The Four Percent Rule

[OverThinkMuch]

A better name is "the 4% guideline". If you look at $200,000 in retirement and expect to withdraw 20% / year, the 4% rule should warn you you're far off the mark. Or if you can live on 2% of assets, that you're probably safe. When you look too closely at the 4% guideline / rule, it's time to get out calculators and factor in your specific circumstances. And that's why I'd say a guideline - it considers nothing about your assets, account types or taxes.

For example, a proposal in Congress to end Roth Conversions cited some tricky people who put millions into Roth IRAs (insider stock options, which rocketed up in value). If you have millions in a Roth IRA, 4% withdrawals will cost you 0% in taxes. If you have a cost basis in a taxable account, you pay a reduced tax rate on the long-term gains. And if you have a Traditional IRA, you're paying ordinary income tax rates regardless of how long you had the assets. So even the tax rate varies by account type, which I think emphasizes the 4% "rule" as more of a guideline and starting point, before digging into specific circumstances.

[mpeirce]

Quote:

Originally Posted by HFWR Have only started the FIRE journey, thus only one withdrawal so far (4%). I plan to follow the method samclem mentioned, i.e. 4% of porfolio value, with no inflation adjustment..

This is our approach. We use a three year trailing average which smooths out big up or down years.

You have to be more comfortable with variation if you use this and have a budget that can accommodate it. We put most of any increase into our travel budget which will be easier to cut when the inevitable down years arrive.

[ERD50]

Quote:

Originally Posted by medved ... Regarding whether the 4% "rule" will give a 95% chance of not running out of money, who knows. The future might be better than the past, or worse. ...

Agreed, but just to put a finer point on that - it isn't so important whether the future is better/worse than the past for the 4/95 guideline to hold. What is important is whether the worst of the future is worse than the worst of the past.

For example, the average inflation adjusted returns of the future might be slightly better than the past, but if there are a few really bad cycles in there, it could wipe someone out.

Conversely, the average inflation adjusted returns of the future might be worse than the past, but if there is a tighter distribution, then maybe no cycles were worse than the past. There is a very wide spread in the final portfolio values you see on a 30 year FIRECalc run, some of those might be considered outliers?

Regardless, a 2% WR is very conservative, and even if things get really really bad, you will be better off than the vast majority of people. Now go and enjoy life!


-ERD50

[Which Roger]

Quote:

Originally Posted by DrRoy The calculations that Firecalc runs use actual historical returns for the probabilities that are the result. If future returns are lower than the ones in the calcualtion (which is what I believe), then the result will be too optimistic.

Unless the lower returns are accompanied by less volatility. What kills a portfolio is a bad sequence of returns during the first few years of retirement. With less volatility, there is less of a chance of this happening.

[audreyh1]

Quote:

Originally Posted by medved When people talk about being able to "safely" withdraw 4% of their invested assets each year (putting aside the many issues with this "rule" and the benefits of flexibility in post-retirement spending), they're talking about the 4% covering taxes as well as living expenses, right? And this includes capital gains taxes, correct? If so, isn't this "rule" somewhat useless because each person's tax basis in their investment assets will differ -- dramatically -- and so will the capital gains tax they need to pay when they're liquidating assets in retirement? How does capital gains tax play into the four percent rule? Is the answer simply that, as a rough general guideline, based on historical results, a retiree can safely withdraw 4% of her investment portfolio each year, and if she has substantial capital gains then she will just have to pay a bigger chunk of that 4% withdrawal to the government that someone who does not have capital gain? So each of these people - the one with big capital gains in the one with no capital gains - can still withdraw 4%, but one of these people will have a lot less than 4% to live on, while the other will have most or all of her 4% to live on?

You have to cover taxes out of that withdrawal. So as part of retirement planning, you need to estimate your taxes in retirement, and have enough of a nest egg to cover expected taxes as well as spending needs.

Fortunately, capital gains taxes are equal to or lower than ordinary income taxes, and there is even a chunk that is subject to 0% taxes if your total income is below around $75K.

And, capital gains are on the difference between sold and bought price, so you might be paying 0 to 15% on a much smaller amount that the total proceeds you receive when you sell. It depends on how much of the sales proceeds are the gain.

People withdrawing from IRAs pay ordinary income taxes on the withdrawal, so they might be worse off than someone paying capital gains taxes depending on the specific scenarios of course.

The rule is perfectly useful as it is independent of any person's tax scenario. You just have to do the work to figure out your tax situation.

Many people find their Federal income taxes drop significantly when they retire and are no longer earning wages.

[old woman]

Not everyone expects to live exactly 30 years. The rule is a guide line only over 30 years so if you retire at 45 and plan to live to 95 take less. I retired at 66 so might not live 30 years, I took 5% this year because I had expenses that aren't annual. I might take too much until social security at 70 then cut back to 2-3%. I might take 2% one year then 6% the next always thinking about 4% but not letting a rule take over my choices.

[NW-Bound]

My expenses during working years were never steady. I did not buy a new car and paid cash every year, or had a major home repair, etc... So, now in retirement, whatever withdrawal amount I choose, how am I going to stick to that every year?

Some people withdraw the planned amount each year, but put aside what they do not spend to build a surplus. I do not separate money into physical piles like that. What I do is to look back at past annual expenses, and see what the average looks, and how each year compares to that average.

If I spot an uptrend in my spending, then it is alarming and something must be done to curb it. If I can reassure myself that the high expenses in one year were one-time events such as daughter's wedding, major home repairs, vehicle purchase, etc..., then it is not so scary because they do not repeat. If different one-time events keep popping up, bringing up the average, then my lifestyle is more expensive than I thought and must be simplified.

So, it is the average over several years that matters.

[NW-Bound]

By the way, FIRECalc can also model the effect of SS coming online later. It will tell you that you can withdraw more than 4% until SS starts, at which point you will cut back the dollar amount that you withdraw. Of course it makes sense, but running FIRECalc gives you something a bit more concrete than just the idea that it is safe. It takes into account the size of the SS check relative to the size of your stash, and how many years before you get there.

Again, that number is still just a guideline, but a lot better than a wild guess.

[pb4uski]

Quote:

Originally Posted by HFWR Have only started the FIRE journey, thus only one withdrawal so far (4%). I plan to follow the method samclem mentioned, i.e. 4% of porfolio value, with no inflation adjustment. The equity portion of a portfolio is there to provide growth, and inflation protection. So that's my inflation adjustment. YMMV, plus it's not chiseled in stone, and can be changed...

I plan to use a rachet strategy. Let's say that I decide that 4% is a sustainable withdrawal rate. My withdrawal would be the greater of 4% of the current balance or last year's withdrawal plus inflation. So if the portfolio grows by more than inflation, I get a "real" raise... as if I retired anew using a 4% WR.... if the portfolio goes sideways or declines, then I get last year's withdrawal plus inflation which is still sustainable.

The reason I plan to do this is that I think the risk of withdrawing too little and ending up as a rich old man who denied myself more than necessary is much greater than the risk of running out of money.

This mindset allows us to feel free to splurge a bit when we are "ahead of the game" and enjoy our retirement while at the same time being sufficiently prudent to hopefully avoid running out of money.

It also avoids the problem associated with a constant percentage of the current balance of having to take a significant cut in withdrawals in the event of a downturn or dying rich if investment results are favorable.

[NW-Bound]

Quote:

Originally Posted by pb4uski I plan to use a rachet strategy...

I thought about that too. But my earned income stopped only 4 years ago. And I have not consciously tracked my expenses for much longer before that.

I do not want to "ratchet up" too soon, remembering the infamous quote by Irving Fisher right before the Depression crash: "The market has reached a permanently high plateau".

Steady, steady... Slow, slow...

[Danmar]

Quote:

Originally Posted by pb4uski The reason I plan to do this is that I think the risk of withdrawing too little and ending up as a rich old man who denied myself more than necessary is much greater than the risk of running out of money. This mindset allows us to feel free to splurge a bit when we are "ahead of the game" and enjoy our retirement while at the same time being sufficiently prudent to hopefully avoid running out of money.

I agree. But so far(10 years) I have just been spending dividends which currently represent a 3.7% yield. These divs have grown nicely (7-10% per year) and my portfolio continues to grow quite a bit as well. Total return For 2016 now about 20% . So I am now planning on liquidating small amounts of stock on a regular quarterly basis. Perhaps about .7% per year. This will increase my available total spend by about 10% per year. In the short term this extra cash will just accumulate in our savings account. Not sure what we will eventually spend it on but no shortage of possibilities.

[GTFan]

Quote:

Originally Posted by NW-Bound I thought about that too. But my earned income stopped only 4 years ago. And I have not consciously tracked my expenses for much longer before that. I do not want to "ratchet up" too soon, remembering the infamous quote by Irving Fisher right before the Depression crash: "The market has reached a permanently high plateau". Steady, steady... Slow, slow...

And not only that but also given your health insurance situation (and potentially those of many others here on the ACA), might be best to keep a larger than usual reserve and/or plan on more of your WDs going towards HC.

[audreyh1]

Quote:

Originally Posted by pb4uski It also avoids the problem associated with a constant percentage of the current balance of having to take a significant cut in withdrawals in the event of a downturn or dying rich if investment results are favorable.

I avoid the significant cut problem by allowing unspent funds to accumulate outside our portfolio. These are available to draw on in the event of a significant "pay cut" by our portfolio shrinking and thus our income (withdrawal) dropping.

Our spending hasn't kept up with our withdrawals, so this has been easy to do.

No inflation adjusting either. I leave that out of the equation. Either the portfolio keeps up with inflation or it doesn't. If it doesn't, we live with less income. In the very long run, the portfolio should keep up with inflation. In shorter and intermediate timeframes, it might lag inflation.

[REattempt]

Quote:

Originally Posted by medved When people talk about being able to "safely" withdraw 4% of their invested assets each year (putting aside the many issues with this "rule" and the benefits of flexibility in post-retirement spending), they're talking about the 4% covering taxes as well as living expenses, right? And this includes capital gains taxes, correct? If so, isn't this "rule" somewhat useless because each person's tax basis in their investment assets will differ -- dramatically -- and so will the capital gains tax they need to pay when they're liquidating assets in retirement? How does capital gains tax play into the four percent rule? Is the answer simply that, as a rough general guideline, based on historical results, a retiree can safely withdraw 4% of her investment portfolio each year, and if she has substantial capital gains then she will just have to pay a bigger chunk of that 4% withdrawal to the government that someone who does not have capital gain? So each of these people - the one with big capital gains in the one with no capital gains - can still withdraw 4%, but one of these people will have a lot less than 4% to live on, while the other will have most or all of her 4% to live on?

For a limited time, you can read the original here:

http://afcpe.org/assets/pdf/vol1014.pdf

[Sunset]

Quote:

Originally Posted by pb4uski I plan to use a rachet strategy. .....

Is there not a considerable risk as you are taking a portion of every extra increase of the portfolio above the inflation amount. Like poking a tiny leak in the retirement ship.

Whereas, I think the 4% concept is that when the portfolio goes up an extra amount, that extra is left alone to compensate for when it is flat or goes down. And the retiree takes out the standard amount plus inflation.

[pb4uski]

No... not at all. Let's use an example. For discussion purposes, let's agree that 4% is a prudent WR in the circumstances. (The principle of ratcheting is the same whether the WR is 4% or 3% or whatever).

Say I retire on Jan 1 with $1 million and a 4% WR so on Jan 2nd I have $960k and it grows to $1.1m by the end of the year (a 14.6% return for the year... a good year).

Under the 4% rule and 2.5% inflation my second year withdrawal would be $41k. Under ratcheting my withdrawal would be $44k, a 7% real increase in spending so I can splurge on some things.

If someone else with $1.1 million retires a year after I did, is their withdrawing $44k from their $1.1m portfolio in their first year of retirement more risky than me withdrawing $44k from my $1.1m portfolio in my second year of retirement? If you think so, please explain why.

[REWahoo]

Quote:

Originally Posted by pb4uski If someone else with $1.1 million retires a year after I did, is their withdrawing $44k from their $1.1m portfolio in their first year of retirement more risky than me withdrawing $44k from my $1.1m portfolio in my second year of retirement? If you think so, please explain why.

All things being equal, your $44k is less risky since you have one less year to live than does the new retiree.

[NW-Bound]

This dilemma has come up times and times again.

It seems like a paradox, because someone who retired at the peak of the market gets to withdraw much more than he could if he did at a market trough on the same portfolio.

Here are some actual numbers. On 10/9/2007, the S&P was at 1565. On 03/09/2009, the S&P was at 677! That's a huge drop of 57%.

Ignoring the bitty dividend, a $1M at the top of the market would become $430K later. So, if you retired at the bottom of the market, you could withdraw only 4% x $430K = $17K instead of $40K/yr.

So, how does one explain this paradox? It is actually quite simple.

If you look at all the squiggly lines that FIRECalc plots for any input parameter set, you will see that there's a wide range of outcome. Thirty (30) years from now, you may become a decamillionaire, or you may be totally broke.

If you take 4% at the top of the market, your portfolio may barely survive 30 years from now. But if you take 4% at the bottom of the market, you are most likely to die a lot richer than you are now. In either case, you've made it.

It's like a student passing a course with a grade A or a grade C. If you keep ratcheting your withdrawal when the portfolio goes up, you are increasing the chance that you will be barely solvent. You still pass the course, but instead of grade A, you will be sweating bullets barely making a C.

[pb4uski]

Quote:

Originally Posted by REWahoo All things being equal, your $44k is less risky since you have one less year to live than does the new retiree.

Ugh... thanks for the reminder.

[pb4uski]

Quote:

Originally Posted by NW-Bound This dilemma has come up times and times again. It seems like a paradox, because someone who retired at the peak of the market gets to withdraw much more than he could if he did at a market trough on the same portfolio. Here are some actual numbers. On 10/9/2007, the S&P was at 1565. On 03/09/2009, the S&P was at 677! That's a huge drop of 57%. Ignoring the bitty dividend, a $1M at the top of the market would become $430K later. So, if you retired at the bottom of the market, you could withdraw only 4% x $430K = $17K instead of $40K/yr. So, how does one explain this paradox? It is actually quite simple. If you look at all the squiggly lines that FIRECalc plots for any input parameter set, you will see that there's a wide range of outcome. Thirty (30) years from now, you may become a decamillionaire, or you may be totally broke. If you take 4% at the top of the market, your portfolio may barely survive 30 years from now. But if you take 4% at the bottom of the market, you are most likely to die a lot richer than you are now. In either case, you've made it. It's like a student passing a course with a grade A or a grade C. If you keep ratcheting your withdrawal when the portfolio goes up, you are increasing the chance that you will be barely solvent. You still pass the course, but instead of grade A, you will be sweating bullets barely making a C.

One thing that you are not factoring in is what REWahoo points out... that as ratcheting happens there are fewer years that the portfolio has to support. I concede that the risk of running out of money is higher.... I'm just trying to balance the conservatism embedded in a SWR... by definition a SWR is principally based on bad scenarios... but there are typically many more scenarios where the retiree dies with a boatload of money and ratcheting mitigates that outcome.

So if I'm 10 years into a 40 year retirement and things have gone well and I have much more money than I started with and have 30 years left, then it would be foolish of me to stick to a 10 year old estimate of what a SWR would be and not adjust.

I concede in an extreme scenario like you describe during the great recession that having previously ratcheted up would have made me nervous, but as I said before, the extra money is use for splurging so in that extreme event there would be plenty of room for belt tightening.

Like I said before, I'm more concerned about dying with a boatload of money than dying broke.