By Dr. James M. Dahle, WCI Founder
An important rule of thumb for the physician investor to understand is the 4% rule. Especially if they're thinking about becoming a part of (or are already involved with) the FIRE community.
What Is a Safe Withdrawal Rate (SWR)?
A safe withdrawal rate is the amount you can withdraw from a portfolio every year without running out of money during your retirement. It seems straightforward, but it can actually get quite confusing. If you only spend the increase in value of a portfolio (or the income you get from it, which is often even less), you will never dip into principal. You will also end up spending much less than you could have during your retirement. At the same time, you also don't want to spend so much principal that you run out of money.
Since you do not know how long you will live, you do not really know how long the portfolio must last. Thus, 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 again unknown and unknowable.
What Is the 4% Rule?
Four percent 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. That 4% has to include ALL of your spending, though, including taxes and advisory fees. Where does this rule come from? Put on your evidence-based investing hats and follow me to what is called “The Trinity Study.”
What Is the Trinity Study?
This study came out of Trinity University in the 1990s with updated data in 2010. It is a classic of personal finance literature. The investigators simply wanted to answer this question:
“How much of a portfolio can an investor spend each year, adjusted upward with inflation, and not run out of money during a 30-year retirement?”
The researchers divided all of our past financial data into rolling 30-year periods (from 1929-2009, so 53 overlapping 30-year periods) and then tested how likely the portfolio was to survive for the whole 30 years at various asset allocations and various withdrawal rates. In the 1990s, 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, which turns out to be false due to something called the Sequence of Returns Risk. The Sequence of Returns Risk is the idea that even if your average portfolio returns are fine over your retirement years, you could still run out of money if the market performs badly at the beginning of your retirement. That's because you are withdrawing money from the portfolio at the same time it is losing value. It turns out that 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 due to the Sequence of Returns Risk. There are ways to mitigate that risk, especially if you're retiring in 2022 when the markets are cratering and inflation is soaring, but it's something of which you have to be aware.
Let's look at the retirement withdrawal rate chart from the study. This is the most important table from the paper:
This table tells you three things. First, your portfolio is much more likely to last if you include stocks in it throughout retirement rather than holding a bond-heavy allocation. Second, with a typical retiree asset allocation 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 on safe withdrawal rates. The first is that it is based on past data. You can no longer invest in the past. Four percent 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 also 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, and investors have 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 three. As Dr. William 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 they're careful about putting their confidence in the shaky stuff.
Plus, with more people retiring in their 50s instead of their 60s and 70s (and with people tending to live longer), retirements now could last longer than 30 years. They could last 40 or even 50 years. That's why some in the FIRE community who are retiring in their early 50s feel more comfortable with a 3% or a 3.5% withdrawal rate.
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, you'd better plan on having 25 times what you'll need each year set aside before pulling the cord on the ejection seat at work.
A Better Idea Than a Fixed Safe Withdrawal Rate
Very few retirees follow any sort of strict fixed withdrawal rate, much less the 4% one. As you have read, the 4% rule is really just a 4% guideline. It's a reasonable place to start. If Sequence of Returns Risk shows up early in your retirement, batten down the hatches and cut your spending. If it does not, bump up your spending. You could even spend 5%, 6%, or even more a year, especially if you can cut back when the market does poorly. The ability to be flexible in retirement is extremely valuable, and it will likely allow you to significantly exceed a 4% withdrawal rate.
What do you think is the true safe withdrawal rate? How do you plan to spend your assets down in retirement? Are you still worried about running out of money? Comment below!
[This updated post was originally published in 2011.]