Note: it probably makes most sense to read these posts in order, i.e., starting from #1, but it’s up to you.
Since I came out of the financial closet by announcing that I would finish work at the age of 50, a number of people have asked me how I have managed to do this. (I have been surprised that more people haven’t asked. I would have thought that everyone would want to know.) For the millennials, the answer is pretty straightforward: read my blog, save lots of money, and don’t buy mutual funds.
This link has more information about “Couch Potato investing”. I think it is a simple, straight-forward approach to investing that does not require a lot of research or knowledge about markets.
For people of my own generation, it is more difficult. There is an old saying that the best time to plant a tree is twenty-five years ago. But I do think that switching from mutual funds to exchange-traded funds, or even better to dividend stocks and REITs can help a Gen-Xer or Baby Boomer get more juice out the oranges they have at this stage of life. By improving an investment strategy, it should be possible to safely draw more than people are thinking they would be able to draw, meaning that people can retire earlier or better than they might think possible now.
A common rule-of-thumb used by people in the financial sector and by do-it-yourselfers is the “4% safe withdrawal rate (SWR)”. The SWR is frequently cited as a financial planning guide for retirees. The idea is that you can set your annual withdrawal as 4% of your portfolio at the time of retirement, and adjust it for inflation annually. So if you have $1 million when you finish working, you can withdraw $40,000 in the first year, and then adjust that amount by inflation every year, and your money will last at least 30 years in the large majority of cases.
The 4% SWR comes from the “Trinity study” which was published by three professors from Trinity University in Texas: Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz.
The authors studied historical U.S. stock and bond returns from 1926 through 1995 to determine sustainable withdrawal rates. They looked at different possible portfolio compositions of stocks and bonds, and evaluated the impact of fixed annual withdrawals. The result that is commonly cited is that someone with a 30-year planned retirement would have been safe in withdraw 4% of the balanced portfolio in the first year of retirement, and then adjusting that amount only for inflation each year, regardless of what year they retired in, for all 30-year periods. In other words, it works in the worst-case scenario without any adjustment to withdrawals.
I spit in the face of the 4% rule.
I am not criticizing the work of the Trinity professors, only its usefulness in telling me how to manage my portfolio.
For every complex problem there is an answer that is clear, simple, and wrong.
— H. L. Mencken
As with any complicated issue, people look for simplifications, and the 4% SWR is just such a simplification. Anyone planning a retirement (their own or a client’s) is doing the retiree a great disservice by incorporating such a gross simplification into their calculations. Like the “70% of income rule” mentioned in post #8, this “rule” should only be used in early stage of analysis. It is like a back-of-the-envelope calculation that you do until you can do the proper analysis.
The authors of the study do not, in fact, recommend taking a fixed withdrawal from any portfolio: “Mid-course corrections likely will be required, with the actual dollar amounts withdrawn adjusted downward or upward relative to the plan. The investor needs to keep in mind that selection of a withdrawal rate is not a matter of contract but rather a matter of planning.” So they reject the idea that someone would actually take the fixed (inflation-adjusted) amount out every year regardless of market conditions.
Our withdrawal rate is based on actually modelling income, spending, rates of return, and taxation over a 45-year time horizon. It starts at about 6%, rises to 10% when we are 65, then falls back to 6% because pension, Canada Pension Plan and Old Age Security start up. After 65, the withdrawal begins to rise gradually. This may be shocking, and devotees of the 4% rule will tell me that we are heading for financial ruin, so I am going to explain why flouting the 4% rule doesn’t scare me, and I think it shouldn’t scare most people.
So let’s get one thing out of the way: the yield on our portfolio at the end of March 2016 is 5.6%, and I am pretty confident that the income stream I have established is reliable. A 4% withdrawal rate from a portfolio that is yielding 5.6% means that our assets would grow over time, and would soon grow rapidly, rather than being paid out. As we have no particular reason to leave a legacy, that would mean a much more parsimonious post-work life than we need to have.
There are a lot of other reasons why the 4% rate should just be a starting point for a discussion about decumulation, and should never replace actual analysis.
The 4% was based, as others have noted, on the original portfolio, with adjustments to the withdrawal amount for inflation. There is nothing wrong with calculating your withdrawal on the current value of the portfolio, but 4% has no meaning or basis in this approach. 4% would be a random or arbitrary percentage.
It was based on a “balanced portfolio of U.S. stocks and bonds”, not on our portfolio which is (a) almost all stocks, and (b) designed to generate income from dividends and REIT distributions. My withdrawal will be related to income from my portfolio, not a figure taken from a different methodology.
Someone whose investments are in higher fee mutual funds, or in investments that do not produce a reliable stream of income, or who wants just a simple rule to follow instead of doing a full analysis, would have good cause to be more conservative than our plans is allowing. 4% could be closer to the right number for them. The trade-off is a shorter, more frugal retirement.
As I noted in post #7, we will have a cash cushion of Guaranteed Investment Certificates [CDs] and a pool in a high interest savings account so that we don’t have to sell off our dividend stocks or REITs during a downturn. If we use these up during a downturn, we will replenish them when share prices recover by selling off at a higher value. This means that in a downturn, I will not be undermining future income streams by selling shares off cheaply.
With less than a month to go, I remain convinced that our plan is prudent.
Thank you for reading. Comments are welcome.