# A Decision Analysis approach to SWR choices

#### Rich_by_the_Bay

##### Moderator Emeritus
I've spent a big chunk of my career in the decision analysis part of the health care world. The discussions here on SWR often remind me of how people can make tough medical decisions. I'd like to know how this admittedly technical approach works for you:

• There are two sides to each decision parameter, a "frequency" component (e.g. likelihood of maintaining your income til you die, a la Monte Carlo analysis), and an "impact" component - the subjective, personal, values-driven impact of having to live on a lot less income if things fail. You can assign each component a score between 0 and 1 (works better than % due to the arithmetic).
• The easy part: for a given SWR, estimate the likelihood of success using Firecalc or a similar calculator. This is basically a statistical probability  based on evidence, not subjective at all. So, if at 4% WR your probability of maintaining your adjusted income forever is 99%, the score is 0.99, 95% might be 0.95, etc.
• Now the hard part: assume your best case scenario for retirement quality of life gets a perfect score of "1." Estimate your quality of life compared to the best case scanario  if you had to take a serious cut in income half way through your anticipated retirement. A score of 1 means no affect on your quality of life at all: plenty of padding, just a number in your monthly statement, living well below your means to begin with. A low score (destitute, bad lifestyle, bills, whatever) might get a 0.2, and a tough but acceptable impact might get a 0.5. You be the judge, just use the same number when comparing different scenarios to one another.
• Assigning a number to this doesn't make it any less subjective in nature, but it forces you to come up with some type of reasonably consistent and useable number so you can compare your options.
• Finally: multiply the two, e.g. 0.9 (firecalc success rate) x 0.5 (hypothetical quality of life given a serious income reduction if you fail) for a score of 0.45.

Compare this to an alternate scenario of a 5% withdrawal rate, given a Firecalc success rate of .87 but where you are more comfortable handling an income reduction half-way out, say for an impact score of .75. The score here is 0.65 (maybe you chose to live well beneath your means, or could easily down size from a nice but way-too-expensive house, location, etc.). This strategy would be the winner for that example.

This approach might make it easier to understand the 4% rule in your own personal context. Others have made this point more clearly than I could, but here is a way to do it with numbers.  Depending on your circumstances, maybe a 5% rule is OK; for others, maybe 3.5%, and for still others, maybe you had better reduce your cost of living more than you initially thought, but go with 5% instead of 4%. There is no right or wrong (as far as the impact number), just whatever reflects your values.

Just a tool, but it can have a powerful effect on how you approach your decision for some people. A typical first reaction we hear is, "you can't put a number on something like...." but give it a try if you find it interesting, remembering that it is not the absolute number that counts, but rather its consistency across different scenarios you might be comparing.

My problem is in evaluating the risks and effects of failure. It would be one thing for us to have to reduce my spending by half because we lost half our assets and another thing to lose 90% of our assets. My problem may be overweighing the risk of losing more than half of our assets. So I end up seriously uncomfortable with a 4% withdrawl rate.

Martha said:

My problem is in evaluating the risks and effects of failure. It would be one thing for us to have to reduce my spending by half because we lost half our assets and another thing to lose 90% of our assets. My problem may be overweighing the risk of losing more than half of our assets. So I end up seriously uncomfortable with a 4% withdrawl rate.

Yes, it is hard to get a "handle" on risk, and we all tend to erroneously overestimate the likelihood of failure when the consequences of failure (impact) are high. It is best to keep them separate - you can think more clearly about it.

My take is that total poverty is not a plausible scenario (barring a doomsday scenario in which case we are all SOL). Rather, we will/should see it coming long before we run out of money, and adjust accordingly. That is, after 10 years we realize our asset base is down 10% from startup, so we will urgently reduce our expenses. This is why the Decision Analysis example is set up the way it is.

Anyone who sees they are down 10% real dollars after several years and doesn't make adjustments is destined for disaster. Haven't "met" many here who would allow that to happen.

Rich_in_Tampa said:
Yes, it is hard to get a "handle" on risk, and we all tend to erroneously overestimate the likelihood of failure when the consequences of failure (impact) are high. It is best to keep them separate - you can think more clearly about it.

My take is that total poverty is not a plausible scenario (barring a doomsday scenario in which case we are all SOL). Rather, we will/should see it coming long before we run out of money, and adjust accordingly. That is, after 10 years we realize our asset base is down 10% from startup, so we will urgently reduce our expenses. This is why the Decision Analysis example is set up the way it is.

Anyone who sees they are down 10% real dollars after several years and doesn't make adjustments is destined for disaster. Haven't "met" many here who would allow that to happen.

I just had a "duh" moment. I can't keep working to simply reduce the risk of a doomsday senario. Nothing will reduce that risk.

Many of the people worried about the "big problem" of a major financial meltdown, a nuke going off in new york, world war three, etc miss that fine point martha...

Like I always say, we dont have to beat/avoid the big disaster, we just have to 'beat' the other folks also running from it. No matter what happens, a well diversified investor with solid net worth that has made good decisions may lose 80-90% of what they 'had', but still be a good bit ahead of their contemporaries.

In short, you dont have to outrun the bear, just the other guy.

Martha said:
I just had a "duh" moment. I can't keep working to simply reduce the risk of a doomsday senario. Nothing will reduce that risk.

Ooohh - exciting . I have lots of "duh" moments - even weeks .

You are exactly right. Diminishing returns: biggest risk is missing out on all the fun that is 97% likely because you were working so hard to get to 99%.

Rich_in_Tampa said:
Anyone who sees they are down 10% real dollars after several years and doesn't make adjustments is destined for disaster.

Well, anyone who retires into a bear market may be down much more than 10% after several years, but if they are withdrawing less than 3-4% they still have a ~100% historical chance of lasting a few more decades.

So it's a bit extreme to say people are destined for disaster if they don't make adjustments. The real issue is what adjustments can you make.. reducing your withdrawls from 4% down to 2% only puts you 2% ahead, which won't bring you anywhere near to your original real account value if you are down say 30% in real dollars in a few years.

Just a minor quibble... your reasoning overall seems quite sound. We all focus mostly on the worst cases here, but focussing on the best and medium cases is also very useful for planning purposes and your approach forces us to think about them as well.

Cute n' Fuzzy Bunny said:
Many of the people worried about the "big problem" of a major financial meltdown, a nuke going off in new york, world war three, etc miss that fine point martha...

Like I always say, we dont have to beat/avoid the big disaster, we just have to 'beat' the other folks also running from it.
In short, you dont have to outrun the bear, just the other guy.

TH,

Can you outrun a nuclear weapon?

Of course, we could be "nuked", but more likely by a dirty bomb than a warhead...

Cut-Throat said:
TH,

Can you outrun a nuclear weapon?

Yep, by living somewhere nobody would ever bother to nuke.

Although that might improve the appearance of some parts of this area.

Its funny, but the risk component of this vs the income makes sense to me. Thats why we have no debt and dont commit ourselves to any extensive out of pocket expenses. We can live comfortably off my wifes take home pay, and even she loses her job, we can slide by on dividends alone for a while without suffering too much. So my risk tolerance is pretty high.

Compare this to an alternate scenario of a 5% withdrawal rate, given a Firecalc success rate of .87 but where you are more comfortable handling an income reduction half-way out, say for an impact score of .75. The score here is 0.65 (maybe you chose to live well beneath your means, or could easily down size from a nice but way-too-expensive house, location, etc.). This strategy would be the winner for that example.

This approach might make it easier to understand the 4% rule in your own personal context. Others have made this point more clearly than I could, but here is a way to do it with numbers

Rich, I understand your algorithm, but not your reasoning. If 2 people have the same starting \$, use the same investments, experience the same economic environment, but one uses an SWR of 5% and the other uses 4%, the 4% guy is going to have more money anywhere along the trip. The 4% guy is
less likely to have to go to spending levels that he cannot tolerate than the 5% guy. In addition, his cutbacks in outlays should be subectively less onerous as well as objectively smaller. Many psychological studies have shown that people like to progress; they don't like to retrench.

It seems to me for example that the safest as well as probably the happiest approach for one with enough money to meet his resonable spending needs starting into retirement would be to spend very conservatively, thus allowing room for increases in spending if things go well, but probably not demading decreases unless things go very badly.

There are some people on this board who advocate starting out spending more so you have a buffer between your usual spending and your rock bottom survival spending. To me this is hard to understand. For a given individual in a given environment rock bottom is rock bottom, and it is likely to feel worse coming from above than below. THe difference comes in becasue these people usually have a larger stash. So if  a5% SWR damages a \$3million portfolio, he still has a pretty good portfolio, and he can live more like other people with less. This has nothing to do with his SWR except possibly negatively, rather it is a function of his wealth.

Where I can understand the use of your technique is in evaluating one's proper risk profile. If a wipeout on a promising investment would have a truly meaningful effect on his level of happiness, he shouldn't do it-even if success would allow him to spend a lot more time at Cabo. Putting numbers (utilities) to this would help to avoid obsessive and unhelpful ruminating.

I hope I have made my ideas clear; and I hope you will comment on them. BTW, I think you are a very helpful poster.

Martha said:
My problem is in evaluating the risks and effects of failure.   It would be one thing for us  to have to reduce my spending by half because we lost half our assets and another thing to lose 90% of our assets.   My problem may be overweighing the risk of losing more than half of our assets.  So I end up seriously uncomfortable with a 4% withdrawl rate.

Martha, how could you manage to lose half or more of your assets? Carry an umbrella and health insurance. Carry half of your stash in cash to medium term fixed. Then even if you lost 75% of your stock portfolio, you still would have better than 60% of your starting total portfolio left. And it is probably pretty hard to lose 75% of  a diversified stock portfolio.

Ha

HaHa said:
Rich, I understand your algorithm, but not your reasoning. If 2 people have the same starting \$, use the same investments, experience the same economic environment, but one uses an SWR of 5% and the other uses 4%, the 4% guy is going to have more money anywhere along the trip. The 4% guy is less likely to have to go to spending levels that he cannot tolerate than the 5% guy. In addition, his cutbacks in outlays should be subectively less onerous as well as objectively smaller. Many psychological studies have shown that people like to progress; they don't like to retrench.

It seems to me for example that the safest as well as probably the happiest approach for one with enough money to meet his resonable spending needs starting into retirement would be to spend very conservatively, thus allowing room for increases in spending if things go well, but probably not demading decreases unless things go very badly.

Ha,

If you would be just as happy with \$400 per month as with \$500, of course \$400 is the best strategy since it is more of sure thing long term. However, there is some number at which you would be less happy than at \$500; maybe it's \$350 or \$300. Whatever that number is, we all have it. Now you need to compare the happiness at \$500 x the likelihood of lifelong asset preservation using \$500, with the happiness at \$350 (or whatever your "now I'm not so happy" number) times its higher likelihood of long term success:

a. \$500 per month: .8 likelihood of success x 1 (ideal happiness scenario) = .8
b. \$350 per month: .98 likelihood of success x .7 (not as happy) = .67

Choice "a." wins here. Now let's run it with your implied example, where you are almost as happy at \$350 compared to \$500:

a. \$500 per month: .8 likelihood of success x 1 (ideal happiness scenario) = .8
b. \$350 per month: .98 likelihood of success x .9 (almost as happy) = .88

Choice "b." wins here.

I hope this helps - you can decide how much unhappier you will be at the lower income, and whether the trade-off in certainty of asset preservation is worth it. Again, just a tool and all decisions it generates are right or wrong only for you, not in any absolute sense.

Rich, this is more of a general question on your algorithm, but how does one decide what is a high enough number to make an affirmative choice? Clearly in a medical situation where you *have* to do something because otherwise somebody will drop dead, using decision analysis makes sense because you can rank order your optons and then make the best choice. But if we are talking about the decision to retire, one (usually) does not have the same "burning platform" since the would-be FIREee can just stay at work. So I am having a tough time making the leap here...

brewer12345 said:
Rich, this is more of a general question on your algorithm, but how does one decide what is a high enough number to make an affirmative choice? Clearly in a medical situation where you *have* to do something because otherwise somebody will drop dead, using decision analysis makes sense because you can rank order your optons and then make the best choice. But if we are talking about the decision to retire, one (usually) does not have the same "burning platform" since the would-be FIREee can just stay at work. So I am having a tough time making the leap here...

Great question. In the "real world" you would compare harm to benefit. If Harm:Benefit is greater than or equal to 1, you pass (i.e. decline treatment); otherwise you accept treatment.

Here I suggested it in in the limited context of simply comparing two sets of post-FIRE circumstances and deciding which was better. To answer your question at the risk of boring you to death:

1. Perform the exercise using your current pre-retirement lifestyle. Use a likelihood of 1, since this is the actual current state of affairs. For the "subjective" part, look at your happiness level, security, social networking, income, work hours, etc. and come up with a quality of life score from 0 to 1, just as discussed.

If your pre-retirement life is peachy, secure, and you feel great about the state of your world, have enough free time, etc.  it might approach a score of 1. We all know people who seem to be there. However, given that this is an early-retirement forum, I suspect this will not often be the case.

2. Consider each of your post-FIRE options and perform the exercise with each one.

3. Look at the scores, including your pre-FIRE score. If pre-FIRE beats all the  post-FIRE scores, keep working. You are lucky. If any of the post-FIRE scenario scores is higher than the pre-FIRE score, it's time.

Of course you have to be realistic in your assumptions and judgments, and avoid the human tendency to "game it" so that you retire before you are ready. But that's a whole other discussion.

Hope that helps.

I posted something along these lines yesterday suggesting that the OPs model was not strictly valid but deleted it so as to not be too critical.

Anyway the OP suggests that if you can put quantitative numbers on the SWR_success and the happiness_factor that the joint probability for these two factors that the OP calls the quality_of_life is just the product of the two. If the happiness_factor and the SWR_success are indeed statistically independent then the multiplication model will exactly discribe the joint probability for "quality of life".

In my opinion the happiness factor is highly dependent on the SWR_success and that the two are highly correlated. This therefore violates the statistical independence criteria required to determine the "quality of life" joint probability using a multiplicative model. Furthermore while the SWR_success is (arguably) determinable provided past pertformance is indicative of future performance, the happiness_factor being derived from feelings is not so determinable.

Therefore, The OPs model may give some insight into how someone feels about their retirement but is along way from an analytic model of retirement success.

I hope I haven't been too critical here. These type heuristic models are challenging.

Martha said:
My problem is in evaluating the risks and effects of failure. It would be one thing for us to have to reduce my spending by half because we lost half our assets and another thing to lose 90% of our assets. My problem may be overweighing the risk of losing more than half of our assets. So I end up seriously uncomfortable with a 4% withdrawl rate.
Perhaps that's a diversification issue. We may have more than 90% of our retirement portfolio in equities, but we also have a govt pension and a rental property. You seem to have quite a few defensive layers in your retirement portfolio, too, notwithstanding Greg's attitude.

Cut-Throat said:
Can you outrun a nuclear weapon?
I can assure you that the Russians & Chinese, even Al-Quaida, would have a hard time justifying the waste of a nuclear weapon on Travis AFB, let alone Yuba City. How would you tell whether there was battle damage?

I'm not so sure what Minot & Omaha have pointed in that direction, however...

HaHa said:
Martha, how could you manage to lose half or more of your assets? Carry an umbrella and health insurance. Carry half of your stash in cash to medium term fixed. Then even if you lost 75% of your stock portfolio, you still would have better than 60% of your starting total portfolio left. And it is probably pretty hard to lose 75% of a diversified stock portfolio.

Ha

Stock market dumps bigtime. Real estate crashes. My sibs lose their jobs and can't pay their bills. Lenders foreclose on our real estate partnership/llc assets. Makes my stomach hurt thinking about it.

Though we do have the insurance. And we do have a lot in cash/bonds. And the real estate partnerships/llcs are only about 15% of our assets.

MB, I am not that comfy with something as "squishy" as the decision analysis score suggested, since I could probably poke half a dozen holes in the methodology pretty easly.  The problem is that making the leap "into the void" is a fundamentally touchy-feely type decision, so it is tough to apply numbers to it.  So offering something better is tough.

Personally, I tend to approach major financial decisions differently.  I usually do as much analytical work as possible to come to a cold, rational decision.  Once it becomes clear what the story is, I then usually sit with it for a bit (days or weeks) to make sure something critical wasn't missed.  After that, I try to put my decision into action.  Sometimes the opportunity is gone by the time I am ready, sometimes not.  I suspect that when the time to FIRE comes I will go through a similar process, assuming I am not suddenly chucked on the street with a big portfolio.

Nords said:
I can assure you that the Russians & Chinese, even Al-Quaida, would have a hard time justifying the waste of a nuclear weapon on Travis AFB, let alone Yuba City.
Beale is a lot closer, but they'll probably close that pretty soon. And thats 10 miles away and we're upwind of it. Maybe get a tan and possibly clean out my driveway a little bit.
How would you tell whether there was battle damage?
Over near Beale? It'd look a lot better. Big time slums over there.
Martha said:
Stock market dumps bigtime. Real estate crashes. My sibs lose their jobs and can't pay their bills. Lenders foreclose on our real estate partnership/llc assets. Makes my stomach hurt thinking about it.

Though we do have the insurance. And we do have a lot in cash/bonds. And the real estate partnerships/llcs are only about 15% of our assets.
So you cut spending a little, both work some extra hours, wait it out for a couple of years, spend any extra cash reinvesting at the ridiculously low prices, watch the bear eat someone who had a half mil in debt and no savings at all.

Whats the problem?

I can see these fears from a couple in their 70's+ that arent and/or cant work and are pinned to a low withdrawal rate from a small portfolio, no significant home equity, and a bit or a bunch of debt. I cant really see it in anyone else.

Martha said:
Makes my stomach hurt thinking about it.

brewer12345 said:
MB, I am not that comfy with something as "squishy" as the decision analysis score suggested, since I could probably poke half a dozen holes in the methodology pretty easly.  The problem is that making the leap "into the void" is a fundamentally touchy-feely type decision, so it is tough to apply numbers to it.
Brewer, that is a good point.

I would only note that poorly scrutinized "touchy-feely type" thinking is what leads less thoughtful people to play the lottery despite limited resources, buy annuities when better alternatives are obvious, or play it safe to the point of self-deprivation and loss of happiness just so they don't take that 1% chance of partial failure.

A good compromise (for me) is to do the model and the math, consider the winning option, then do a final "sanity check" - basically, how does this conclusion "feel" to me. If the two jive well, I am content with the decision. If there is a disconnect, I re-evaluate my assumptions, often finding that I kind of failed to consider something, had a new insight. That's my "intuition" telling my intellectual side that it is being a jerk. Sometimes, I just go with my gut despite the analysis.

It's a tool, just a tool. But it can be startlingly powerful and insight-generating sometimes.

And, it's free .

Rich: As always, each of us has to dow hat works for them. FWIW, "behavioral finance" is probably one of the hottest areas of research in the field right now.

I think this approach might work very well in the case of a government worker who wants to choose between retiring at time t, with cola'd income of say \$50,000; vs. retiring at time t+x with a larger cola's income. Then he can confidently make the assignments of utilities that you suggest. But in my case, and I would imagine in the case of many others who have only their nest-egg plus small and somewhat insecure SS to support them, there is going to be a powerful, asymmetrical interaction between the curve of their net worth, and their happiness. In fact, a severely falling net worth might even turn happy memories of trips, etc., into painful reminders of one's folly.

If my portfolio goes up by \$1million, I will like it and feel more like a fat cat, but it would likely have a more powerful effect on my happiness by increasing my security, than by any additional spending I might undertake.

If it goes down by \$1 million, I am feeling like shite and wishing I never heard of early-retirement.

In the final analysis, what do you really need to make you happy? A good meal at home is very similar to a good meal in Rome. A glass of Relska vodka is likely indistinguishable from a glass of Grey Goose. And unless you are paying cash for it, you are going to get the same quality sex on a low budget as on a high one.

In my case, my manhood might even go into hiding at least for a while if I really thought I was heading down the death spiral of a broken retirement.

As the song says- "All I need to make me happy,
Two little kids to call me Pappy..."

And maybe a fat chick in short shorts and dinner at Carl Jr.'s!

Ha

Mmm...six dollar burger...

HONEY! We're going out for dinner!

Rich in Tampa, [I assume Rich as in Ricardo and not Rich as in rico :]

This was a really good post that you have started. You are saying that instead of spending so much time analyzing the data that goes in, spend some time analyzing the data that comes out for your particular situation -- give it some thought and customize it.

Every time that I think I fully understand SWR stuff something like this gives me more insight. Thank you very much. I have touched on this in Monte Carlo analysis that I have done, but not much. For instance, I keep track of instances where I end up having to go back to work for awhile, which is a lot more often than one goes broke.

Yes, a lot of it does depend on your backup plan, too. I liked Larry Swedroe's recent post on the Vanguard Diehards morningstar board about a plan advocating a 5% SWR:
7. try this
larry swedroe| 03-03-06 | 07:12 PM
those who have options, like can cut spending or sell other assets to live off of (e.g.second home) or continue working, etc. can take the risk of a higher withdrawal. Those that do not should not because, as in this example, if inflation rises and you cannot cut back on real expenditures your screwed. And too late to do anything about it at that point.

And if you have options you must be prepared to exercise them if the risks in fact do show up

Kramer

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