The 4% rule and safe withdrawal rates
An important rule of thumb for the practicing investor to understand is the 4% rule. Especially if they are thinking about joining (or are already participating in) the FIRE community.
What is Safe Rejection Ratio (SWR)?
A safe withdrawal rate is the amount you can withdraw from the fund each year without running out of money during your retirement. It seems straightforward, but it can actually be confusing. If you only use the increase in the value of the portfolio (or the income you get from it, which is often even lower), you will never dip into the principal. You will end up spending much less money than you might have in retirement. At the same time, you also don’t want to spend so much principal that you run out of money.
Since you don’t know how long you will live, you don’t really know how long the portfolio should last. Hence, the need to know the safe withdrawal rate. It gets even more complicated when you realize that your withdrawals must also account for future inflation, which is also unknown and unknowable.
More info here:
Fear of the Retirement Crash Phase
A Framework for Thinking About Retirement Income
How Flexible Can You Be in Retirement?
What is the 4% Rule?
Four percent is the amount you can take out of your savings every year and expect it to last long into your retirement. You get to increase that 4% with inflation each year. That means that in order to retire, you need a portfolio 25 times larger than the amount you plan to spend each year. That 4%, however, must include ALL of your spending, including taxes and advisory fees.
Where does this law come from? Put on your evidence-based investing hats and follow me on what’s called “The Trinity Lesson.”
What is the Doctrine of the Trinity?
This study came out of Trinity University in the 1990s with information updated in 2010. It is a classic personal finance book. The researchers wanted to answer this question:
“How much of a portfolio can an investor use each year, inflated by inflation, and not run out of money during a 30-year retirement?”
The researchers divided all of our past financial data into 30-year periods (from 1929-2009, so 53 30-year periods) and assessed how likely the portfolio was to survive the entire 30 years for various asset allocations and various withdrawal rates. In the 1990s, there was this popular idea in the financial planning community that if the stock market returned 7%-12% a year, you could use 7%-12% of your portfolio every year during retirement and expect it to last a long time.
This important study threw a lot of cold water on that theory, which turned out to be false because of something called the Risk-Recovery Sequence. Sequence of Returns Risk is the idea that even if your portfolio averages good returns throughout your retirement years, you could still lose money if the market doesn’t perform well early in your retirement. That’s because you’ll be pulling money out of the portfolio at the same time it’s losing value.
It turns out that if you were investing more than 5% of your portfolio annually (again, adjusted for inflation), you’d be very lucky if your portfolio lasted 30 years because of the Risk-Return Sequence. There are ways to reduce that risk, but you need to be careful.
Let’s take a look at the retirement withdrawal rate chart in the study. This is the most important table in the paper:
This table tells you three things. First, your portfolio may last longer if you invest in stocks throughout retirement rather than holding a heavy bond allocation. Second, with a typical retirement asset allocation of 25%-50% of stocks, any withdrawal ratio above 4% is reckless with a high risk of bankruptcy before death. Finally, if you lower your withdrawal rate to 3%, almost any asset allocation will do.
There are two important caveats in this paper about safe withdrawal rates. The first is that it is based on past data. You can no longer invest in the past. The four percent may only be safe as the future is like the past. If future returns are very low or if inflation is very high, then 4% may be a very dangerous number.
Stocks are also a risky investment. We understand intuitively that, in the short term, the volatility of stocks makes them very dangerous. But they are also dangerous in the long run. Sometimes stocks go down and DON’T come back. All stock exchanges disappeared, and investors lost 100% of their investment. It hasn’t happened in the US yet, but it could. Increasing your share of stocks in retirement because you didn’t save enough or because you spent too much is probably not a good idea.
The second caveat is that the data are limited. Sure, there are 53 different time periods, but how many independent 30-year periods are there? Only about three. As Dr. William Bernstein discusses art here, we only have financial information for two hundred. You couldn’t sneak past the FDA’s shaky data to get a new treatment approved, but it’s the best we’ve got for investing. A smart practitioner (and investor) knows the difference between hard data and weak data, and they are careful to put their trust in moving objects.
In addition, with more people retiring in their 50s instead of their 60s and 70s (and people tend to live longer), retirement can now take more than 30 years. They can live for 40 or 50 years. That’s why some in the FIRE community who retire in their early 50s feel more comfortable with a 3% or 3.5% withdrawal rate.
In any case, even if the safe withdrawal rate is 2% or 3% or 5%, it will certainly not be 8%. So, when setting goals for your retirement nest egg, you’d better plan to have 25 times what you’ll need each year set aside before pulling the plug on retirement.
More info here:
Real-Life Examples of How WCIers Live, Worry, and Cash Out in Retirement
Comparing Portfolio Withdrawal Strategies for Retirement
A Better Idea Than a Fixed Safe Withdrawal Rate
Very few retirees follow any kind of strict withdrawal rate, much less the 4% one. As you have read, the 4% rule is actually a 4% guideline. It’s a reasonable place to start. If the Risk Return Sequence shows early retirement, reduce the intervals and reduce your spending. If not, increase your spending. You can even use 5%, 6%, or more per year, especially if you can reduce when the market is not doing well. The ability to be flexible in retirement is very important, and will allow you to significantly exceed the 4% withdrawal rate.
What do you think is the actual safe withdrawal rate? How do you plan to use up your assets in retirement? Still worried about running out of money?
[This updated post was originally published in 2011.]
