Stocks — Part XIII: Withdrawal rates, how much can I spend anyway?

4%.  Maybe more.

So, you’ve followed the jlcollinsnh big three:

You’ve avoided debt

You’ve spent less than you’ve earned

You’ve invested the surplus

eggs

Eggs

by Sergey Gusev

Now you’re sitting on your stash and wondering just how much you can spend each year and not run out.  This could be stressful, but it really should be fun. You might even be cheeky enough to ask, “What percent of his own stash does jlcollinsnh spend?”  We’ll get to that.

You don’t have to have read far in the retirement literature to have come across the “4% rule.”  Unlike most common advice, this one holds up to our beady-eyed scrutiny pretty well, even though it is really very little understood.

Back in 1998 three professors from Trinity University sat down and ran a bunch of numbers.  Basically they asked what would happen at various withdrawal percentage rates to various portfolios, each with a different mix of stocks and bonds, over 30 year periods depending on what year the withdrawals were started.  Oh, and both with adjusting withdrawals for inflation and with not adjusting withdrawals. Whew.  Then they updated it in 2009.

Out of the scores of options, the financial media seized on just one of these models:  The 4% withdrawal rate, 50/50 stock/bond portfolio, adjusted for inflation.  Turns out, 96% of the time, at the end of 30 years such a portfolio remained intact.  Put another way, there was just a 4% chance of this strategy failing and leaving you destitute in your old age.  In fact, it failed in only two of the 55 starting years measured:  1965 & 1966.  Other than those two years, not only did it work, many times the remaining money in the portfolio had grown to spectacular levels.

Think about that for a moment.

What that last line means is that in most cases the people owning these portfolios could have taken out 5, 6, 7% per year and done just fine. In fact, if you gave up the inflationary increases and took 7% each year you would have done just fine 85% of the time.  Most of the time taking only 4% meant at the end of your days you left buckets of money on the table for your (all too often ungrateful) heirs.  Great news were that your goal.  Also great news if you anticipate living on your portfolio for longer than 30 years.

But the financial media knows that most people don’t like to think too hard.  By reporting the results at 4% they could report on just about a sure thing.  Roll it down to 3% and we have as sure a thing as we’ll ever see short of death and taxes.  Oh, and that’s giving yourself annual inflation increases.

While 1965 & 1966 were the last and only two years where 4% failed, remember that more recent start years have not yet had their own 30 year measurable runs.  My guess is that if you began your own withdrawals in 2007 and the early part of 2008 just prior to the recent collapse, you will have hit upon two more years in which the 4% plan is destined to fail.  You’ll want to scale back.  On the other hand, if you started with 4% of your portfolio’s value as of the March 2009 bottom, you’re very likely golden.

Here’s the Trinity Study Update.  The prose is a bit dry, it is written by PhDs after all, but don’t feel you need to read it closely.  What you should take a close look at are the very cool charts showing how differing scenarios play out.  If you want a detailed answer to the question of what percent works for you and your own unique situation and attitudes, you can figure it out here.  Plus, you’ll need to refer to those charts to follow along in the rest of this post. So go ahead. Take a look. I’ll wait.

Here’s the Cliff Notes version:

    • 3% or less is a near sure bet as anything in this life can be.
    • Stray much further out than 7% and your future will include dining on dog food.
    • Stocks are critical to a portfolio’s survival rate.
    • If you absolutely, positively want a sure thing, and your yearly inflation raises, keep it under 4%.  Oh, and hold 75% stocks/25% bonds.
    • Give up those yearly inflation raises and you can push up towards 6% with a 50% stock/50% bond mix.
    • In fact, the authors of the study suggest you can withdraw up to 7% as long as you remain alert and flexible. That is, if the market takes a huge dive, cut back on your percent and spending until it recovers.

When you look at the article you’ll see it has four charts.  The first two look at how various portfolios performed over time and at various withdrawal rates.  The difference is the second one assumes you increase your dollar withdrawal amount each year to account for inflation.  So if you look at Chart #1 and at the 50/50 mix with a 4% withdrawal rate, you see you have a 100% chance of your portfolio surviving 30 years.  Chart #2 tells you that if you take those same parameters but give yourself inflation raises, your portfolio’s chance of survival drops to 96%.  Makes sense, no?

Charts 3 & 4 tell us how much money remains in the portfolios after the 30 years have passed and this, to me, is really compelling stuff.  Again, Chart 3 assumes a straight percentage withdrawal and Chart 4 assumes giving yourself inflation raises.  Let’s take a look at some examples.

Assume a 4% withdrawal rate on a portfolio with an initial value of $1,000,000.  Here’s what you’d have left (median ending value) after 30 years:

Chart 3:

  • 100% stocks = $15,610,000
  • 75% stocks/25% bonds =  $10,743,000
  • 50% stocks/50% bonds= $7,100,000

Chart 4:

  • 100% stocks = $10,075,000
  • 75% stocks/25% bonds =  $5,968,000
  • 50% stocks/50% bonds = $2,971,000

Very powerful stuff and it should give you a lot to feel warm and fuzzy about as you follow The Simple Path to Wealth.

As you look over these charts, one thing that should become very clear to you is just how powerful and necessary stocks are in building and preserving your wealth.  This is why they hold center stage in my Portfolio Ideas.

What is likely less obvious, but every bit as important, is the critical importance of using low-cost index funds to build your portfolio.  When you start paying 1-2% or more to active mutual fund managers and/or investment advisors all these cheerful assumptions wind up in the trash heap.  Blogger Wade Pfau in this article says it best:

“For an example of this, the 50-50 portfolio over 30 years with 4% inflation-adjusted withdrawals had a 96% success rate without fees, 84% success rate with 1% fees, and 65% success rate with 2% fees.”

In other words, using the Trinity Study projections with portfolios built from anything other than low-cost index funds is invalid.

So, now to answer that question:  What withdrawal percent do I personally use in my retirement?  I confess I pay so little attention it took a few moments to figure it out and even then it’s not exact.  But this year my best guess is it is running somewhere north of 5%.  If you are a regular reader, this casualness probably surprises you.  But there are mitigating circumstances:

1.  I have a kid in college.  That is a huge annual expense, but in 1.5 years it goes away.  The money for it is figured into my net worth, but it is also earmarked as “spent.”

2.  Since my retirement, my wife and I have accelerated our travels and the related spending has spiked sharply. Not to be morbid, but at my age I am more worried about running out of time than money.  If the market were to tank in a major way, this is an easy expense to adjust.

3.  Sometime in the next few years we will have two nice new income streams coming on-line in the form of Social Security.

4.  Most importantly, I know I’m well under the 6-7% level that requires close attention.

Within that 3-7% range, the key to choosing your own rate has less to do with the numbers than with your personal flexibility.  If as needed you can readily adjust your living expenses, find work to supplement your passive income and/or are willing and able to comfortably relocate to less expensive places, you will have a far more secure retirement no matter what rate you choose.  Happier too I’d guess.

If you are locked into certain income needs, unwilling or unable to ever work again and your roots go too deep to ever seek out greener pastures, you’ll need to be much more careful.  Personally, I’d work on adjusting those attitudes.  But that’s just me.

My pal, Mr. Money Mustache, did a fine piece on this a while back.  It is as good an explanation/defense of the 4% rule I’ve yet to read. Nothing, of course, is guaranteed. That why we all need to remain flexible, alert and, well, Mustachian.

Last Spring I dealt with a lengthy comment from reader “ddrem” describing the disastrous position the world is in today and calling into question my portfolio recommendations accordingly. (See: http://jlcollinsnh.wordpress.com/2012/05/12/stocks-part-vi-portfolio-ideas-to-build-and-keep-your-wealth)

No worries.

sea by Gusev

Sea

by Sergey Gusev

Not only will we muddle thru, it is my belief we are on the verge of another great bull market. For lots of reasons, not the least of which is simply these things go in cycles and the drumbeat of pessimism (always a bullish sign) seems unusually high.  People seem to believe the world will end on their watch. But it never does. It is the dark that sets the stage for the dawn.

If I’m wrong and the dawn is still a ways off, that’s OK too. There are lots of adjustments I can make and options to explore.

4% is only a guide. Sensible flexibility is what provides security.

Addendum: For another way to look at this, consider The Rule of 300, courtesy of Johnny Moneyseed.

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