The Bogleheads Forum is a great resource for investors, and in a recent discussion thread, user umfundi proposed/requested a new way to illustrate the results about sustainable withdrawal rates in retirement. I thought it seemed like an interesting way to express things, and since I have the resources to perform the necessary calculations, it seems like a pretty good topic for a post.
This is based on the idea behind the 4%
rule. What percentage of your retirement date assets can you withdraw,
and then adjust the amount of income provided by this initial withdrawal
rate for inflation in subsequent years, and sustainably maintain these
withdrawals throughout your entire retirement? The 4% rule is based on a
30-year retirement duration. But umfundi is essentially asking to see
the results for all the different possible retirement durations in order
to help coordinate one's planning for different retirement lengths.
we do this analysis, we naturally need to make some assumptions. I will
use Monte Carlo simulations, which use computer power to extrapolate
out hypothetical scenarios for future stock and bond returns. These
simulated returns need to be tethered around some assumptions. Often the
assumptions used to guide Monte Carlo simulations are historical
averages, which include an inflation-adjusted average stock return of
8.6% for the S&P 500, and with intermediate-term government bonds,
an inflation-adjusted return of 2.6%. In the second figure, I will
provide results for these assumptions, but I really think they are too
optimistic when looking forward from today as interest rates are so low
at the present. So the baseline assumptions I will use in the first
figure below are assumptions which I think are more realistic and come
from a very popular financial planning software program called
MoneyGuidePro. With their assumptions, average inflation-adjusted stock
returns are 5.5%, with 1.75% for bonds.
Two more assumptions we
need are at the asset allocation to be used by the retiree, and the
probability of failure that a retiree accepts for their strategy. For
these figures, I will simply use a 40% stock allocation, which I think
is within a reasonable ballpark for what many retirees will use (though
of course everyone's situation is different and 40% may not be a good
idea for any particular reader). About the probability of failure, the
whole purpose of these figures is to show what the sustainable
withdrawal rates are for different probabilities of failure over
different retirement lengths. So this is what is illustrated.
is worth suggesting one more note about how these results can be used.
Mainly, they are initial planning numbers about what might be a
reasonable withdrawal rate in retirement. Real people, when using
volatile assets like stock and bond mutual funds, will need to make
adjustments to their spending over their retirement. They will not play a
game of chicken in which they keep withdrawing the same amount as the
portfolio plummets toward zero. And so what the different probabilities
of failure really mean is that someone using a higher probability of
failure (which lets them use a higher withdrawal rate) is much more
likely to have to make cuts to their spending throughout retirement.
There is a trade-off here. Spending more today allows for more enjoyment
in the early part of retirement, but a larger chance of having to make
cutbacks in the future. People have to make their own decisions about
how they feel regarding these trade-offs.
And so this
brings us to our figures. This first figure is the one I would suggest
spending the most time with, since I believe it has a more reasonable
underlying assumptions about future market returns. We can look at this
figure in different ways. For instance, moving horizontally, let's
consider a 4% withdrawal rate. The figure shows that 4% should work for
22 years with a 5% chance of failure, 24 years with a 10% chance of
failure, 28 years with a 20% chance of failure, 32 years with a 30%
chance of failure, and so on.
Another way to look at the figure
is to follow one particular curve, such as the curve associated with a
10% chance of failure. With a 10 year retirement, a withdrawal rate of
over 9% could be used, while for a 20 retirement the withdrawal rate is
about 4.8%, for a 30 year retirement the withdrawal rate is about 3.2%,
and for a 40 year retirement the withdrawal rate is about 2.8%. For an
early retiree planning a 60 year retirement, the withdrawal rate they
can be expected to work with a 10% chance of failure is just above 2%.
final way to look at the figure is to move vertically and to note how
small increases in withdrawal rates can quickly result in higher failure
rates. For instance, consider a 30 year retirement. With a 5% chance of
failure, the withdrawal rate is just above 3%. If someone increases
their withdrawal rate to 4%, the failure rate will be somewhere between
20% and 30%. With a 5% withdrawal rate, the failure rate is already 60%.
I am also including the figure below based on historical averages
without further comment, except to note that you can see outcomes are
much more optimistic across the board, as this figure can be interpreted
in the same way. I know some people really want to hold onto the belief
that it is okay to use these historical average assumptions but I
suggest that readers beware when making their retirement plans based on
this second figure. I think the first figure is much more applicable.