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.