Explain the 4% withdrawal rate

[retire@40]

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

Did you mean 4% is the maximum withdrawal including bad times, but in good times it could be adjusted upward?

 

[dory36]

Did you mean 4% is the maximum withdrawal including bad times, but in good times it could be adjusted upward?

Sorry -- min and max can mean different things depending on how you look at it. Let me rephrase...

The whole idea of the safe rate is that you have reasonable assurance before you retire that you will have at least X to live on per year in bad years. X works out to about 4% of your starting portfolio, adjusted for inflation.

Does that help?

 

[retire@40]

...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.) 

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).

Or if you keep spending the same, adjusted for inflation, that extra $200K in the portfolio will increase the chances for success over the 30 or 40 years.

I would think when someone determines what the withdrawal amount is with which he would be happy and that withdrawal amount gives him a 90% or 95% success rate, it would be wise not to go above that withdrawal amount if it is not necessary, thereby increasing that 90% to 95% confidence level closer to 100%.  Only after arriving at the 100% level, it may make more sense to increase withdrawals, but only to the point that the success rate does not drop below 100%.  

 

[dory36]

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

When you buy TIPS you get some interest rate that is current inflation plus a little more. That "little more" was about 2.5% when Firecalc was first written.

At http://wwws.publicdebt.treas.gov/AI/OFNtebnd they show TIPS bringing 2.0% above inflation.

The number you would use would be the yield associated with the TIPS you own. If you don't own TIPS, or plan to, then ignore this.

 

[dory36]

Or if you keep spending the same, adjusted for inflation, that extra $200K in the portfolio will increase the chances for success over the 30 or 40 years.

I would think when someone determines what the withdrawal amount is with which he would be happy and that withdrawal amount gives him a 90% or 95% success rate, it would be wise not to go above that withdrawal amount if it is not necessary, thereby increasing that 90% to 95% confidence level closer to 100%.  Only after arriving at the 100% level, it may make more sense to increase withdrawals, but only to the point that the success rate does not drop below 100%.  

Yep.

 

[wstu32]

so when i use 30 yr treasury, i would put 0 (zero) in tips? or does it not matter?

 

[jerryo]

It means that 4% of your CURRENT portfolio is the AMOUNT of money (adjusted for inflation) that you could REASONABLY expect to be able to take for 30 years. 

BUT after a year you're in a new situation.  Something has happened (either your portfolio has gone up or down).  You could at that point recalculate 4% of your THEN CURRENT portfolio as the AMOUNT you could reasonably take.

And, I think Dory is right, most people do adjust what they take up or down (based on their portfolio performance).  That's the REASONABLE thing to do, if your budget is sufficiently flexible.  It also INCREASES the likelyhood you'll survive (by decreasing your expenditures in a down market).  And increases the likelyhood that you'll be able to live better than you expected (since most years your portfolio will grow more than 4% plus inflation).

   

 

[dory36]

so when i use 30 yr treasury, i would put 0 (zero) in tips?  or does it not matter?

I suggest you leave it at the default if you are using treasuries. The calculation for 1871-1924 30 year use that, as the notes explain.

TIPS are a funny thing, since they eliminate much of the inflation risk. But otherwise, I suggest trying several different fixed income options when running your tests, since these things are all fairly close, but specific offerings change from time to time.

 

[dory36]

It means that 4% of your CURRENT portfolio is the AMOUNT of money (adjusted for inflation) that you could REASONABLY expect to be able to take for 30 years. 

The calculators like Firecalc and Intercst's RE2002 spreadsheet look at the starting portfolio, not the current portfolio.

It is not that the starting portfolio is magic -- using the current portfolio is certainly easier and more practical in future years.

But these calculators are trying to answer a pre-retirement question, not a year-to-year spending question.

When you are trying to decide if you can retire, and you feel comfortable that you can live on $40,000 but would keep working rather than create a situation where you had to live on, say, $32,000 starting in 4-5 years, then all you really have to work with is the starting portfolio amount.

So Firecalc (etc) use the starting amount, and keep your spending constant by adjusting for inflation, to give you that retire/keep working decision info.

Hope this helps...

 

[wstu32]

can you explain 'starting' vs 'current' portfolio

 

[jerryo]

Sorry for the confusion in my use of language. I meant that you could take 4% of your STARTING portfolio (which is your CURRENT portfolio the year you retire). But each year you COULD (and probably should) recalculate your withdrawal as if your then current portfolio is your new STARTING portfolio....you're simply taking into account what actually happened to your portfolio during the preceding year.

 

[wstu32]

understand. Thank you for the explination. Next question: according to the 4% rule
if you take the $40k out on the $1million portfolio, and the next year your portfolio is $960k for example...
you then take out $38000 (4%) plus increase it by approx $1140 (3% inflation).
so you would take out $39,140 the next year ?

 

[dory36]

understand.  Thank you for the explination.     Next question:  according to the 4% rule
if you take the $40k out on the $1million portfolio, and the next year your portfolio is $960k for example...
you then take out $38000 (4%) plus increase it by approx $1140 (3% inflation).
so you would take out $39,140 the next year ?

Nope -- remember the goal is to keep your spending constant.

So you take $40,000 the first year -- 4% of $1 mil.

The second year you take out $40,000 (the same 4%, since you are dealing with the portfolio as of the moment you retired) plus another $1200 (assuming 3% inflation), for a total of $41,200. Presumably, $41,200 will buy in the second year what $40,000 bought in the first year, so your lifestyle doesn't suffer.

Obviously, you don't want to run out of money by taking too much. This is what Firecalc is calculating -- and the approx 4% you get from Firecalc is what would be safe for the duration you entered.

As jerryo mentioned, what you ACTUALLY do down the road will probably take into consideration what has happened in the market, in your life, and so forth. But for planning and feasability testing, we're talking about a percentage of the number as of when you retire.

 

[wstu32]

wow...
now what is the assumed rate of return on the $1 million?

 

[haha]

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

Dory, is your other name Dr. Pangloss? No wonder FireClac is popular -"Heads, I win, tails, I win." Gotta love it!

Ha

 

[dory36]

wow...
now what is the assumed rate of return on the $1 million?

Firecalc assumes nothing about the rate of return. What it does is to simulate what would have happened had you retired in 1871 with whatever split of stocks and bonds you specified etc., and assumes you withdraw some specific amount of dollars, adjusted for inflation, for 30 years (or however many years you specified.

Then it does the same thing for 1872, and again for 1873, and so forth, all the way to the most recent years for which we have data.

Every one of these simulated 30 year retirements that winds up with money left over is a successful year.  Every one that runs out of money before the end is a failure.

When Firecalc reports 96% success, it means that there were about 5 different simulated 30 year retirements that failed, and about 127 that succeeded.

Spending about 4% is where the results come in close to 100%, depending on your stock-bond split and other variables.

 

[dory36]

Dory, is your other name Dr. Pangloss? No wonder FireClac is popular -"Heads, I win, tails, I win." Gotta love it!

Ha

Usually I get yelled at because the safe rate isn't 10% or higher!

But a lot of folks confuse the whole safe rate stuff, thinking it is a spending plan. It isn't -- it's a safety plan, especially for the first few years.

If you dodge the bullet, then you didn't need the bullet-proof vest -- but you didn't know that before you walked into the firefight.

 

[retire@40]

wow...
now what is the assumed rate of return on the $1 million?

The general assumption of a 4% SWR is that you will earn at least 7% on your money. 3% goes to inflation.

 

[unclemick]

And then and then - we have the 1/2 panic as opposed to the whole panic.

In the minor dip of 2002 - I just spent the div./interest (hint - less than 4%) BUT ala Bogle I stayed the course portfolio wise.

Now - I have all this stupid money - dented slightly post Katrina - but still not getting any younger - need to get up to 4%.

? But what if the other shoe drops

heh heh heh heh heh heh heh

12 years into ER - it's still an inside job -emotional/mental.

Running FireCalc is a lot cheaper than a shrink - and it does make me feel better.

Still think div.'s/interest per the Norwegian widow are real money.

Better get back to my taxes.

 

[wstu32]

some VERY good info today..thank you all...
7% on your money is kind of high though!

 

[dory36]

some VERY good info today..thank you all...
7% on your money is kind of high though!

I recall a year or so before I retired that everyone was saying that if you couldn't get 15-20%, you were incompetent. (This was on the Motley Fool Early Retirement forum, before they started charging to let us spout off our own wisdom and read the incoherent ramblings of everyone else.)

The Vanguard S&P 500 Index Fund had gone from about $40 a share to about $140 a share in the previous 5 years, without a dip or plateau of any significance. I think that is something like 28% annual growth. And this was the boring index funds. Technology stocks and funds were where the real action was.

That was only about 6 years ago . . . and in the 2-3 years after that, the S&P fund shares lost almost half their value. Tech stock owners were back to work.

So no, 7% isn't that high. Historically and very long term I think it's been over 10% per year.

And using that 10% long term figure, you have about 4% for spending, 3% for inflation as retire@40 says, plus another about 3% buffer for down markets in the early years.

 

[dory36]

This thread reminds me of the little kid who asks his mom about sex, and gets the whole birds and bees story -- when all he wanted to know was what to put in that little spot in the id card that came with his new wallet. :

 

[wstu32]

10%...
what asset allocation is this assuming
how much in stocks?

 

[REWahoo]

(... on the Motley Fool Early Retirement forum, before they started charging to let us spout off our own wisdom and read the incoherent ramblings of everyone else.)

I know I speak for a lot of posters when I once again say "Thank You, Dory" for setting up this board so we could continue to spout off our own wisdom and read the incoherent ramblings of everyone else free of charge (donations sincerely appreciated).

 

[dory36]

10%...
what asset allocation is this assuming
how much in stocks?

Below is a chart (the red line) of the average 30 year returns for the S&P 500 from 1931 - 2002. Below that is an allocation chart, from http://www.retireearlyhomepage.com/restud1.html