Explain the 4% withdrawal rate

[SteveR]

Quote:

Originally Posted by TomSimpsonAZ Does anyone plan to use up their nest egg? Like....I have 1 million....I'll make a % on it, but I'm going to spend 100k a year and eventually end up at zero, right as I croke. Just wondering because I'd like to hear the reasons for not using it, pass on inheritance, living longer than expected, etc etc.

My spreadsheet says I will croak with a nice chunk of change to pass on to whoever outlives me. My SWR will be higher in the early years but lower in the later years. This still makes my "final" numbers much larger than the current stash.

My spending the first 8 years will be 35% higher than in year 9 and 50% higher than in year 15. This is due to planned expenses in these early years without SS income. I plan on spending very close to current income levels for a few years and then cut back. My spending will still allow a nice inheritance to my family. If I live longer, I will have that much more I can either spend or give away. In fact, one reason I want a higher early income is to spend down one of my IRAs so the RMDs will be lower when I hit 70.5 years of age. It is my plan on lower taxes later in life; both income and estate.

[wstu32]

thanks dory

[MasterBlaster]

Quote:

If you retired in 2000 with $1 mil and it grew to $1.2 mil in 2004 as of the same time that your buddy retired, then you are both starting 2005 with $1.2 mil, so your withdrawals can be the same. The fact that you had some prior history doesn't somehow taint your returns for the same investments that pay 4% of $1.2 mil for your buddy. Intercst calls this the "Pay Out Reset Method" or something like that, and published spreadsheets with that model as well.

The twin paradox ?

Does the reverse of that work too ? You retire with $1 mil taking $40k/year out. Several years later it is worth $700k due to down markets. But your buddy retires now with $700k and will take out only $28k. Could your buddy then look at past peaks and take out the same $40k/year as you.

[dory36]

Quote:

Originally Posted by MasterBlaster The twin paradox ? Does the reverse of that work too ? You retire with $1 mil taking $40k/year out. Several years later it is worth $700k due to down markets. But your buddy retires now with $700k and will take out only $28k. Could your buddy then look at past peaks and take out the same $40k/year as you.

Yes, other than the fact that the later retiree will have to assume a shorter withdrawal period, to match the earlier retiree's remaining years.

Again, step back and look at the reasoning.

If Bob has $300k in long term treasuries and $400k in the S&P 500 index, and Joe has exactly the same thing at the same time, and both do exactly the same things with these funds, then there is no way that their future results can differ. It doesn't matter that one of them used to have a lot more money, and the other is perhaps starting from a lump sum payout of a retirement plan -- the future results have to be the same for them.

This seems even more counter-intuitive than the original example, but I see, after looking at the historical numbers, the reason this seemingly anomalous situation works is that historically, we haven't had extended bear markets that exceeded 5 years, and very few that exceeded even 2 years. So the fact that the first guy was unlucky enough to retire into a serious long term bear market means that it is behind him -- and if so, then it is behind the other guy as well -- he just didn't have to deal with it.

Since 1871, we have only had two 5-year periods when each year-end stock market value was lower than the previous year-end, and that was back in the pre-depression days. (This is adjusted for inflation -- there was only one such period when I ignore inflation). There were only three periods with consecutive 4 year downturns, and only five 3 year downturns.

Had this not been the case, then we would be talking about the 2% rule, or maybe the 1% rule I suspect.

So... the best time to retire is after a bunch of crappy years. If history is any guide, it will only get better.


dory36

(Can you see people watching the market, waiting to retire, saying "Oh crap - another good year -- now I have to postpone my retirement again!")

PS - if you want to look at numbers, see the original source data for Irrational Exuberance and for a good part of what Firecalc and the REHP spreadsheets use, at http://www.econ.yale.edu/~shiller/data/ie_data.htm. I used the start-of-year figures for the above.

[REWahoo]

Quote:

Originally Posted by dory36 (Can you see people watching the market, waiting to retire, saying "Oh crap - another good year -- now I have to postpone my retirement again!")

Maybe you need to change FIREcalc to start with the question "Were market returns positive or negative in the year before you retire?". If the answer is "positive", post an appropriate warning that they are taking on unnecessary risk and should consider delaying retirement until the market goes south.

[wstu32]

quick question:

inflation is gauged on cpi ?? why use ppi?
i understand it is more conservative, but using cpi data seems pretty safe?

any thoughts?

[dory36]

Quote:

Originally Posted by wstu32 quick question: inflation is gauged on cpi ??* why use ppi? i understand it is more conservative, but using cpi data seems pretty safe? any thoughts?

No good reason -- both were available, so I offered both.

Our own individual inflation rates will vary anyway -- those with interest rate exposure (adjustable rate mortgages etc) will see one inflation rate, those paying medical bills out of theor own pockets (shudder!) will see another. So I just wanted to give a couple of options.

[F M All]

OK I'm confused. The OP asked for an explanation of the 4% withdrawal rate. What I read here is two interpretations of the rule:-

1) each year take 4% of the portfolio. As the portfolio fluctuates spending is adjusted accordingly. Portfolio will survive a bad run but retiree will switch from eating caviar to catfood.

2) each year take an amount equal to 4% of the original portfolio, adjusted for inflation. Spending stays at the same "real" level. Portfolio could get wiped out in a bad run. Retiree may need to move to Oregon.

ESRBOB appears to offer a version of 1) that says spending will never be less than 95% of previous year.

What is the rule?

[wstu32]

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

[dory36]

Quote:

Originally Posted by F M All OK I'm confused. The OP asked for an explanation of the 4% withdrawal rate. What I read here is two interpretations of the rule:- 1) each year take 4% of the portfolio. As the portfolio fluctuates spending is adjusted accordingly. Portfolio will survive a bad run but retiree will switch from eating caviar to catfood. 2) each year take an amount equal to 4% of the original portfolio, adjusted for inflation. Spending stays at the same "real" level. Portfolio could get wiped out in a bad run. Retiree may need to move to Oregon. ESRBOB appears to offer a version of 1) that says spending will never be less than 95% of previous year. What is the rule?

The 4% rule we talk about here is based on the starting balance of your portfolio, with inflation adjustments as you go.

So presumably, when you take that risky step to pull the paycheck plug based on being able to live on 4% of the portfolio at that moment, your spending ability will stay the same from then on.

So in year 7, instead of $40,000 from a $1 mil portfolio, you are perhaps taking $45,000 because inflation has make you increase your withdrawals. According to the 4% rule, it doesn't matter what your portfolio is at that point -- your withdrawals are always 4%, with inflation adjustments, of the starting portfolio.


So your #2 explanation is the correct description of the rule -- except for the portfolio to be wiped out, the future would have to be worse than we've ever seen, including the Great Depression. (Well, we could have a great future and you can put all your money into lousy investments. "The 4% rule" is shorthand for the approximate results of investing with something like a 75/25 split between S&P total market and bonds -- see the Firecalc calculator or similar calculators in Excel at the REHP to try different mixes. )

I don't think many people slavishly follow this rule after they retire -- that's not what it is for. It is a test of the feasability of retiring with a given portfolio and an expected level of expenses. We will all react to the conditions we encounter as we go, and the more flexible your budget, the better you will be able to do so. Perhaps you are debt free and have low fixed costs and can follow your #1 description with caviar, or you have a heavy mortgage, 3 cars on loan from the bank, college loans, etc., and have to fight off the cat.

[retire@40]

Quote:

Originally Posted by dory36 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]

Quote:

Originally Posted by retire@40 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]

Quote:

Originally Posted by dory36 ...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]

Quote:

Originally Posted by wstu32 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]

Quote:

Originally Posted by retire@40 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]

Quote:

Originally Posted by wstu32 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]

Quote:

Originally Posted by 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.*

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