Return more than planned

[bobbee25]

So when using the calculators you use conservative numbers, 5% return - 3% inflation. Now in actual practice you get 6 or 7% return with 3% inflation. At what point can you say I am making more than expected and spend some of the extra, versus never as it is may be required to offset bad years ?

 

[MasterBlaster]

There have been lots of studies on safe withdrawal rates using historical data.

The conclusion from these studies is that you can take around 4% total from a stock-bond portfolio with very low risk of running out of money. That withdrawal amount is then increased with inflation every year. The percent varies somewhat depending on how long you expect to need the money.

So if when you retire 4 percent gives you X dollars a year to live on, if at some later time your stash has grown you can safely take 4 percent of the larger amount with very low risk.

 

[bosco]

here's a withdrawal scheme that is somewhat designed around this idea

http://www.gummy-stuff.org/sensible_withdrawals.htm

 

[MasterBlaster]

The variable withdrawal schemes such as the gummy-stuff scheme linked to by Bosco may allow you to withdraw more than the 4 SWR that a fixed rate scheme does.

The downside of such plans are that in a down market you have to cut back, perhaps significantly. Depending on your fixed expenses you may or may not be able to live on the (now lowered) allowed withdrawal in an extended bear market.

The Gummy plan tries to get around this using a hybrid scheme that has a fixed component that (hopefully) will cover a bear-bones budget and a variable component that goes up and down with the markets.

There are quite a number of these withdrawal-based plans. Keep in mind though that all the analysis is based on historical data so the more complicated plans may not really be acheivable into the future.

Also, if you can eliminate periods like the depression and the 70's oil-related malaize then the safe withdrawal rate could be significantly higher. Under this scenario you could withdraw 5-6 percent safely.

 

[justin]

I tentatively plan on taking something like a 2% fixed amount, adjusted by inflation every year plus a ~2.5-3.0% variable amount of the portfolio value each year. The first component should be stable year to year, while the second component lets me live it up in good years (or in periods of long term good performance) or tighten the belt in bad years.

Otherwise I think you have to base it on your circumstances as you go along.

 

[youbet]

I tentatively plan on taking something like a 2% fixed amount, adjusted by inflation every year plus a ~2.5-3.0% variable amount of the portfolio value each year. The first component should be stable year to year, while the second component lets me live it up in good years (or in periods of long term good performance) or tighten the belt in bad years.

Otherwise I think you have to base it on your circumstances as you go along.

Justin, how does this impact the size of portfolio you require to consider yourself FI and ready for RE? Does it make it more or less than using the 4% and inflation adjustment approach?

We stuck it out until we felt we could do the 4% thing (as long as returns stayed within the boundaries of documented historical returns as in FIRECALC) so we wouldn't have to cut back if we're unlucky and RE into poor times. We knew slashing travel, dining out, entertainment and other discretionary spending would be a bummer we'd hate if it lasted very long. And we weren't unhappy in our jobs. We worked a couple extra years and feel like we can now continue discretionary spending through an economy like the Great Depression or the high inflation/low return 70's.

When we were young, the idea of "tightening our belts" for a few years seemed satisfactory. When we finally RE'd in our late 50's, we realized that doing without discretionary spending for 5 - 10 years while a portfolio crashed and then recovered, might mean heading for the great beyond without ever doing the discretionary things at all.

Are you planning on at least some discretionary spending in your base 2%?

 

[justin]

Justin, how does this impact the size of portfolio you require to consider yourself FI and ready for RE? Does it make it more or less than using the 4% and inflation adjustment approach?

When we were young, the idea of "tightening our belts" for a few years seemed satisfactory. When we finally RE'd in our late 50's, we realized that doing without discretionary spending for 5 - 10 years while a portfolio crashed and then recovered, might mean heading for the great beyond without ever doing the discretionary things at all.

Are you planning on at least some discretionary spending in your base 2%?

The portfolio can be smaller with the fixed+variable method of withdrawal. Or you can withdraw a higher amount (if the portfolio does well) of a same sized portfolio.

I'm not really sure how things will play out for me. I'll probably end up padding the portfolio for a little longer in order to be able to live off of 4% with inflation adjustments. The thing I like about the fixed+variable withdrawal strategy is that it lets you take advantage of higher spending potential during the up years. Even during the down years, things won't get so bad. Under the 2% fixed plus 3% variable method, a 50% drop in portfolio value will still give you a 3.5% withdrawal rate.

The "problem" (if you want to call it that) I'm trying to address is what to do about huge portfolio balances 10, 20 or 30 years out if one spends a fixed amount and the portfolio balance continues to grow year after year. Let's say I retire with 1.5 million, and I'm happy with $60k/yr. Then 20 years later, the portfolio is now at 3 million (in real terms). Am I still going to spend $60k/yr? No! I'll spend more. What if my portfolio has dropped from 1.5 million down to 600k. Am I still going to spend $60k/yr? No! I'll spend less. That's why I think it makes sense to have some feedback function in the withdrawal rate so you can adjust spending based on actual results.

There's also an important distinction to make between safe withdrawal rates and actual withdrawal rates. I may be able to safely withdraw 2% fixed plus 3% variable, but I might only spend 4% total if there is simply nothing else I want to spend money on. The other 1% would stay in the porfolio and would increase my variable component of withdrawal in the future. I'm still far enough away from FIRE where I don't know if the fixed plus variable strategy will be more safety net, or a way to get out earlier.

 

[MasterBlaster]

Just for fun here is a somewhat complicated withdrawal rate model that allows initial withdrawal rates of 5.2–5.6 percent initial withdrawal rates.

This model (as claimed by the author) is sustainable at the 99 percent confidence standard for portfolios containing at least 65 percent equities.

http://www.fpanet.org/journal/articles/2006_Issues/jfp0306-art6.cfm

 

[MasterBlaster]

Here is yet another fun model for variable withdrawal rates in excess of 4%.

This model is interesting in that the author (Bernake) noticed that his clients spending generally declines in real terms with age. So this model front-loads the spending. You won't end up with a huge nestegg with this spending model.

http://www.fpanet.org/journal/articles/2005_Issues/jfp0605-art7.cfm

< from the FIRECALC discription... >

Ty Bernicke's Reality Retirement Planning: A New Paradigm for an Old Science describes extensive research showing that most people see significant reductions in spending with age (not related to reduced assets or income). If selected, this option will reduce your current dollar withdrawals from your nest egg (based on your initial Annual Spending setting, but not other adjustments) by 2-3% per year starting at age 56, and then stabilizing at age 76 to keep up with inflation. You should read his article for details if you plan to use this option.

 

[lazyday]

At what point can you say I am making more than expected and spend some of the extra, versus never as it is may be required to offset bad years ?

Here's a very conservative way to increase spending with a runaway portfolio:


First year of retirement, withdraw 3-4% of portfolio.

Each year afterwards, withdraw whichever of A or B is greater:
A: last year's actual withdrawal plus one year inflation
B: the minimum of (2%, stock dividend yield, TIPS real yield) times your current portfolio value


Just made that strategy up now, and it needs some improvements, but something along those lines might make sense for someone who likes the idea of increasing luxury over time, and with several decades to go.

 

[Sam]

So when using the calculators you use conservative numbers, 5% return - 3% inflation. Now in actual practice you get 6 or 7% return with 3% inflation. At what point can you say I am making more than expected and spend some of the extra, versus never as it is may be required to offset bad years ?

I'm in the minority as far as NOT believing the 4% SWR. I think that is way too conservative. At 4%, I will most likely die with an asset 10 times larger than the one I starts with. I love my kids dearly, but definitely not that much For me 5% initial withdraw rate is the minimum. I'm not trying to convince anyone to do the same at all. I fully understand how the 4% swr is arrived at (please don't try to explain to me again 8) )

I do recommend this: If you feel that 4% is too conservative, how about trying 5-6% of the previous year balance. Forget inflation, forget cost of living adjustment. Just simple 5-6% of the balance, each year and every year. The disadvantage of this approach is that the annual income varies quite a bit, but so is life, in my opinion.

 

[justin]

I do recommend this: If you feel that 4% is too conservative, how about trying 5-6% of the previous year balance. Forget inflation, forget cost of living adjustment. Just simple 5-6% of the balance, each year and every year. The disadvantage of this approach is that the annual income varies quite a bit, but so is life, in my opinion.

That's what I'd like to do with a hybrid 2% fixed + 3% variable. I might even be able to get 3.5% variable. Definitely doable, and the fixed percentage adds a lot of stability to the portfolio in down years to cover most of my basic needs.

 

[youbet]

I do recommend this: If you feel that 4% is too conservative, how about trying 5-6% of the previous year balance. Forget inflation, forget cost of living adjustment. Just simple 5-6% of the balance, each year and every year. The disadvantage of this approach is that the annual income varies quite a bit, but so is life, in my opinion.

No thanks. If we return to a period of dimishing portfolio values and high inflation such as the 70's, this method would result in diminishing purchasing power as you go along. That's way too conservative for us. If our portfolio drops in value and inflation is high, we still want to keep the purchasing power of our withdrawals constant and continue with discretionary spending. Our lives are going by and getting too old to enjoy things won't wait for an economy to recover.

If the 70's happens again, and it might, we won't be canceling travel, entertainment, dining out or other discretionary spending because we tested our plans using FIRECALC which includes challenging time periods.

My point is that in periods of diminishing portfolio value and high inflation, the 4% plus inflation of the original portfolio value plan is more liberal than your 5% - 6% of the previous years balance plan.

We paid a price for this and worked extra years, but hey, you pay your money and you takes your chance!

 

[unclemick]

Yep

5% of the 12/31 balance each year - varible and even if I get a 1974 type -18% portfolio drop ala Vanguard's portfolio analysis or get really wimpy/chickenhearted and take current yield for a year or so - still waaay more expensive than my el cheapo ways the first ten years of ER.

heh heh heh - gotta get used to nosebleed territory.

 

[Sam]

No thanks. If we return to a period of dimishing portfolio values and high inflation such as the 70's, this method would result in diminishing purchasing power as you go along. That's way too conservative for us. If our portfolio drops in value and inflation is high, we still want to keep the purchasing power of our withdrawals constant and continue with discretionary spending. Our lives are going by and getting too old to enjoy things won't wait for an economy to recover.

If the 70's happens again, and it might, we won't be canceling travel, entertainment, dining out or other discretionary spending because we tested our plans using FIRECALC which includes challenging time periods.

My point is that in periods of diminishing portfolio value and high inflation, the 4% plus inflation of the original portfolio value plan is more liberal than your 5% - 6% of the previous years balance plan.

We paid a price for this and worked extra years, but hey, you pay your money and you takes your chance!

No problem, youbet

You read my answer in the wrong context though. The OP, bobbe25, was not worried about "disminishing portfolio value and high inflation" period. In fact s/he worries about the "good times", when the actual return is higher than expected, the complete opposite of your thinking.

We paid a price for this and worked extra years, but hey, you pay your money and you takes your chance!

And yes, everyone works for their own money, and takes their own chance in life. :

 

[MasterBlaster]

I'm in the minority as far as NOT believing the 4% SWR. I think that is way too conservative. At 4%, I will most likely die with an asset 10 times larger than the one I starts with. I love my kids dearly, but definitely not that much For me 5% initial withdraw rate is the minimum. I'm not trying to convince anyone to do the same at all. I fully understand how the 4% swr is arrived at (please don't try to explain to me again 8) )

I do recommend this: If you feel that 4% is too conservative, how about trying 5-6% of the previous year balance. Forget inflation, forget cost of living adjustment. Just simple 5-6% of the balance, each year and every year. The disadvantage of this approach is that the annual income varies quite a bit, but so is life, in my opinion.

Sam:

You can probably get away with a 6% withdrawal rate. Keep in mind though, of the consequences of going broke. Even though you won't go broke, a 6% withdrwal rate may be too low to live on during high inflation periods.

Just so you know there was a famous study called the Trinity study that looked at how often someone who took 4,5,or 6 percent withdrawals from their stash went broke. This study used historical data from 1926-1995 and evaluated what the likely outcomes would be for a 30 year retirement. The results from the study showed that if you took:

4 % withdrawals you would never go broke.
If you took 5% withdrwals you'd go broke about 2 % of the time.
If you took 6% withdrawals you'd go broke about 5% of the time
If you took 7% withdrawals you'd go broke about 12% of the time

Now if you upped the withdrawals every year for inflation things got much worse.

If you took 4 % withdrawals with inflation increases you would go broke 2% of the time.
If you took 5% withdrwals with inflation increases you'd go broke about 17% of the time.
If you took 6% withdrawals with inflation increases you'd go broke about 32% of the time
If you took 7% withdrawals with inflation increases you'd go broke about 51% of the time

There are lots of similar studies. In my opinion there may be better ways to extract your stash but these studies have a great message in them and should not be ignored.

 

[Sam]

MasterBlaster, I'm well aware of those numbers. But thanks anyway.

 

[justin]

It's all a tradeoff. I might have two options:

1. FIRE today, have some sort of higher than 4%, partially or wholly variable withdrawal rate, and I will have a 25% chance of having to belt-tighten for up to 2 years of my portfolio plan period and a 10% chance of having to belt tighten for 5 years of my portfolio plan. With this plan, I also get to enjoy higher spending in the good years.

2. FIRE in 3 years after padding the portfolio to allow a 4% SWR with annual inflation adjustments. This plan is 99% certain (according to FIRECALC) to have a positive portfolio balance during the duration of my plan and belt tightening will never be required unless I fall in that unlucky 1%.

The numbers will obviously be different from what I'm hypothesizing, but the point remains the same - work longer to ensure a more secure, stable retirement or work less and increase your risk of having a suboptimal retirement. Here's how I view the balancing of the two options. With the first choice, I will get out of the rat race 3 years earlier. I'll be enjoying every day of that 3 year period. Sure, there's a 1 in 4 chance I'll be pinching pennies, cancelling cable, eating at McD's instead of Chili's, and going camping instead of that mediterranean cruise on vacation for 2 years. And a 1 in 10 chance of this penny pinching lasting 5 years. During periods of penny pinching, I'll still be able to enjoy life, just at a cheaper pace. But think about the good years! Maybe I can go on a nicer vacation (or longer vacation) with option 1 when the portfolio balloons upwards. Get a new car. Who knows? I guess I'm a risk-taker.

How do you SWR = 4%+ inflation only folks plan on taking advantage of swelling portfolio balances, if at all? Not that there is anything wrong with this approach, just overly conservative for me.

 

[donheff]

Well, someone with a strong stomach can take as much as they want out of good times and "start fresh" the next year. Lets use $1M as an example with 3% inflation as the expectation. The basic plan is to be able to pull 4% ($40K) inflation adjusted (i.e. a 4% SWR). In year 1 you get a bonanza - 12% returns = $120,000. Leave $30K in the pot to adjust the $1M for inflation and spend $90K (or spend $60K and put $30K into your mad money pot for bad years ahead). Start year 2 fresh with a $1,030,000 portfolio and plan for the magic 4% SWR. If you get another banner year repeat the whole process. Do this until you get a bad year (i.e. can't grow your egg 3% and have at least $40Kadjusted to spend). At this point you get to test whether the 4% SWR really works when you start retirement on a down year Theoretically, you are just starting retirement with your newly calculated portfolio so pull $40K (adjusted up for inflation over whatever years you have been partying) and follow the traditional SWR approach. At worst, you will have gotten a few fun years and some mad money in before you have to bite the bullet. If the market turns up and you quickly get back in the black you can do the above again. Eventually, you will get to test out a real bear market so you need a strong stomach. Of course, a few good years might give you a nice pile of mad money to blow in bad years. Keep the mad money in CDs or bonds so it doesn't get trashed by the bear.

 

[Cut-Throat]

I'm in the minority as far as NOT believing the 4% SWR. I think that is way too conservative. At 4%, I will most likely die with an asset 10 times larger than the one I starts with. I love my kids dearly, but definitely not that much For me 5% initial withdraw rate is the minimum. I'm not trying to convince anyone to do the same at all. I fully understand how the 4% swr is arrived at (please don't try to explain to me again 8) )

I do recommend this: If you feel that 4% is too conservative, how about trying 5-6% of the previous year balance. Forget inflation, forget cost of living adjustment. Just simple 5-6% of the balance, each year and every year. The disadvantage of this approach is that the annual income varies quite a bit, but so is life, in my opinion.

Sam, I agree with you on this. Most would end up with a lot of money on the table.

Last month Master Blaster explained how delaying Social Security to age 70 allowed you to increase your SWR significantly during your late 50's and 60's (when you'd really like to spend it) - With a 80% + Increase in S.S. coming at age 70 it allows you to spend a lot of your portfoilo, with the knowledge that the bigger S.S. check is coming for your later years. This is probably a lot safer than taking a SWR of 4% and S.S. at age 62. - If you have that option, I'd look into it. For me it's a slam dunk to delay to age 70! - Oh and we're not talking peanuts here either. I think for myself it worked out to around $350,000 extra to be spent from age 62-70 and be in the same retirement postion as talking S.S. at age 62.

By the time I hit 80, I am pretty sure that spending money will not be as fun as it is now! So this was a true Epiphany to me!

 

[Dawg52]

Sam, I agree with you on this. Most would end up with a lot of money on the table.

Last month Master Blaster explained how delaying Social Security to age 70 allowed you to increase your SWR significantly during your late 50's and 60's (when you'd really like to spend it) - With a 80% + Increase in S.S. coming at age 70 it allows you to spend a lot of your portfoilo, with the knowledge that the bigger S.S. check is coming for your later years. This is probably a lot safer than taking a SWR of 4% and S.S. at age 62. - If you have that option, I'd look into it. For me it's a slam dunk to delay to age 70! - Oh and we're not talking peanuts here either. I think for myself it worked out to around $350,000 extra to be spent from age 62-70 and be in the same retirement postion as talking S.S. at age 62.

By the time I hit 80, I am pretty sure that spending money will not be as fun as it is now!

I'm warming up to the idea. Retiring in a few months at age 52. I will have to see how well my portfolio holds up between now and 62. If it is in decent shape, I may delay my SS as well.

 

[2B]

I've been trying to figure out how to meld Bernicke with Guyton. Guyton lets you start at about 6% but then adjust withdrawls based on inflation and portfolio performance. This reduces the "residual portfolio" but runs the risk of cutting real spending to less than half of the initial withdrawl if the market tanks for a few year. Bernicke assumes a tail off in spending as one ages so "natural" spending declines anyway.

I don't won't to die with $12MM but I don't want to enjoy a Medicaid nursing facility either.

 

[youbet]

How do you SWR = 4%+ inflation only folks plan on taking advantage of swelling portfolio balances, if at all? Not that there is anything wrong with this approach, just overly conservative for me.

I built enough discretionary spending into my budget and 4% plus inflation SWR plans that I'll be having fun regardless of market conditions. If, after several years, things are really looking very, very good, I'll figure out then how to handle the situation. And happily!

For now, I do my own testing by assuming I retired just before a down few years in the market, say in 2000, and draw my conclusions from that. Or better yet, run FIRECALC and plug 1966 as your first year of retirement. Then check the graph that shows terminal portfolio values. Yep...... in a couple of years you go negative. In others you have a ton of money. Lot's of variability. We all want to avoid going negative but somehow harvest the possible generously favorable outcomes. But it's hard to have your cake and eat it too.

Everyone has their own priorities. We felt we wanted to be able to have our plans and dreams manifest even if the markets go against us early on. If we're lucky and the markets are good to us in the first few years, why that's a problem I'll be more than happy to work on!!

The variable schemes seem too conservative for me. Given the first years of retirement being hit with significant portfolio losses and staggering inflation, we still want to do what we planned. Tightening our belts to 50% or less of our planned WR would suck.

 

[samclem]

If the 70's happens again, and it might, we won't be canceling travel, entertainment, dining out or other discretionary spending because we tested our plans using FIRECALC which includes challenging time periods.

My point is that in periods of diminishing portfolio value and high inflation, the 4% plus inflation of the original portfolio value plan is more liberal than your 5% - 6% of the previous years balance plan.

We paid a price for this and worked extra years, but hey, you pay your money and you takes your chance!

youbet,
I understand and appreciate why you've taken this position, and I'm NOT trying to argue against it. Still, it wouldn't work for DW and me. I've imagined how I'd feel if inflatonhit double digits again and if the stock market dropped 25% plus. The newspapers full of stories on the has-been US economy. Other countries beating us in the economic arena. US currency devaluing. Given al this, I know I would not continue wioth the same spending rate and take comfort in the fact that, if history is a guide, the markets would rebound in time to save us. If we DID take that trip to Europe as doom gripped the economy and our portolio plummeted, we wouldn't enjoy it much ("Hey, 10 Euros for a crepe? Forget it! I'll need that to buy 10 cans of beans in two more years."). Our pension covers the essentals, and our withdrawals from savings will be 4% of year-end totals. Even at that, I suspect we'll tighten our belts if things go south fro more than a year or two. It's all about marginal utility--the first $5k per year in discretonary spending buys a lot more fun per buck than the $25-$30k increment.
Again, I understand your reasoning, but it wouldn't work for us.

 

[Sam]

Well, someone with a strong stomach can take as much as they want out of good times and "start fresh" the next year. Lets use $1M as an example with 3% inflation as the expectation. The basic plan is to be able to pull 4% ($40K) inflation adjusted (i.e. a 4% SWR). In year 1 you get a bonanza - 12% returns = $120,000. Leave $30K in the pot to adjust the $1M for inflation and spend $90K (or spend $60K and put $30K into your mad money pot for bad years ahead). Start year 2 fresh with a $1,030,000 portfolio and plan for the magic 4% SWR.

Donheff, I agree with this foolproof plan. Excellent job explaning it.

However, I don't think the "someone with a strong stomach" clause is necessary. If your plan is followed, there is no risk introduced into the equation at all.

Sam, I agree with you on this. Most would end up with a lot of money on the table.

Last month Master Blaster explained how delaying Social Security to age 70 allowed you to increase your SWR significantly during your late 50's and 60's (when you'd really like to spend it) - With a 80% + Increase in S.S. coming at age 70 it allows you to spend a lot of your portfoilo, with the knowledge that the bigger S.S. check is coming for your later years. This is probably a lot safer than taking a SWR of 4% and S.S. at age 62. - If you have that option, I'd look into it. For me it's a slam dunk to delay to age 70! - Oh and we're not talking peanuts here either. I think for myself it worked out to around $350,000 extra to be spent from age 62-70 and be in the same retirement postion as talking S.S. at age 62.

By the time I hit 80, I am pretty sure that spending money will not be as fun as it is now! So this was a true Epiphany to me!

Thanks CT. You are a lot more optimistic about longevity than me. I plan to withdraw SS as soon as possible. I did some calculation, and came to the conclusion that it's not beneficial for me to delay SS. I have absolutely no plan to live beyond 85 On top of that, I believe I would need a lot lot less once I reach 75. Not pessimistic, just realistic, in my opinion.