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I might even send one of you (by random selection) a surprise gift (HINT: think ‘apple’ and think ‘card’) AND you will be amongst the first to know what I’m up to over the next few weeks! Now, back to today’s post …
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Philip Brewer is the first to break ranks … that makes him a pioneer!
He’s the first personal finance writer to question the validity of the 4% Rule; I’ll let him do what he does best … explain:
There’s a rule of thumb that’s pretty well known to retirement planners: the 4% rule. It states that if you spend 4% of your capital in your first year of retirement, you can go on spending that much — and even adjust it for inflation — and you won’t run out of money before you die. That rule is starting to look kind of iffy.
The rule is just an observation: Over the past hundred years you could have followed the 4% rule starting in any year and you wouldn’t have run out of money. That’s been true because the return to capital has been pretty high, and because downturns have been pretty short.
So, that’s the genesis of the 4% Rule … basically an assumption that if inflation runs at 3%, you can get at least 7% return on your investment (the difference being the amount you can spend: 4%). But, most investments haven’t ‘returned’ 7% – or anywhere near that – for quite some time, as Philip explains:
Stock investors saw some price appreciation in the 1990s, but there’s been no appreciation since then. In fact, your stock portfolio is probably down over the past decade, even with reinvested dividends.
… and bonds and cash haven’t fared much better, certainly not enough to keep up with inflation and provide spending money for a retiree!
The problem is we’re trying to fit a square peg into a round hole:
Square Peg
Bonds, cash, and stocks are all capital investments (my term); they are designed to hold (preferably, appreciate) the capital that you put in.
You create ‘income’ from these investments: (a) from their (relatively speaking) meager dividends, and/or (b) by selling down your portfolio as needed. The 4% Rule says that the amount that you need to selll down SHOULD be offset by the increase in value of what you have left even after accounting for inflation.
The problem is in the ‘SHOULD’ word: this should all work, but as Philip points out, there are times when it doesn’t …
Round Hole
When you are retired you shouldn’t spend capital unless you print the stuff … or, at least, have an unlimited supply.
You don’t want capital, when you are retired, you really want income.
Specifically, you want a certain amount of income – and, you want regular pay increases (at least enough to keep up with inflation) – just like when you were working.
But, you want it:
a. without needing to work, and
b. without running the risk of being ‘fired’ (i.e. having your retirement income run out).
Other than some nebulous (perhaps, for you, well-defined) need to leave some of your hard-earned, precious, irreplaceable, capital behind for charity, your cat, and/or the next generation, you really don’t – shouldn’t – care very much about it, except for its ability to provide that much needed income.
So, why try and cajole capital-appreciating assets to do the work of your former employer, when there are perfectly good investments out there specifically manufactured for the sole purpose of:
1. At least maintaining their own value (ideally, after inflation), and
2. Providing you with an income, indexed for inflation, for your life or the life of the asset (whichever comes first).
A few such assets immediately spring to mind … each with their own pros/cons (which we can explore in the comments and/or future posts):
1. Real-estate: it tends to increase in value according to inflation; it tends to provide semi-reliable income that increases (again) with inflation,
2. Inflation-indexed annuities: you give up claim on the capital in return for a guaranteed (well, as long as AIG or its like stays in business) income that increases with inflation,
3. Treasury Inflation-Protected Bonds (some Municipal MUNI’s also do much the same): These guarantee that your capital will increase with inflation, and you can ladder them cleverly to provide some semblance of a (albeit low) income stream that increases with inflation.
Of all of these – and, in retirement – I like 100%-owned (i.e. paid for by cash) real-estate the best; what do you recommend?
Inflation is a major concern for all people looking at a financially secure retirement of any reasonable duration. Do a spreadsheet or use one of the many on line calculators and compare 3% inflation against 5% inflation. The results will be very very different.
I’m going for a mix of real estate and equities. Neither will track inflation too exactly, but they will at least have the potential to grow over time. Bonds etc won’t. I’m also happy to carry some mortgage debt against some of the properties as long as interest rates are below the true rate of inflation (which they are out here in HK thanks to the Fed making inflation america’s biggest export).
TIPS don’t cut it for me. Not only because I believe that US CPI lags (i) HK inflation (ii) inflation in the real world and (iii) my personal cost of living increases, but because I want a real rate of return. I want to do more than barely break even.
@ TraineeInvestor – For me, the advantage of TIPS would be that they guarantee an after inflation return. The disadvantage is that the return is so low that my Number would need to be 2+ times larger than, say, an R/E only strateg.
However, if I had enough cash to provide my required living expenses, then I would go for the guarantee, every time. Note that this is quite opposite to my “still aiming for my Number” philosophy!
Surely Philip is not the first one. It’s fairly well-established (by the original Monte Carlo paper) that the 4% rule is only good for 30 years. Also it only pertains to a broad market total return portfolio. For shorter periods I’ve seen people quoting up to 7%. For longer periods, 3% or less seems to be in order.
For more extensive discussions see Bob Clyatt’s book.
There is so much investment advice out there, with more than a few voices directly opposite each other in philosophy, that I don’t trust any one strategy anymore. That’s why the hubby and I own real estate, mutual funds, and our own business. We’re covered no matter who’s right or wrong. So far, it’s been a smashing success. :0D
@ ERE – Thanks, Jacob. I have seen that book, and will certainly read it. As you might imagine, being 49 when I (fully) retired, I investigated the whole subject of so-called ‘safe’ withdrawal rates VERY closely.
Monte Carlo analysis certainly showed rates in the high 2’s to low 3’s, depending on which tool that you chose … all the way up to Paul Grangaard’s stock + bond laddering system at 6.6%
Then I realized that statistically you may have 90% chance of staying dry, but if you are outdoors without an umbrella when the storm hits ….
In short, I reject ANY statistically-based withdrawal rate in favor of RENEWABLE (even after taking inflation into account) retirement income. The only ones that even come close for me are 100% owned real-estate; TIPS, and possibly inflation-indexed (VERY expensive!) annuities. I’d certainly like to hear what others say (but, don’t even get me started on ‘dividend stocks’!).
I don’t want ANY chance of my money running out before I do (global depressions, war, pestilence aside) 🙂
@ MelodyO – coming from somebody who’s actually become rich from (2 out of three of) the strategies you name, I can only say PERFECT …
… but, delete the Mutual Funds and buy Phil Town’s book, instead (Rule # 1 Investing). It’s more fun, to boot! If that’s too much work, do what Warren Buffett suggests: buy super low-cost index funds (dollar cost average in) and you will still beat the mutual funds by about the same % as their fees! 🙂
which do i recommend? i recommend a combination of building/ selling businesses and investing in stocks and perhaps a few bonds.
Adrian
With respect there is no 100% safe option anywhere. When Money Dies(Adam Fergusson) was a bit of an eye opener there – even real estate failed to preserve its real wealth when the currency failed. It’s one of my two preferred asset classes, but it does not come with any guarantees – look at Germany in the hyperinflation of the early 1920s and Japan post-1990 as examples.
TIPS are only a guarantee if CPI is an accurate measure of inflation where you live and there is no tax leakage and CPI matches your personal cost of living increases. The Forbes cost of living well index has outstripped CPI by a big margin every year since they started publishing it. I’d like to be able to continue living well.
Put differently, if (i) the trailing earnings yield on a very diversified basket of stocks is greater than the yield on TIPS + CPI AND (ii) the dividend yield is enough to meet my needs without reaching for high yield stocks, I would sleep easier with the stocks. And yes, I accept that I am taking on a different set of risks compared with TIPS but as Max Gunther said “if you’re not worried then you’re not risking enough”.
I’m with MelodyO on covering all the basis though.
@ TraineeInvestor – With double respect I said “global depressions, war, pestilence aside” 😉
I have a friend who retired circa 2000 with a basket of stocks; he now has one truck delivering stock to grocery stores to supplement his income … sometimes he has to drive or carry boxes himself (not a problem unless you’re retired …. even then, it’s probably good exercise!).
I have another friend who has a basket of real-estate: he had 50% equity, now he has 20% equity … but, he doesn’t (greatly) care: he’s not selling and he still has rental income!
Rental real estate is a great investment, but only if you want to be a landlord.
A great deal of the rent is not a simple return to capital, but actually payment for landlord services like finding tenants, maintaining the structure, repairing things that break, etc. Hiring someone to do that work for you costs enough that you’re no longer going to get a return that’s much better than you’ll get from more passive investments like stocks and bonds. (Especially not once you factor in losses due to the property occasionally being vacant.)
Thanks for the link!
@ Philip – Say that you need $100 a week to live off (inflation indexed) for the rest of your life.
What matters more? Getting the best return on the $200k that you retired with, or NOT losing the $200k?
What do you do if the stock market halves?
I don’t mean to push stocks as preferable to real estate for the income investor! I just want to acknowledge that owning real estate is as much like a second job as it is like owning a dividend-paying stock.
My own inclinations have lead me to investing in a mix of stocks and bonds (including some inflation-indexed paper). But rather than investing in real estate and working as a landlord, I went ahead and put that fraction of the money into more stocks and bonds and am working as a writer.
It’s work I’m much more suited to than work as a landlord (which I’d do poorly while hating every minute of it).
@ Philip – Agree! In fact, My point also isn’t to invest in R/E: it’s to invest (in retirement) into vehicles that EITHER:
a) guarantee your capital + provide an indexed income stream that’s sufficient for your needs (e.g. TIPS / Inflation-Indexed Annuities)
OR
b) tends to grow your capital with inflation + provide an indexed income stream that’s sufficient for your needs (e.g. Real/Estate)
Then you have to argue whether stocks can provide b): I say ‘no’ …
Is your real-estate 100%-owned (i.e. paid for by cash)?
@ Bob – Not yet; but, it’s definitely the strategy that I want to put in place with the condo’s (apartments) that I keep after building these two condo projects:
http://7million7years.com/2009/09/09/ive-been-out-shopping/
Real estate v stocks – which is better: http://money.cnn.com/galleries/2007/real_estate/0704/gallery.stocks_v_realestate.moneymag/index.html
YMMV – with a lot depending on the specifics of which piece(s) of real estate are being compared to which stock(s) (and which markets and which time periods) but taken as a whole there seems to be much more evidence that stocks provide better long run returns than real estate. When it comes to individual pieces of real estate and individual stocks there will be much greater variations in returns and risks – which is why I want to own both.
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