This was not a post I had originally drafted in the que, but after a request on the Social Security post, I decided to start putting one together. Thanks, Glincoln for the suggestion:
Thoughts on Withdrawal Rates for the Early Retire
The short answer is “I am also interested in what my thoughts are on safe withdrawal strategies for the early retiree” … I have been guilty of utilizing the Trinity Study results for the 4% rule without considering all of the implications. For this reason, I have
delayed (procrastinated) on publishing a post about it while doing a deeper dive into the assumptions embedded in the 4% rule.
This is a critical topic and is one of the backbones of RE in FIRE (Financial Independence Retire Early). Many angles have been explored, analyzed, and projected out, so, what can I add to the conversation that has not already been discussed? Or at least how does this information change my own RE goals?
On the Choose Beta blog, we always enjoy making a point with math. The cool thing about math is that assuming that it is done correctly, everyone should get the same results… Because it’s just math. For this reason, I don’t really want to go back through and re-calculate what has been extensively documented. Instead, I will highlight a couple of my favorite sources and highlight a couple of concepts.
4% Rule Origins
Classic retirement calculations often plan for a safe withdrawal rate based on the 4% rule. This concept is a simple rule of thumb that estimates a target retirement nest egg with minimal effort. It is based on a research paper which was published in the 90’s by three professors from Trinity University in San Antonio Texas and was dubbed the “Trinity Study”:
These professors evaluated historical market returns in attempt to define a safe withdrawal rates over 20, 25 and 30 yr periods. Through the study, they evaluated the effects of time horizons, inflation, and bond/stock allocations. Upon publishing their results, the 4% rule was born.
It was coined based on the findings that a portfolio consisting of 50% Stocks / 50% Bonds had a 95% “success” rate for lasting a retiree 30 years based on historical data. Since then, it has been used to estimate how much a retiree can drawdown from their assets.
The major issue with utilizing this for early retirees is that the time horizon will most likely extend well past the 30 year threshold. This factor is even acknowledged in the report:
“The numbers imply that young retirees who anticipate long payout periods should plan on lower withdrawal rates than their older counterparts.”
The 4% Rule and the Early Retiree
Extending the retirement horizon past the 30 yr mark requires further investigation and cannot be simply extrapolated out. In order to better understand the reason for this, we must review the critical assumptions in the Trinity Study:
- Annual Returns from 1926 – 1995
- Utilized the S&P500 to represent the stock market
- Utilized Long-term, High-grade Corporate Bonds to represent the bond market
- Analyzed 15 yr, 20 yr, 25 yr, and 30 yr time frames
- Reviewed the results of portfolios with the following allocations
- 100% Stocks
- 75% Stocks / 25% Bonds
- 50% Stocks / 50% Bonds
- 25% Stocks / 75% Bonds
- 100% Bonds
- Allows for depletion of portfolio by the end of retirement
Gaps in Extrapolating the Trinity Study
There are a couple of critical items to understand about the assumptions in the Trinity study’s analysis:
- The study capped out at 30 years
- It allowed depletion of the nest egg
These assumptions are part of the reason for the unraveling of the 4% rule for the early retiree. This is because as an early retiree, the planning timeframe will be significantly longer than 30 years on average. Many have taken the trinity study and justified extrapolating the 4% rule well past 30 years on the basis that “if it is good for 30 yrs, then it should be good for longer as well”. The main fallacy in this argument is that the Trinity study allows the nest egg to deplete to $0 and still consider it a success as long as it does not drop below zero before the 30 year mark.
If the market is averaging 8% returns overtime and we are only drawing down at 4%, won’t we end up making money and growing the nest egg? True, but that is not the point. We aren’t worried about the averages right now. When looking at the distribution of historical data, we need to consider the full range of probabilities including the “tails” of the distribution in order to achieve this same 95% confidence in a portfolio not failing as claimed in the Trinity study.
Accounting for Early Retirement Time Horizons:
One of the best spots to check out extremely detailed analysis of safe withdrawal rates is on Big ERN’s blog Safe Withdrawal Rate Series. His entire series covers an extensive review of scenarios and Safe withdrawal rates for the early retiree, including:
- Analysis of up to 60 years of drawdown
- Effect of preserving the nest egg vs depleting it
- Effect of Cape Ratios and sequence of returns risk
If you haven’t checked it out yet, I highly recommend the read.
So where do We Go from Here?
As I mentioned in the beginning, I have taken the 4% rule for granted; however, the assumptions that go with it do not necessarily align with my personal goals. We are planning for a much longer time horizon than 30 years. Also, I would like to have a nest egg that could be passed on to my children and a couple of charities that are important to us. For this reason, we are considering the effects of adjusting our personal plan. When doing so for yourself, there are a couple of points to consider:
- How long is your Horizon? I think it is fair to say that most early retirees are in the ~60 year range plus or minus a decade. Remember, it is going to be much easier to work a little longer while you are younger then it will be to find something in your 80’s if you run out of savings (even if it is a part time gig).
- Do you want a nest egg left to pass on to heirs? – This is the main concept behind “Capital Preservation vs. Capital-Depletion”. One of the benefits of preserving your nest egg, is that the safe withdrawal rate can be extrapolated out over extended time frames. This is not true for the trinity study which considered principal drawdown “ok” as long as it got the retiree to the 30yr mark before it went to $0. This is a concern because once the principal begins to be depleted, it becomes harder and harder to recover. A good analogy is the concept of living off the golden eggs and not hurting the goose that is laying them.
Based on these results, let’s turn to some of the research that Big ERN has provided in his blog:
Compare the 30 year results in table 1 and table 2. The scenario that gets cited for the 4% rule is the 50% Stocks/50% Bonds case for a 30 year time horizon. When accounting for nest egg preservation, the probability of success for 4% withdrawal drops from 95% to 50%. WTF! The success of the 4% rule relies heavily on drawing down off of the principal of your savings.
Running a 60 yr Time Horizon
So with that said, let’s assume a 60yr time horizon with 100% preservation as a conservative approach. What does this really mean from a savings rate and time horizon? Will we have to work an extra 10+ years of our life?
I am going to run with the 100% stock scenario and before you jump out of your seat, let me explain why:
- I am planning a long time horizon and I don’t want to eat the low returns from bonds over 60 years
- This time horizon is so long that even with the major volatility of stocks, there is very low risk of failing under the right drawdowns (as seen in table 2)
- Early retirees have a huge insurance against total failure. They can simply go back to work. The first 10 years plays a significant effect on the performance of the portfolio. If within the first 10 years, there are some concerns with the value of your portfolio, you can simply go back to work (or pick up a side gig!). This is much easier to do in early retirement than in traditional retirement. This advantage should not be downplayed.
There should be no surprise that the timeline to retirement is driven by savings rate. This was popularized in the FIRE community through the iconic The Shockingly Simple Math Behind Early Retirement post from Mr Money Mustache. The key is that there is a two fold effect by increasing savings rate. A higher savings rate means more money going to savings, but it also means that cost of lifestyle is lower (AKA the more of your income that is saved, the less you are living off of, which then means the less you need to save to maintain that lifestyle).
For this reason, we pulled in a couple of different scenarios for savings rates to review the effects on timelines:
Adding in the success rates from table 2, we can see the intersection of probability of success over time:
This concept can be reproduced for a rage of savings rates and scenarios. Notice that the difference in achieving the 4% (25x expenses) rule and a 3.5% (28.6x expenses)/3.25%(30.8x expenses) rule is only ~1.5-2 years within a data set. However, achieving a 4% rule takes approximately 4 years longer if savings rate is dropped from a 60% to 50%. Another way to look at it is that you can achieve a 3.25% (30.8x expenses) 2 years faster with a 60% savings rate than you can get to a 4% (25x expenses) rule on a 50% savings rate.
Thank you compound returns!
Insurance against failure:
Let’s say you decide to run the 100% stock scenario out until you hit a 3.5% drawdown on the 60 year horizon, this means that you have a 96% chance of success (see table 2). Huge! In the unlikely chance that it doesn’t work and you are uncomfortable with the direction you are heading in the first 10 years of RE, you still have youth on your side.
A small side gig, part-time work, or even starting your own business could easily stall and reverse the trend. You don’t even need to make that much! Simply supplementing your drawdown enough to take it from 4% to 3% or 3% to 2.5% will provide a significant probability of turning the trend around. The key is to create trigger points on when to pursue this option.
Just remember, the data utilized to create the tables above included all of the major downturns including the great depression.
This idea of being able to return to work if needed may also enable you to lean to the higher drawdown side, because your worse case scenario is going back to the life that you are living today (going back to work). Your worst-case scenario is everyone else’s normal life…
Also, remember that we are not even talking about averages here. On average, the 4% rule should result in significant growth. These rules are addressing the “tails”, the left side of the distribution.
It is important to fully understand the assumptions embedded inside of the 4% rule and not take them for granted. Early retirees must account for longer time horizons and the implications that come with them. The 4% rule is a great starting point as a rule of thumb. It provides a simple way to run out calculations on savings timelines and targets.
For those that are willing to risk going back to work or picking up a side gig, the 4% rule is an ok starting point. Remember, it is a game of probabilities and while there is a risk associated with it, the odds are in your favor based on all historical data.
For those not willing to take the risk, the difference in the 4% rule and a 3.25% rule is only a couple of years if you are running with a >50% savings rate. In the big picture, a couple extra years is a small price to pay for the peace of mind. This is especially true when you compare it to the decades of extra working years the “Normal” person will be committing to.
It all comes down to your risk tolerance. The good news is that your worst case is everyone else’s reality (I am sure I stole this line from someone else but it has been repeated throughout our community many times).
Educate yourself and don’t blindly take someone else’s advice. No one in as vested in your future as you are.
Until Next time, continue to Choose Beta