I came home from a busy shift last night to discover the traffic on this site had been 10 times higher yesterday than what it had been averaging. I couldn't figure out what was going on until I saw a post by Taylor Larimore at Bogleheads.org about this blog. It has been a month since I began working on the website and I've learned a lot about blogging, HTML etc. We're up to 31 readers on the RSS feed and daily hits on the site have climbed this week from around 100 to around 500 and then over 1500 yesterday. I hope you're getting as much out of this project as I am. I think there is a real need for this information among the health care community so I'm glad to contribute. Now, on to today's post:
Another important rule of thumb for the physician investor to understand is the 4% rule. 4% is the amount you can withdraw from a portfolio each year and expect it to last you through retirement. You get to increase that 4% with inflation each year. That means that to retire you need a portfolio 25 times bigger than the amount you plan to spend from it each year. Where does this rule come from? Put on your evidence-based investing hats and follow me to what is called “The Trinity Study.” This study came out of Trinity University, and was recently updated. The researchers divided all our past financial data into rolling 30 year periods (from 1929-2009, so 53 overlapping 30-year periods), then tested how likely the portfolio was to survive for the whole 30 years at various asset allocations and various withdrawal rates. Back in the 90s, there was this idea prevalent in the financial planning community that if the stock market returned 7-12% a year, you could spend 7-12% of your portfolio every year in retirement and expect it to last. This important study threw a lot of cold water on that idea. It turned out if you were spending more than 5% of your portfolio a year (again, adjusted to inflation), you would be very lucky if your portfolio lasted 30 years. Let's look at the data from the study. This is the most important table from the paper:
This tells you three things. First, your portfolio is much more likely to last if you include stocks in it throughout retirement rather than holding all or mostly bonds in retirement. Second, at typical retiree asset allocations of 25-50% stock, any withdrawal rate larger than 4% is quite reckless, with a significant risk of running out of money prior to death. Lastly, if you decrease your withdrawal rate to 3%, just about any asset allocation will do.
There are two important caveats to this paper. The first is that it is based on past data. You can no longer invest in the past. 4% may only be safe inasmuch as the future resembles the past. If returns are significantly lower in the future, or if inflation is significantly higher, then 4% may turn out to be a pretty risky number. Stocks are risky investments. We intuitively understand that in the short term, the volatility of stocks makes them pretty risky. But they are also risky in the long-term. Sometimes stocks go down and DON'T come back up. Entire stock exchanges have disappeared previously in the history of the world and investors lost 100% of their investment. It hasn't happened in the US, but it could. Increasing your allocation to stocks in retirement because you didn't save enough or because you spend too much probably isn't a good idea.
The second caveat is that the data is pretty limited. Sure, there are 53 different periods of time, but how many independent 30 year periods are there? Only about 3. As Dr. Bernstein discusses so eloquently here, we only have two centuries of financial data. There's no way you could sneak data that shaky past the FDA to get a new treatment approved, but it is the best we have in investing. The wise doctor (and investor) knows the difference between robust data and not-so-robust data, and is careful about putting his confidence in the shaky stuff.
Either way, whether the safe withdrawal rate turns out to be 2% or 3% or 5%, it surely isn't going to be 8%. So when setting goals for your retirement nest egg, better plan on having 25 times what you'll need each year set aside before pulling the cord on the ejection seat at work.
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Just wanted to thank you very much for posting your insights for the rest of us. While I had heard of the Trinity study, the clarity with which you dissected the study helped solidify its meaning for me. The rest of your posts are amazing as well. They are all food for thought without the fluff.
“up to 31 readers on the RSS feed…” !! 🙂
I had not heard of this study. Thanks for hitting the main points.
Do you still use 4% as the benchmark?
I don’t as I’m still in the accumulation phase. I think most retirees are using a variable plan to be honest. When investments do well, they withdraw more. In bad times, they hunker down a bit. But 4% is a great starting point.
I love the Trinity Study table, and its brother the Cooley Table, which uses the same data and shows what the median amount of money is for the different allocations and time frames. That information brings context to the binary nature of the Trinity table which is just run out of money or don’t.
However, it may be time to update this post a bit. Several factors make it more accurate to project in excess of 5% as a withdrawal rate. One of those factors is the addition of small cap stocks to the allocation. When the equity portion has one third small caps the safemax increases to 4.59%.
The other issue is that the 4% Safe Withdrawal rate assumes that spending stays constant (relative to inflation) throughout retirement. This isn’t accurate. It declines 2-3% a year. This has a huge effect on withdrawal rate safety.
Combining those two facts actually leads to a safe withdrawal rate of close to 6%.
Food for thought.
Bob
I agree with all that (except the bit about small cap stocks- that’s probably cancelled out by the fact that the Trinity guys used long-term corporates). Maybe I should do an update on this post and include the Cooley Table. A lot of people are really surprised when they learn they will PROBABLY die with more money than they retired with following a 4% withdrawal rule.
Here’s a link for those interested. Table 3 is the “Cooley Table” he’s referring to:
http://www.onefpa.org/journal/Pages/Portfolio%20Success%20Rates%20Where%20to%20Draw%20the%20Line.aspx
Cooley is the first author on the paper and one of the original Trinity authors. The link probably doesn’t work. Google: Portfolio Success Rates: Where to Draw The Line and it’ll come right up.
I know it’s an old post, but figured it would be a good spot to ask a question. I’m reading William J. Bernstein’s fairly recent book “The investor’s Manifesto Preparing for prosperity, Armageddon…” and he keeps harping on a 2% withdraw rate. To quote him “at 3 percent, you are probably safe; at 4 percent, you are taking real risks; and at 5 percent, you had better like cat food and vacations very close to home.” I always heard 4%, adjusted for inflation, and figured that number into planning. Is there some new info out there, or is this just ultra-safe, no way ever running out, planning?
I disagree with Bill on this point. I think 2% is ridiculous, 3% is hyperconservative, 4% is almost surely safe, and 5% might be safe. I have a post I wrote last night coming up on it this summer. (Yes, I’m that far out right now.) The Trinity data suggests that if you use a 3% rate, and are invested in 100% stocks, you are likely to die after 30 years with 13 times as much money as you had when you retired. That’s on average. Half the investors will have MORE! That data includes the Great Depression, WWII etc etc etc. You really feel like you need to be that conservative? I certainly don’t.
Wow. I think I just wet myself. That is mind-blowing. Never even crossed my mind as possible to come out with half the amount. It really is possible to win at this game.
Good to know, I’ll be looking forward to the post. I see myself pulling out around 4% a year, likely less, but not really increasing with inflation. Most of the things I like to do are the same price they were 20 years ago so unless inflation gets crazy, I don’t see that being to much of an issue for me. Worst come to worse, we can both drive our jazzy over to his place and beg for table scraps when we run out of money at 80!
Does the 4% rule attempt to preserve the original nest egg or does that get consumed as well? I want to die broke!
Most of the time you will die with many multiples of what you started with. Sometimes you die broke and other times you will run out of money before you die. I can’t remember the numbers of the top of my head, but I think 96% of the time you have money in the bank when you die with a 50/50 portfolio, and the rest of the time you run out of money.
The best way to die broke is to annuitize a large chunk, perhaps even all, of the nest egg at some point. That allows you to maximize what you spend without having to worry about running out of money until you die. Then you die broke.
4% is much to conservative. Retiresoft. By David Zolt shows you can withdraw up to 6 to 8% annually if you do not increase your inflation adjusted return in bad market years. Why fly coach when your heirs will fly buisiness class?
Remember as people go thru retirement they spend less as they get older. Spend it earlier while you have your health and energy, unless you want to leave a huge inheritance
I agree a variable withdrawal strategy is ideal, but 4% is the right neighborhood to start in. If you don’t have crummy returns in the first 5 years of retirement, 6% is very doable. If you’re very fortunate and retire into a bull market, 8% is quite possible. But historically, 8% (adjusted for inflation) only worked 1/3 of the time with a 75/25 portfolio. But if you tighten your belt in bad years, that increases your odds.