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! 🙂