The 4% Rule is probably not exactly what you think it is. To be fair, there are as many opinions on appropriate safe withdrawal rates from retirement portfolios as there are experts who give them. I was reading an article the other day on Investopedia, written by a financial planner, which advocated, among other things, that the oft cited 4% rule is often inappropriate for retirees when deciding how much to take from their portfolios every year. The article I was reading Why Early Retirees Should Reconsider the 4% Rule, discussed worst case scenarios intended to drive the readers to thinking they need professional help (he is, after all a fee based financial advisor – how long would he be employed if he advocated a “do it yourself” approach?).
The Original 4% Rule
At the risk of annoying you, my reader, and for the benefit of the three of you who are unfamiliar with the 4% rule, it is this: Withdraw 4% of your retirement portfolio in the first year of retirement. Each successive year withdraw 4% plus an amount equal to the increase of inflation in the previous year. So if inflation was 3% during your first year of retirement, you would withdraw 4.12% (the original 4% and an additional 0.12% for inflation).
This rule, originally put forth by William Bengen in 1994, was meant to help retirees make their money last through 30 years of retirement. The time aspect of how long the portfolio should last is often misunderstood and misapplied, or even ignored completely. If you read enough within the FIREosphere (see what I did there?), you’ll read about folks who have accumulated 25 times their annual expenses and then retire assuming the 4% rule will allow them to live forever without the portfolio well running dry. This is not what Bengen was saying. If you are 35 years old and retire with 25 times annual expenses in the bank, Bengen is saying you should be ok until you are at least 65, assuming no lifestyle creep (aka, Hedonic Adaptation). After that, he makes no guarantees (actually, before that either). For most folks on the RE side of FIRE, that is not what they were thinking with early retirement. The very real danger here is running out of money at a time when you are much less able to accumulate significant amounts of additional capital.
One Size Does Not Fit All
The problem with the discussion about safe withdrawal rates is that there is no “one size fits all” solution. Every system for taking money out of your retirement account and spending it on depreciable assets (like food) entails some degree of risk that you will spend yourself out of money. How then does one best prepare for this uncertain future? Good question.
As a preface, let me say that the sheer volume of information on safe withdrawal rates would stagger the imagination. However, all, and I mean all of that information is targeted to an audience who will retire within what is considered the normal window (usually understood as post 62 yrs old). There is no deep study on what it will take to retire at 35 (at least none that I have seen), though there is an increasing amount of discussion of the issue. Everything we know about the RE of FIRE is extrapolated from what has been written and discussed about retirement at a “traditional” age (read: “old”).
So, on to what one needs to consider. First, you need to understand where you are and what you want. I know that sounds really broad, but let me pin it down. If you are 25 years old and want to retire when you are 35, your needs and plan are going to be different from someone who is 60 and is going to retire at 70 (same 10 year period before retirement, completely different analysis). Barring unforeseen circumstances, the first person is going to need their portfolio to last significantly longer than the second. This is where Bengen’s 4% rule is often misunderstood. Remember, it was put forth with the idea of making a portfolio last 30 years. That is not long enough if you are going to retire at 35, but probably long enough if you retire at 65 or 70. Different needs may call for a different strategy.
Second, you need to understand what your risk tolerances are. I’m not thinking in terms of the standard Aggressive, Moderately Aggressive, Conservative investment categories you see in financial planning, crafted to help you determine if you should be 100% in tech stocks, or 100% in gold buried under the elm tree out back. I’m talking about what you would do if you woke up tomorrow and found that you are worth half of what you were worth yesterday. If you are 35, you can pack lunch into your briefcase and head back into the workforce if necessary. At 70, that is a bit more difficult. What you can, or should risk, is directly related to the options you have available if things go horribly wrong. A higher risk tolerance means being willing and/or able to weather a possible financial storm with fewer assets. If you won’t be able to sleep without my proverbial Five Years of Cash, you may need a bit more bank before you hang up your spurs.
Once you understand these two things, where you are and want to be, and what you’ll do if the dreaded “Black Swan” swims into your pool, you are ready to start looking at strategies to best live in retirement.
Why 4% May Not Equal Early Retirement for Everyone
David M. Blanchett is the head of retirement research for Morningstar Investment Management, LLC. He is the author of several studies on safe withdrawal rates and the creator of an Excel Spreadsheet that puts his research and findings into a more concrete and easy to understand format misleadingly called the “Simple Calculator.” I strongly encourage you to play with this calculator. You’ll see several criteria that can be changed depending on your circumstances, but the original settings are what Blanchett feels are reasonable. The results when you plug in a 60/40 (stock to bond) portfolio ratio and a 65 year old retirement age (assuming living until 95 – nothing wrong with being optimistic!) is that you can safely withdraw 4.28% of your retirement portfolio in the first year (adjusted for inflation in subsequent years). Leaving the allocation the same, but retiring at 55 (meaning a 40 year withdrawal period) would result in a safe withdrawal rate of 3.22%. At 45 years of age the safe withdrawal rate is 2.39%, and at 35 it is 1.72%.
What is the practical effect of this? If we go back to our assumption that you’ve amassed a retirement portfolio of $1 Million, then you would be able to safely withdraw the following amounts starting at the indicated age:
65 Years Old $42,800
55 Years Old $32,200
45 Years Old $23,900
35 Years Old $17,200
You can see that Blanchetts idea of safe withdrawal rate for early retirement is significantly different from those usually discussed in the FIRE community. Spend some time playing with the calculator and see what you can learn from it. If nothing else, it is a good idea to play “what if” when it comes to the possible outcomes for your retirement portfolio.
The 95% Rule
Another popular approach to safe withdrawal rates is the way that Bob Clyatt does it. You may know Bob from his popular retirement book: Work Less, Live More. Bob’s method is to take the greater of either 4% of the portfolio value, or 95% of the previous year’s withdrawal. The basic idea here is that when times are good and the nest egg is growing, you can spend more. When times are bad you will have to cut back, but never more than 5% in any given year.
This ability to be dynamic in your spending is a vital ability. If you can ratchet back your retirement spending if necessary by 5%, 10% or even 25%, you can extend the life of your retirement funds by a very large factor.
Floor and Ceiling
Another method put forth by Bengen (yes, that Bengen) is known as the Floor and Ceiling approach. This method is also a dynamic method (as opposed to the static 4% + inflation). The rule is that during good market years you are allowed to take an amount up to 125% of the initial year’s withdrawal (adjusted for inflation). But that in down cycles, you reduce your withdrawals, but never more than 10% below the amount of the first year’s withdrawal. Ignoring inflation (for simplicity’s sake), that means that if your first year’s withdrawal was $50,000, your subsequent withdrawal could be between $45,000 (10% less), and $62,500 (25% more), depending on whether the market was up or down. The ability to scale your lifestyle to fit comfortably within this range is, in my opinion the greatest safety feature available to you to make your retirement portfolio last as long as possible.
Conclusion
The point I’m trying to make here is that it is a mistake to simply say “I have 25 times annual expenses, so I can safely retire.” It is just not that simple. Neither is it so complicated that you need to run out and hire an asset manager. You need to understand that when you retire is as important as how much you have. They are different components of the same machine, and both rely on the other to keep the system healthy. Your retirement portfolio is not a perpetual motion machine. It needs care, feeding, and the kind of thoughtful stewardship that you, the well-informed and willing participant are more than capable of bringing to the table.
Until Next Time, FIRE On! – Oldster
