatch between when inflation occurs and when TIPS interest payments are made. If you look at the data, you will see that the number of years before the balance is depleted (i.e., falls below zero) varies.

It may be that FIRECalc is exactly right. It may be that FIRECalc is essentially right, but that the details of the actual interest payments are off by a very small amount.

My numbers are mathematical results that assume that the interest payments and inflation match up exactly.

Have fun.

John R.

 

[Dave Z]

Using the $1,000,000 of 100% 2.4% tips, and withdrawing 4% a year plus inflation %. Does someone still have my $1,000,000 at the end?

 

[JWR1945]

Dave Z: To end up with the entire $1.0 million (plus inflation), you would have to withdraw at the (real) interest rate, in this case 2.4%.

In my references in reply #5, I have written down the mathematical formulas. The first thing to do is to calculate the TESWR (the TIPS Equivalent Safe Withdrawal Rate) that would last for exactly 30 years. That works out to 4.714%. (In the real world, it doesn't quite work out that way because the timing coupon rate evidently does not match the timing of inflation exactly. But it is close.)

Next, you use this formula to calculate the fraction of your initial balance that is left over after 30 years. Letting WR = the withdrawal rate (in this case 4%) and r = the TIPS interest rate (in this case 2.4%), the formula is:
remaining fraction = ( [TESWR-WR] / [TESWR-r] ).
This works out to 30.855%.

At the end of 30 years, you still have $308 550 (in real dollars). If you reinvest that a zero percent real interest and continue to withdraw your original 4% of the initial balance (plus inflation), it would last you another 7.7 years. After that, your remaining balance would be zero.

I would hope that you could do better than zero percent real interest. Still, $1.0 million at 2.4% real interest (in long-term TIPS) can be expected provide you with $40 000 for 37+ years with no risk whatsoever.

There are lots of qualifiers. The biggie is taxes. And I don't recommend staying out of growth investments (such as stocks and real estate) entirely. But you sure can hold out for bargain prices for a long, long time.

Have fun.

John R.

 

[JWR1945]

This is a fine point, but it is worth knowing.

The treasury no longer sells long-term TIPS. The longest lasting maturity is ten years.

There are long-term TIPS available on the secondary market. Some come very close to lasting another 30 years. IIRC, some are available that mature as late as 2032.

That is why I have set the real interest rate equal to zero after 30 years.

This is bad news for those far from retirement. Still, they may become available once again in the future.

Have fun.

John R.