I have noticed an unusual phenonemom: I write a post on one theme and your (i.e. our readers’) comments explore another one entirely!
This is a GOOD thing … it means – I hope – that we are building an online community dedicated to the idea of linking our finances to our life, rather than simply attempting to fit within society financial ‘norms’.
Case in point: I wrote a post exploring various windfalls, and the comments lead us down the path of exploring so-called ‘safe withrawal rates’, which is the idea that there is a Magic Percentage of your Number that is ‘safe’ to withdraw to live off each year.
The problem is, what % do you choose?
For example, I have proposed the ‘Rule of 20’ for calculating your Number, which seems the same as proposing a 5% ‘safe withdrawal rate’, but Jake disagrees:
A 5% drawn-down rate on the pot of gold is a little on the risky side if you want the money to last.
After looking at a bunch of data, I feel that a draw-down rate of 2-3% is too conservative, but 5-6% to aggressive. 4% or so seems right. I know, only 1% off from your value but over time it makes a huge difference.
So, Jake has highlighted one problem with selecting a ‘safe’ withdrawal rate … if you are out by even 1% your spending can be over (or under) the ideal by 20%. I don’t know about you, but a 20% payrise (or paycut) is a pretty big deal … people quit their jobs over less!
So, what do the experts recommend?
Believe it or not, there is support out there for just about any annual % of your nest egg that you may choose to spend, for example:
7% – Not so long ago, the financial services industry proposed spending as much as 7% of your portfolio each year in retirement.
6% – More recently, Paul Graangard wrote two books proposing a bond-laddering and stocks strategy that supported a spending rate as high as 6.6% of your portfolio each year.
5% – Investment funds routinely allow spending of 5% of the portion of their investment portfolios dedicated to simply keeping up with inflation. Indeed, my Rule of 20 appears to support this withdrawal rate, too.
4% – A large number of studies – probably, the most famous of which is the so-called Trinity Study – advocate spending up to 4% of your initial portfolio (ideally, 50% stocks and 50% bonds, rebalanced each year), which provides somewhere between a 90% and 100% certainty that your money will last at least 35 years.
3% – A whole slew of new retirement planning tools (generally using a Monte Carlo approach to modelling tens, hundreds, or even thousands of potential economic scenarios) have been released over the last 4 or 5 years by the financial services industry, purporting to analyse hundreds of alternative economic scenarios to try and model what would happen to your retirement portfolio (i.e. simulating changes in interest rates, market booms and busts, etc.) to find the ideal ‘safe’ withdrawal rate. The trouble is that a lot of these advocate very low withdrawal rates, typically in the 2.5% – 3.5% range.
2% – Some even advocate a totally ‘risk-free’ approach to retirement savings by investing close to 100% of your retirement portfolio in inflation-protected bonds (i.e. TIPS); historically, these have provided a 2% return, after inflation and with total protection of your starting capital.
So, which is right?
None, as TraineeInvestor explains in his comment to my post:
I’m not fan of draw down models either. If you have to spend your capital to avoid eating cat food (or the cat) or are working with a very limited time period fair enough. But with a sufficiently long time horizon, my view is that any draw down rate is dangerous – in fact I would be uncomofortable if my nest egg was not growing at at least the rate of inflation (after taxes and spending).
Another way of looking at it is that if you are relying on draw down of capital for living expenses you are very vulnerable to adverse events. No thanks – I’d rather sleep soundly at night.
Me too! 🙂
Do I get a boy-scout badge for being quoted? 🙂
I think the issue has two lenses through which you need to look at the withdrawal rate:
a.) The rate you use for planning purposes
This is like your rule of 20, or the way I would plan with the 4% figure: how much of the yield can you skim off the top of the barrel without depleting the principal AFTER inflation. I.e. you don’t eat into your pot of gold after adjusting its value for inflation. I think TraineeInvestor and I are in violent agreement on this one.
b.) The rate at which you actually withdraw
So now you actually hit your Number and retire or do whatever you want to do. You start living off your pot of gold. More specifically, you live off the returns you harvest above and beyond inflation. To avoid feast or famine situations, you need to use discipline. If your investments have a great year, only take out as much money as you have alloted to yourself via your withdrawal rate. To do not give in the temptation of spending all those extra returns you made. Why? Well next year could look like 2008 where you lost your shirt. You need to save in years of excess to afford to pay yourself in years of famine. That said, if a particular famine is esp bad, you may need to suck it up and tighten the belt regardless.
That’s a bit limiting for the planning isn’t it? I think you need some % to calculate your number.
I would suggest picking a conservative base % say 3% and in years your investments do well give yourself a “bonus”.
I never understood withdrawal rates. Maybe someone can help me out, or explain why I am wrong lol.
Lets say I am 55 years old (I am only 28 btw) and my current living expenses are $150K/yr and it doesn’t look like they are going down anytime soon. Who the hell cares what my “safe” withdrawal rate is…wouldn’t I just need to take my nest egg apply a historical growth rate (call it 3% call it 30% if you are AJC) and then withdraw WHAT I NEED TO LIVE. Not some made up number derived from a % of my nest egg?
@ Rick – >None = None of the Above 🙂
Seems to me ,when your figuring your number/date. You should be thinking of this withdraw scenario,so that when your no longer working, your able to live comfortably with what ever you have decided to withdraw. Be that 3 % or 10%.
I mean, isn’t that the idea of this whole thing? so we can do the things we want,at the date we wish to begin,and still have enough money to provide for us until death do us part?
@ Steve – sounds like a pretty good analysis to me! Thanks.
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