Smart guys question 4% SWR strategy

[Rich_by_the_Bay]

This article is way over my head, but it intrigues me. Sharpe offers alternatives which use, in part, laddered TIPs plus total market. I got this from the diehard board where it's the third message on this page.

The abstract:

The 4% rule is the advice most often given to retirees for managing spending and investing. This rule and its variants finance a constant, non-volatile spending plan using a risky, volatile investment strategy. As a result, retirees accumulate unspent surpluses when markets outperform and face spending shortfalls when markets underperform. The previous work on this subject has focused on the probability of short falls and optimal portfolio mixes. We will focus on the rule’s inefficiencies—the price paid for funding its unspent surpluses and the overpayments made to purchase its spending policy. We show that a typical rule allocates 10%-20% of a retiree’s initial wealth to surpluses and an additional 2%-4% to overpayments. 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.

You thoughts?

[REWahoo]

Quote:

Originally Posted by Rich_in_Tampa You thoughts?

I'll get back to you in about 20 years with some first-hand evidence.

[Martha]

I tend to think that few people follow the 4% rule religiously. Most would not be able to stomach taking the full amount in a substantially down year. Even this year I am more conservative in spending because of volatility. And maybe a good year is when you incur that large expense, like a new vehicle or large home repairs.

[haha]

Did you notice that this involves annuities? Have look at the recent annuity thread for help in seeing how this will be a definite non-starter on this board.

And TIPS ladders? Isn't harping on TIPS ladders what got Rob Bennet subjected to nasty personal attacks and ultimately banned?

For the first year that I posted on here I wrote long pieces explaining why I thought that the 4% rule underestimated risk, given volatile portfolios.

Most responses were "So what? or just automatic incantations of the 4% catechism. Or yeah, but I will cut back if that happens. Or praise of 100% equity portfolios, often from fully COLA'd government retirees. To question FireCalc as an absolute test for one's hoped for retirement success was often met by "You think things could get worse than the Great Depression?" A non-sequiter if there ever was one.

The difficulty is in decoupling attitudes toward financial plans from recent emotional experience. The last big market break was during the time that most on this board were still working, and also it was limited to tech, dot-com and large S&P companies. Many "old economy " stocks were quite cheap, as were foreign stocks.

So the thesis wasn’t tested, not was our resolve as self-funded retirees.

IMO, if flaws are present in the heavy allocation to equities for retirement funding, we will mostly discover them when it is too late to react.

This article does show a way to increase spending, still keeping funding more conservative. But it would not work as well using today's TIPS rates, or for a very young retiree, let alone a young family.

Anyhow, we are here for Happy Talk and Entertainment. This type of article is a downer.

Ha

[d]

seems the deficiencies noted with the 4% rule have all been discussed on this board, but it's not clear to me from reading the paper exactly what is being suggested as the alternative. could someone clue me in?

[jIMOh]

I will post some excerpts

Quote:

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. For example, a retiree with a $1MM portfolio should confidently spend a cost of living adjusted $40K a year for 30 years, independent of stock, bond, and inflation gyrations. Confidence in the plan is often expressed as the probability of its success, e.g., in nine of ten scenarios, our retiree will sustain his spending. Modifications to this basic example include changing the amount to withdraw, the length of the plan, the portfolio mix, the rebalancing frequency, or the confidence level. However, all these variations have a common theme—they attempt to finance a constant, non-volatile spending plan using a risky, volatile investment strategy. For simplicity, we refer to this entire class of retirement strategies as 4% rules, the sobriquet of its first and most popular example.

So far so good

Quote:

Supporting a constant spending plan using a volatile investment policy is fundamentally flawed. A retiree using a 4% rule faces spending shortfalls when risky investments underperform, may accumulate wasted surpluses when they outperform, and in any case, could likely purchase exactly the same spending distributions more cheaply.

Bold statement. Let's see what follows.

Quote:

First Larry Bierwirth (1994), and then William Bengen (1994) argued that since actual asset returns and inflation rates were historically quite volatile, retirement plans based on their averages were unrealistic. Bengen proposed an alternative strategy that retained the basic investment and spending strategies inherent in the mortgage calculation. In particular, he assumed that a retiree’s assets were invested in a mix of stocks and bonds and annually rebalanced to fixed percentages. Further, he assumed that in terms of real dollars, a retiree’s annual spending was constant and financed by a year-end, inflation adjusted withdrawal from the portfolio. Hence, choosing a stock-bond mix and a withdrawal rate—the ratio of annual, real spending to initial wealth—specified a retirement plan. Now, for a given horizon, some of these plans would have historically performed better than all the other possibilities. So, Bengen collected scenarios of past asset returns and inflation rates, simulated a number of plans under these scenarios, and identified the best performers.

that was history. some more history

Quote:

Cooley, Hubbard, and Walz (1998, 20, Table 3) reported a 95% historical success rate for a 30-year horizon, a 4% withdrawal rate, and 50%-50% mix of stocks and bonds. This success rate increased to 98% when the percentage of stocks was increased to 75%. This paper is often cited as the Trinity Study—all three authors are finance professors at Trinity University in San Antonio, Texas.

Quote:

Our market model is similar to those used by investment consultants for asset allocation and asset liability studies. A 2% risk-free real rate is broadly consistent with the historic record for U.S. Treasury STRIPS and TIPS investment returns. In addition, our market portfolio assumptions imply a Sharpe ratio of 1/3, a fairly typical choice. While the actual market values of bonds and stocks vary over time, on average, bonds contribute about 40% of the value of the market portfolio and stocks 60%. Thus, a strategy that invests 100% in the market portfolio can be thought of as a 60% equity strategy. An investor can guarantee a real dollar every year for thirty years by purchasing a series of zero-coupon, risk-free bonds. The cost of this investment is the sum of the discounted prices8 $1/(1.02) + $1/(1.02)2 + … + $1/(1.02)30, which amounts to a little less than $22.40. Alternatively, if a retiree invests in a risk-free bond portfolio, he can safely withdraw at a yearly rate that is a bit more than $1.00 / $22.40 » 4.46%. This withdrawal rate—the guaranteed rate—is the maximum withdrawal rate that can be guaranteed to never fail. This risk-free strategy is analogous to Eric’s strategy and is a special case of the 4% rule—the limit of zero investment volatility. This version of the 4% rule never has a surplus, never has a shortfall, and is the cheapest way to receive a constant, guaranteed payout every year. If a cheaper investment were to exist, then there would be an arbitrage opportunity.

Quote:

Conclusion The 4% rule and its variants finance a constant, non-volatile spending plan using a risky, volatile investment strategy. Two of the rule’s inefficiencies—the price paid for funding its unspent surpluses and the overpayments for its spending distribution—apply to all retirees, independent of their preferences. For a typical rule, we used a market model to estimate that between 10%-20% of a portfolio’s initial wealth is being allocated to surpluses, and an additional 2%-4% is going towards overpayments. If the spending distribution of the 4% rule is inconsistent with a retiree’s preferences, then the costs can be much higher. All in all, any retiree that adopts a 4% rule pays a high price. Our approach can be easily extended to investigate other retirement rules of thumb and to use alternative market models. If a retirement plan generates unspent surpluses then our approach can price the surplus. A scatter plot of spending amount versus cumulative market return will quickly reveal whether a strategy is least cost. Strategies with overpayments will generate a cloud of points (Figure 1), while least cost strategies will generate a non-decreasing curve (Figure 2). Many practical issues remain to be addressed before advisors can hope to create individualized retirement financial plans that maximize expected utility for investors with diverse circumstances, other sources of income, and preferences. While we still may be far away from such an ideal, there appears to be no doubt that a better approach can be found than that offered by combinations of desired constant real spending and risky investment. Despite its ubiquity, it is time to replace the 4% rule with approaches better grounded in fundamental economic analysis

I read the conclusion twice and still don't know what he's talking about.

[REWahoo]

Quote:

Originally Posted by haha Anyhow, we are here for Happy Talk and Entertainment. This type of article is a downer.

Maybe I'm reading more into your post than you intended, but I think I detect a hint of bitter sarcasm in your remarks.

[brewer12345]

Quote:

Originally Posted by REWahoo Maybe I'm reading more into your post than you intended, but I think I detect a hint of bitter sarcasm in your remarks.

Nah, that's just the scent of fried fish.

[FUEGO]

From reading the abstract, I think there might be something to the article. I'll read the entire thing and comment if I have anything to say.

I will say that most folks don't seem to plan on taking the 4% rule literally. "4% rule" being defined as 4% of initial portfolio balance plus CPI inflationary increases in the withdrawal each year. I'm still a good bit from RE, but it seems crazy to think I would take my same 4% if we saw a 30%+ correction in worldwide equity prices and things still looked bleak.

[haha]

Ok guys, touché. I'll cop to sarcasm, but pass on the bitter.

Martha has cautioned us against excessive sarcasm. That word excessive can be a real term of art.

Ha

[Notmuchlonger]

Whats the alternative? Save more, spend less, work longer? You will never get rid of risk.

[FinanceDude]

How bout we keep it simple: If your portfolio doesn't get a return of at least 4% above inflation and before taxes you can't take 4% that year......

[cute fuzzy bunny]

Quote:

Originally Posted by haha And TIPS ladders? Isn't harping on TIPS ladders what got Rob Bennet subjected to nasty personal attacks and ultimately banned?

Nope. I think it was 13 page schizophrenic monologues written into every thread whether they had anything to do with his monologue or not. He didnt even recommend TIPS at their current prices but was happy with the 4% versions he had bought.

His all fixed income strategy has forced him to sell his house and last I heard had him heading for divorce court. So it seems that his strategy wasnt so good.

I'm also pretty sure the other 12 boards that banned him and the one that went out of business due to his antics werent just similarly "poorly cultured".

For goodness sakes, two entire discussion groups (raddrs and diehards) were formed by people who couldnt stand him and formed those communities with him pre-banned, and an entire early retirement community web site was turned into a shrine to make fun of him (retireearlyhomepage).

BTW, I'm pretty sure that excessive sarcasm doesnt get you banned either. It looks to me like you have to be a jerk for six months to get that benefit awarded.

[retire@40]

Quote:

Originally Posted by FinanceDude How bout we keep it simple: If your portfolio doesn't get a return of at least 4% above inflation and before taxes you can't take 4% that year......

The general rule is that you can take 4% for that year. That's the whole point of the 4% rule. Over time, the 4% compensates for up and down markets, based on historical worst-of-time scenarios.

Also, the general rule is that taxes are included in the 4%.

[cute fuzzy bunny]

Back to the topic at hand...

Mechanically the 4% rule has worked for the last 100 years. My problems with it are many, but I think the 4% and portfolio of 25x your annual spending rules are decent rules of thumb.

I think someone who follows it religiously in both up and down years, spending more than they need or making unnecessary expenditures in down markets, may be carrying it to extremes.

Look at it from the other direction. Most balanced portfolios have long term average returns in the 8% range. Inflation runs about 3%. Taxes around 1%. 4% left over.

Things may not be so good in the future. Or they might be better. Or they might be just average. 3% might be pretty conservative. 6% might be a little liberal.

Who was it who says "agile, mobile, hostile"?

[Rich_by_the_Bay]

Quote:

Originally Posted by REWahoo Maybe I'm reading more into your post than you intended, but I think I detect a hint of bitter sarcasm in your remarks.

Who, Ha?

[REWahoo]

Quote:

Originally Posted by Rich_in_Tampa Who, Ha?

Hoo-hah right back at you, Doc.

[Rich_by_the_Bay]

Quote:

Originally Posted by REWahoo Hoo-hah right back at you, Doc.

Texan for "my shorts are a little tight."

[rogersteciak]

Quote:

Originally Posted by Notmuchlonger Whats the alternative? Save more, spend less, work longer? You will never get rid of risk.

I subscribe to the "three buckets" approach to retirement financing:

1. Bucket #1 (cash) -- Enough cash to pay the next year or two of living expenses. This lets you sleep well at night.
2. Bucket #2 (income) -- Dependable income sources such as pensions, social security, and high-quality bonds and dividend-paying stocks. You own these assets for the dependable income they provide so that it helps to restore the cash you need in bucket #1.
3. Bucket #3 (appreciation) -- A diversified portfolio of stocks and other investments that are expected to appreciate over the long term, but may be highly volatile over the short term of a few years. The 4% safe withdrawal rate applies to this bucket, so when there are a few lean years, the other two buckets pick up the slack.

When you do withdraw from bucket #3 (volatile appreciation assets), add the amounts to bucket #1 (cash) to restore its balance to a year or two of living expenses; otherwise, use the money to buy more assets in bucket #2 (dependable income assets).

[ERD50]

I didn't read the whole thing, just the excerpts provided above, but I interpret this to mean....

Quote:

Alternatively, if a retiree invests in a risk-free bond portfolio, he can safely withdraw at a yearly rate that is a bit more than $1.00 / $22.40 » 4.46%. This withdrawal rate—the guaranteed rate—is the maximum withdrawal rate that can be guaranteed to never fail. This risk-free strategy is analogous to Eric’s strategy and is a special case of the 4% rule—the limit of zero investment volatility. This version of the 4% rule never has a surplus, never has a shortfall, and is the cheapest way to receive a constant, guaranteed payout every year.

that at the end of 30 years of a 'guranteed' 4.46% SWR, you are also 'guaranteed' to have zero dollars left.

Is that correct? That is how I interpret 'never has a surplus'. If you assume a fixed % return (I don't know how he predicts future returns, or does he just buy 30 year bonds?), you can simply self-annuitize that over 30 years. Is that what the article is saying?

Fine approach - at the same time I can call and have my gravestone carved at today's wages with the year '2038' on it.

edit/add:

Quote:

A 2% risk-free real rate is broadly consistent with the historic record for U.S. Treasury STRIPS and TIPS investment returns

OK, I can go plug that into a SS, but 4.46% sounds right if you self-annuitize and assume a 2% real return.

-ERD50