I had the distinct pleasure of spending time with my wife’s family this week. Between catching up on life events and helping with a few household chores, my father-in-law (let’s call him John) took the opportunity to ask his financially-minded visitor a question directly pertinent to his own immediate goals.
“How can I use my investments to cover the bills in retirement?”
I knew that John is a CPA and a knowledgeable investor who has actively traded his family accounts for years. So as a well-educated student of retirement finance, I naturally jumped in to an explanation of safe withdrawal rates, retirement spending methods, and how portfolio theory can be used to tweak the numbers to safely spend a certain percentage of his portfolio every year without fear of running out of money over his expected lifetime. John listened intently and replied with a deceptively simple follow-up question:
How do you guarantee that level of investment income every year?
That’s a terrific question, and the simple answer is you don’t have to. But that’s the exact moment I recognized my own investing bubble. The internet these days contains more information than ever about every nuance of retirement finance, but the gap between the theory debated by eggheads and John’s completely rational income-driven paradigm is just as perfectly normal as it is surprisingly wide to bridge.
I was talking about systems theory, and he just wanted to directly replace income. Which makes perfect sense! And I imagine many of you may have the same question.
So rather than jumping into a painfully long series on every possible way to tweak the numbers, let’s start with the basics. If you’ve ever wanted to know how to safely move beyond depending on regular work income to pay the bills, this article is for you.
Vanguard has always been one of the most respected voices in the investing industry, and its values have defined a whole generation of DIY investors. Jack Bogle started the first index fund in 1976 and took a lot of heat for that decision among his contemporaries who felt that “Bogle’s Folly” was destined to fail. But he was a true visionary, and his dedication to low costs and customer-centric business practices helped build the company into the financial titan it is today. So when Vanguard speaks, people listen.
I’ve always been a big fan of road trips. Some of my fondest memories involve cruising through unknown roads soaking in beautiful scenes with the music turned up on the radio. Of course the best road adventures also involve a bit of concentration, as the most magnificent mountain vistas often come hand-in-hand with challenging hairpin turns. So even though road trips are a blast, you still have to be careful to avoid dangerous situations like taking a cliff-side turn with too much speed.
As a responsible driver acting in an abundance of caution, imagine for a moment planning your route ahead of time and deciding to set your cruise control for the entire trip to the minimum speed required to safely navigate the most dangerous turn. So even with miles of straight highways with no other cars in sight, you choose to never exceed 10mph. Sure, it will take you ages to get to your destination. And it might seem like not only an extremely inefficient way to travel but also a complete waste of the engine under the hood, but at least you won’t have to worry. Is it worth it?
I assume most people will find that idea completely silly and unrealistic, as dynamically adjusting your speed to the conditions of the road is a natural part of any intelligent driving experience. So why do so many people take this over-cautious approach with their retirement planning?
Perhaps because of the proliferation of personal finance websites focusing on early retirement, I’ve noticed a lot of talk lately about safe withdrawal rates. I think this is absolutely terrific, as financial independence is one of the single most empowering life goals one can pursue! But greater exposure also has its downsides, as core assumptions such as the portfolio options, withdrawal method, and retirement length don’t always scale the way you might think and misconceptions can quickly propagate.
Withdrawal rates are an intellectual passion of mine, and I’m always looking for opportunities to contribute to the conversation. And with the recent boon in global portfolio data, I’m finally able to address one of the biggest questions that I’m starting to see more frequently these days.
Does the 4% rule apply outside of the United States?
I’m always on the lookout for ways to improve the tools on Portfolio Charts, and Siamond really came through with his latest update to the Simba spreadsheet. Buried in the heaps of interesting returns data is something really cool — direct calculations for safe and perpetual spending rates for a given investing period. Based on an equation from a Morningstar white paper, they are particularly elegant compared to my old method and allow me to significantly improve the speed and stability of the Withdrawal Rates calculator. And by doing so they open up a great deal of additional data that was previously too laborious to manage.
Well I’m a sucker for new data, and in the process of updating the calculator mechanics behind the scenes I took the opportunity to revisit an old question I’ve been wrestling with for a while.
How do you calculate a 40-year withdrawal rate when the worst start date for a particular portfolio was less than 40 years ago?
There’s a decent chance that anyone who has considered retirement with some amount of self funding has heard of the concept of the safe withdrawal rate — the amount of money that one can safely spend every year without prematurely running out of money. First proposed by William Bengen in 1994, the math is pretty well established by now and many well-respected authors have written extensively on the subject dissecting it from different angles.
There’s also a pretty good chance that that the average person following a safe withdrawal rate does not actually understand how it works, and that lack of context can cause quite a bit of confusion. You see, the various studies and calculators that determine SWRs do so based on a myriad of very narrow assumptions, and breaking from those assumptions also breaks the conclusions. I’ve written quite a bit about the asset allocation assumption and the withdrawal method assumption, and I recently realized that I’m due for a discussion on another key assumption — how long do you plan to be retired?
In all my years of working, I have yet to run across someone who didn’t appreciate getting a raise or become really agitated with the prospect of taking a salary cut. Justified or not, the way that income level sets personal expectations seems to be ingrained in each of us from a young working age. And after thinking that way for perhaps decades, it should come as no surprise that such a mindset doesn’t necessarily immediately evaporate the day we retire. If you have a choice, do you really like the idea of leaving retirement income on the table?
So when studying the ins and outs of retirement finance, one little detail tends to really nag at the minds of certain optimization-oriented people — the assumption about the retirement spending method.
After publishing a few tools and articles based on safe withdrawal rates, one of the most common questions I’ve seen so far is some iteration of this:
Obviously higher returns support higher withdrawal rates. That’s why I invest in 100% stocks! How can a lower-return portfolio possibly support higher withdrawal rates than a higher-return portfolio?
I admit the answer is fairly unintuitive, and explaining this without getting too deep into the weeds is a bit of a challenge. I’ve touched on it here and there around the site, but this is an important concept that deserves a thorough explanation.
Several years ago I discovered the concept of financial independence, and the idea was a revelation. Life too often becomes a series of developed habits, and the process of questioning the basic assumptions behind those habits and envisioning a system where your investments can do the work for you to fund your lifestyle in perpetuity was a life-changing exercise.
As an engineer with a math minor, I was especially taken by a few prominent retirement studies on the subject of safe withdrawal rates. They famously came to the conclusion that for a traditional mix of stocks and bonds one could have retired with a 4% safe withdrawal rate, adjusted their expenses for inflation each year, and had a successful 30-year retirement with a high amount of certainty historically. The process they used for back-testing retirement scenarios was fascinating, and the results form the backbone of the vast majority of retirement advice today.
So I dove in and explored the data and assumptions and engaged full-force in various early retirement communities online. I played with a few of the prominent retirement calculators out there and tinkered relentlessly. Anyone else who has done the same can understand how intoxicating it all can be.
So much so, that after building my own models I realized a lot of people totally misinterpret the conclusions and get it all wrong!