How to Retire Early (The 4% Rule?)

Hey. I recorded this video well before the  Coronavirus situation really started to play out. And the reason that I’m mentioning that now in  this introduction is that I think it ties in really well with the topic.

The New York Times  had a piece on how the FIRE movement is being or is expecting to be impacted by the coronavirus  situation and the expectation is that it could have a big negative impact on people who were  retired very early and living on the 4% rule and a lot of the reasons why are going to  be discussed in this video why the 4% rule might not be sufficient for a  very early retiree with sixty year time horizon. Now with everything going on  in the world this just hasn’t felt like the right video to release. I’ve been trying to work on more  relevant content.

But why am I releasing it now? Well I’m out of content, and not because  I’m out of ideas, I’ve just been out of time recently. My wife and I had a new  baby, our fourth about a month ago.

And so yeah. I’ve just been strapped for time.  And I had this recorded so I’m releasing it with this introduction to make it a little bit more  relevant and then I'll be coming out with more new content soon.

But I just didn’t want this channel  to get stale. I do hope you enjoy this video. Nobel Laureate William Sharpe has referred to  retirement income as the “nastiest, hardest problem in finance.

” The 4% rule for retirement  spending has gained popularity as a simple answer. The rule says that you can safely spend 4%  of an investment portfolio in the first year of retirement, and then adjust that amount for  inflation each year for the rest of your life. Distilling a complex problem down to  a simple rule of thumb can be useful, but the 4% rule for retirement spending has  some serious flaws.

And even beyond those flaws, the retirement income problem is complex  enough to warrant a more involved discussion. I’m Ben Felix, Portfolio Manager at PWL Capital. In this episode of Common Sense Investing I am  going to tell you how to fund an early retirement.

The 4% rule makes retirement  math exceptionally easy. Take your required expenses and divide by 4%. If  you want to spend $40,000 per year in retirement, divide $40,000 by 4% and you have a $1m required  portfolio to meet your retirement income goal.

In its design, the 4% rule is meant to deal  with the main risks that a retiree faces. Once you have decided to stop  working, or stop working for money, you will likely be relying on relatively risky  assets, like stocks and bonds, to sustain a steady stream of income. This introduces a unique  retirement risk called sequence risk.

Funding a steady stream of income using a volatile  asset like stocks poses some big challenges. Sequence risk is based on the fact that repeated  negative returns early on in the distribution period can have a meaningful long-term  impact on the ability to fund your lifestyle. As if sequence risk weren’t enough to  deal with, we are also planning for an unknown period of time - nobody can  predict how long they are going to live.

This risk is called longevity risk. Together, sequence risk and longevity risk make planning  for a secure retirement a unique challenge. Let’s come back to the 4% rule - the supposedly  simple solution to the retirement income problem.

The 4% rule was designed to address sequence risk,  and it did touch on longevity risk. I’ll explain the genesis of the rule. William Bengen,  a financial planner, wrote a paper in 1994 with the creative title Determining  Withdrawal Rates Using Historical Data.

Bengen took historical data for US stocks and  intermediate term treasuries and tested how long a portfolio of 50% stocks and 50% bonds would be  able to sustain various levels of withdrawals. Bengen modelled withdrawals starting  as a percentage of the portfolio and increasing with inflation each year. The  result is constant inflation adjusted spending.

He tested withdrawals starting each calendar  year from 1926 to 1976 and observed how long the portfolio lasted at each starting point. For a  30-year retirement period with a 50% stock and 50% bond investment portfolio, Bengen found that  a 4% withdrawal rate was always sustainable. This research was further supported  by the 1998 paper Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable by  Cooley, Hubbard, and Walz, commonly referred to as the Trinity Study.

Instead of using intermediate  term treasuries as fixed income, the Trinity Study used long-term high-grade corporate bonds. This  decision to use riskier bonds ended up resulting in a 4% withdrawal rate being successful  only 95% of the time in the historical data. A 95% success rate sounds great, but this  is only true in the historical data.

A retiree today should not expect a 95% chance  of success with a 4% starting withdrawal rate. I’ll explain why that’s true in a minute,  but first we have to come back to one of the most important assumptions built  into the 4% rule: the time frame. The 4% rule was based on testing a 30-year  withdrawal rate in the historical data.

This video is about retiring early. How many early  retirees are planning for a 30-year horizon? Bengen based 30 years on a 60-65 year-old investor and added roughly ten years onto  normal life expectancy to plan for longevity risk.

A 40-year-old retiree would  usually expect to live for more than 30 years. If we repeat the same analysis for a 40-year  period, the 4% rule has a success rate of 87% with a 50% stock and 50% bond portfolio.  Longer time periods will see more failures.

One consideration might be increasing the  weight in stocks to improve the outcome. The paper Safe Withdrawal Rates:  A Guide for Early Retirees by earlyretirementnow. com looked at longer  retirement periods and higher equity weights.

Expanding the analysis to longer time periods  and more aggressive stock allocations, they found that while anywhere between 50 and 75%  stock exposure resulted in great results for a 3. 5% spending rule over 30 years, moving out to 60  years required much higher stock exposure in order to reach a comparable success rate. They found  that for 60-year horizons, higher equity weights give better results.

Anything below 70% in stocks  becomes precarious over such long time frames. To quote earlyretirementnow, “Over  longer horizons, bonds are bad! ” This finding is extremely important for any early  retiree.

In the historical data bond exposure over very long periods of time is arguably riskier  than stock exposure. This looks fine on paper, but investors are myopic. They evaluate  long-term decisions with a short-term view.

You still have to live with the volatility  of stock exposure in your investment account. I’m not saying that you shouldn’t have an  aggressive portfolio if it makes sense for the situation, but I am saying that an aggressive  portfolio can be stressful even if it makes sense. I think that we have established that  the 4% rule is probably not useful when it comes to retirement planning in general  and especially early retirement planning.

Increasing the weight in stocks might support a  3. 5% withdrawal rate in the historical US data, but we are still missing some important pieces.  Everything that we have covered so far centers on historical US stock and bond data.

There is  a good chance that the historical experience of the US financial markets might not be  representative of expected future returns. There are a couple of different ways  that we can think about this. The first one is looking at the 4% rule based on  stock market data from other countries.

Wade Pfau documented this analysis in his  book How Much Can I Spend in Retirement using data going back to 1900 through 2015 for  20 developed market countries. He found that the only other country that could have historically  sustained a 4% withdrawal rate for a 30-year retirement period was Canada. 18 other countries  would have had failure rates between 8 and 62%.

The global stock market as a whole would have  sustained a 3. 5% withdrawal rate historically. It’s also important to point out that  the 20 countries in Pfau’s data set are the countries that made it into the dataset  - there is survivorship bias potentially making things look better than they actually are. 

Countries like Argentina, Russia, and China did not make it into the dataset, but you can be sure  that they would not have historically sustained a 4% withdrawal rate, and they would pull down that  3. 5% safe withdrawal rate for a global portfolio. Getting our heads out of the US was  important, but we are still stuck in history.

Today stock valuations are  high relative to the past. Bond yields are historically low, or even  negative depending on where you look. Nobody can predict the future, but stock valuations  matter a lot to expected future returns.

In the 2019 edition of Aswath Damodaran’s  annually updated paper Equity Risk Premiums, Determinants, Estimation and Implications  Damodaran demonstrated that the earnings yield is the best predictor of the future equity  risk premium. It’s still far from perfect, but it is the most reliable metric that we  have for forecasting future stock returns. The earnings yield can be found by taking the  inverse of the Shiller cyclically adjusted earnings.

For example, if the Shiller CAPE for US  stocks is currently 29. 71, we take one divided by 29. 71 to find the earnings yield.

This gives us a  result of 3. 36%, which is the expected real return for US stocks. The geometric average real return  for US stocks from 1900 through 2019 was 6.

5%. Interestingly, 6. 5% is roughly what the historical  average Shiller CAPE ratio would predict.

Think about that for a moment. We are looking back  at 119 years of data for US stocks during which the 4% withdrawal rate was sustainable, but over  that period valuations were considerably lower, and the average historical returns that we see  are commensurate with those lower valuations. Today’s high stock valuations  forecast much lower future returns.

Applying any historical analysis to  today’s starting point does not make sense. Knowing the limitations of historical  data due to currently high valuations, one approach to testing spending rules  involves using current expected returns and simulating future periods using  Monte Carlo simulation. Monte Carlo involves randomly sampling returns from a  defined distribution of potential outcomes.

Using Monte Carlo for a 60-year period  with current expected returns for a 100% stock portfolio consisting of Canadian, US, and  International stocks, and ignoring taxes, I find a 2. 5% safe withdrawal rate where safe means a 5%  chance of failure. This analysis is interesting for more than observing the safe withdrawal rate. 

It also allows us to see the range of outcomes. In the worst 10% of outcomes our 60-year spending  period left the investor with $1m adjusted for inflation, while in the best 10%, they were  left with around $30m adjusted for inflation. That massive range of outcomes  seems inefficient, and it is.

In a 2008 paper titled The 4% Rule—At What  Price? , William Sharpe and two co-authors explain: “Supporting a constant spending plan using a  volatile investment policy is fundamentally flawed. A retiree using a 4% rule faces spending  shortfalls when risky investments underperform, may accumulate wasted  surpluses when they outperform, and in any case, could likely purchase exactly  the same spending distributions more cheaply.

” In simple terms, retirees who use a fixed  spending rule from a portfolio of risky assets to fund their inflation-adjusted  lifestyle needs are overpaying for the potential of investment gains that they do not  need to meet their retirement income goals. More efficient solutions to this problem are  mathematically dense and often involve complex financial products like options, leverage, and  annuities, but there are some spending rules out there that approach a more efficient solution  without getting too complicated to implement. In a 2017 paper, Vanguard explained some potential  approaches.

The authors explain that there is a spectrum of spending rules that depend on the  preferences of the retiree. Constant spending rules like the 4% rule cater to the preference  of spending stability while risking premature portfolio depletion or inefficient consumption. At  the other extreme, spending a constant percentage of the portfolio each year results in no chance  of depleting the portfolio and more efficient consumption, but it also results in potentially  wild swings in the annual spending amount.

The Vanguard paper suggests a middle ground  where spending is a percentage of the portfolio, but is only allowed to increase up to a ceiling  or decrease down to a floor. The ceiling and floor can be tailored to the needs and preferences of  any retiree, keeping in mind the trade-offs at each extreme. In their paper they use a 5% ceiling  and a 2.

5% floor. Keep in mind, though, that in bad markets there could be multiple years of  spending reductions required to follow the rule. Finally, I think that one of the most  important considerations for any early retiree is their ability to earn an income.

That might  sound counterintuitive - are you really retired if you are still earning an income? If you are  able to do something that you love and earn a little bit of income doing it, you are effectively  introducing a large safe asset to your portfolio. This changes all of the retirement math -  maybe you only need a 2% withdrawal rate to supplement your earned income. 

Plus, work is important for humans! Martin Seligman’s PERMA theory of well-being  suggests that there are five building blocks that enable flourishing – Positive Emotion, Engagement,  Relationships, Meaning, and Accomplishment. Working at something that you love to do,  even if it doesn’t make a ton of money, is a great way to get engagement,  meaning, and accomplishment.

For early retirees, the 4% rule is not  useful. Based on a longer time period, global data, and current market valuations a  more reasonable guideline might be closer to 2%, and even then, constant inflation  adjusted spending is both risky and inefficient. Alternative spending  strategies like Vanguard’s dynamic approach might be part of the solution, but any early  retiree should also keep in mind the possibility of finding ways to turn themselves into a safe  asset by continuing to earn a bit of income.

Thanks for watching. I’m Ben Felix of PWL Capital  and this is Common Sense Investing. If you enjoyed this video please share it with someone who  you think could benefit from the information.

And don’t forget, if you’ve run out of  Common Sense Investing videos to watch, you can tune into to weekly episodes of the Rational  Reminder podcast wherever you get your podcasts.