Welcome back! It took me two weeks again to put together a full blog post. That’s what early retirement does to you! Especially while we travel – pretty much permanently between now and December – I figure I will scale down the blog frequency to every 2 maybe 3 weeks. I hope people don’t mind. If two weeks is what it takes to come up with quality content then so be it!
For today’s post, I thought it was time to add another installment to the Safe Withdrawal Rate Series. 25 posts already! What have I learned after so many posts? Well, I started out as a skeptic about the so-called “4% Rule” and I thought it might the time to poke a little bit of fun at the “makers of the 4% Rule.” Just to be clear, this post and the title are a bit tongue-in-cheek. Obviously, the “makers” of the 4% Rule, the academics, financial planners and bloggers that have popularized the rule aren’t part of any conspiracy to keep us in the dark. Sometimes I have the feeling they are still in the dark themselves! So here are my top ten things the Makers of the 4% Rule don’t want you to know…
1: We actually mean “4% Rule of Thumb“
As I said before, here on the blog and in various podcasts, there is no one-size-fits-all solution to safe withdrawal strategies. Suggesting that we should follow a 4% Rule is about as ludicrous as suggesting that we should all wear size 10 shoes. No, I should correct myself; it’s actually more ludicrous than prescribing size 10 shoes for everyone! Different folks have different shoe sizes, but at least during my adult life, my shoe size hasn’t changed. It’s always been 14, hence the name Big Ern! Not so for safe withdrawal rates! There is both idiosyncratic variation across people, i.e., person A will potentially require a very different withdrawal rate from Person B, just like they have different shoe sizes. But sustainable withdrawal rates can and should also vary over time even for one single individual depending on asset price valuations, i.e., bond yields and equity price-earnings ratios, see Part 3 (Equity Valuation) and Part 18 (CAPE-based rules) for more details! At the bottom of the 2009 bear market, you’d have to be crazy to withdraw only 4%. A 6% initial withdrawal rate would have been more appropriate! But almost 10 years into this economic expansion and bull market, I like to operate a bit more cautiously, especially looking at today’s high CAPE ratio! Boy, am I glad my shoe size doesn’t fluctuate that much over the business cycle! I would have spent a fortune on shoes over the years!
2: The 4% Rule is likely way too conservative for many early retirees
Just for the record, I have come across a lot of case studies where a 4% withdrawal rate would have been way too conservative. Even with today’s expensive equity valuations, i.e., a Shiller CAPE above 30! I did a total of ten case studies for readers of my blog who volunteered their early retirement plans and finances and I was positively surprised by how well positioned a lot of early retirees were. Many expect sizable pensions and Social Security benefits. They also tended to be a little bit older, usually in their 40s or early 50s and they have the advantage of a slightly shorter retirement horizon. Add to that the fact that pension and Social Security benefits start only around 10-20 years into retirement (as opposed to 30-40 years for a lot of extreme early retirees) and you get a withdrawal rate higher than 4%. So, this goes back to point #1: there cannot be one simple unique rate and it means that there could be retirees who will vastly over-accumulate (!) wealth if they don’t do their homework and instead follow the naïve 4% Rule! It’s a failure of the 4% Rule, maybe not quite as dramatic and traumatic as running out of money in retirement. But for many, working several more years targeting a 4% Rule (25x expenses) when, say, 4.8% (20.8x expenses) would have sufficed is a failure of sorts as well!
3: We conveniently ignore expense ratios, transaction costs, taxes, etc.
True, a lot of folks in the FIRE crowd can probably avoid federal taxes if they stay within the $24k standard deduction for their ordinary income and around $77k for dividends and long-term capital gains. But how about state taxes? Oh, you live in a state with a 4% flat tax? Well, your gross safe withdrawal rate might still be 4% but you’re left with only 3.84% net of state taxes. And did I tell you that many of the simulations rely on market index returns, so let’s subtract another 0.05% to account for the expense ratio of your ETFs. (side note: In my simulations, I subtract an estimated 0.05% expense ratio). The 4% Rule is now down to 3.79%. To generate $40k per year in consumption we’d need a $1,055,000 net worth, quite a bit more than 25x expenses! And I’m not even subtracting the 1% or so for actively managed funds and/or financial advisors because then the 4% Rule would be completely toast. But even the for-fee Robo-advisors, charging around 0.25% per year (in addition to the ETF expense ratios!) would make a sizable difference.
4: Flexibility is overrated
The standard response of the makers of the 4% Rule to the potential failures: just be flexible. Who knew it was that simple? We will certainly be flexible and adjust our withdrawals and/or take one some side gigs if when we go through the next equity bear market. Think about this as starting with “FatFIRE” and scaling down our budget to FIRE for a while. Or maybe even “LeanFIRE.” But I don’t have any illusion that this is going to easy. I did some simulations in Part 23, Part 24, and Part 25 to check how long one would have to be flexible if we were to go through something comparable to the bad equity bear markets of the past. The implicit (sometimes explicit) claim by the 4% Rule makers is that you have to be flexible only for as long as the stock market is down. Not true! I knew that the “flexibility” had to last longer than the equity bear market thanks to, you guessed it, Sequence Risk (see Part 14) but I was shocked that the lower withdrawals lasted for 15, sometimes more than 20 years! I would still call that a failure!
5: Some of the simulated cohorts that didn’t run out of money still would have had a very scary and turbulent retirement!
A side effect of that flexibility mantra (see #4 above) is that we’d also potentially overreact to market fluctuations and lower our withdrawals, tighten the belt, and/or get a side gig in retirement even though in hindsight it wouldn’t have been necessary. Look at it through this analogy: Imagine you are flying with “Trinity Air” which has a slightly spotty safety record. Its success rate is 97%, which means that out of 100 flights only three would crash. What makes us think that the 97 “successful” flights would have had a smooth ride? What if out of the 97 flight that make it, an engine blew up in 30 of them? Or smoke in the cabin? Or the pilot shouting “we’re all gonna die” into the intercom? Sure, in the end, you made it, but it likely wasn’t a pleasant ride. The analogy of “we’re all gonna die” scenario would be the numerous cohorts that saw their portfolio value drop precipitously (e.g. 1972). They might have been “flexible” for years, even a whole decade which might involve going back to work and/or substantial cuts in the retirement budget. Only to find out in hindsight that all that hassle wasn’t even necessary and the “inflexible” 4% Rule would have worked after all. (See parts 23-25 of the SWR series again for the simulations!) Quite intriguingly, nobody else in the retirement research world (at least to my knowledge) seems to want to research this issue of type 2 errors (false alarms) very much. I guess they not only don’t want you to know this, they don’t even want to know themselves…
6: The 4% Rule works all the time! But only if you assume that the retiree had perfectly timed the bond duration decision over time
If you read this and wonder what the hell does it even mean to “time the bond duration decision” then sorry to tell you, you’ve already lost! The 4% Rule would have failed for you. You see, a lot of retirement researchers use a 60/40 portfolio as their baseline for their standard 30-year horizon. (Just as an aside, 40% bonds is way too high for a long horizon in early retirement, see Part 2 of the series). There is relatively little ambiguity about the equity portion. Normally people use a U.S. Total Stock Market index. I use the S&P500 with very similar results. But on the bond side, results vary wildly depending on whether you use short-term bonds (e.g., 3-month T-bills) or longer-term government bonds (e.g., 10-year Treasury Bonds). Long duration bonds did well in the Great Depression, Dot-Com bust and Great Recession (all demand shocks with low inflation or even deflation = good for bonds, i.e., bonds offered great diversification) but not so well during the inflationary 1970s and early 80s. So, some retirement researchers who tout the success of the 4% Rule have very sneakily made that little switcharoo: assume that the retiree had short-term bonds during the 1970s. But the folks who retired in 1929 and 2000 had the magical foresight of using long-duration bonds during the 2000s.
But, unfortunately, for the rest of us who don’t have the perfect foresight, we have to make a decision about the bond duration ahead of time without knowing how exactly bonds will perform in the next recession and bear market!
7: We routinely confuse nominal and real numbers!
I frequently hear and read stats like “the average retiree with a $1m initial portfolio using the 4% Rule would have ended up with $2.7m after 30 years!” Or “90% of the retirees using the 4% Rule would have ended up with more than their initial capital after 30 years!” Maybe you’ve heard those, too? Impressive stats for the 4% Rule, right? Maybe, maybe not! You see, the folks who coined those phrases don’t want you to know that those numbers are completely meaningless. They are in nominal dollars! $2.7m might be a lot if inflation was close to zero for 30 years. $2.7m might be a lot less impressive if the 30-year time span included the inflationary 1970s and early 80s where the dollar lost almost 80% of its value.
According to my calculations, for retirees with an initial $1m portfolio using a 60/40 portfolio the average and median final portfolio values were $1.47m and $1.14m in real, inflation-adjusted dollars. Still impressive but only about half as impressive as when you bungle nominal and real numbers! The probability of preserving the initial portfolio value drops from 90% to only 58% over the entire sample. And that probability drops to exactly 0% conditional on a Shiller CAPE above 30!
8: For the next 12 years, we can conveniently ignore another potential failure of the 4% Rule!
Proponents of the 4% Rule always point out that we now have data on the dot-com bust and Global Financial Crisis and there are still no failures despite the pretty atrocious equity performance between 2000 and 2009. That means the 4% Rule must be pretty robust, right? Maybe it is but I wouldn’t bet my retirement on it. So far we can only gauge the success or failure of cohorts that started retirement up until 1988 for a 30-year horizon. The jury is still out on the cohorts since then, especially the year 2000 cohort. Michael Kitces pointed out that this cohort has actually recovered its initial portfolio value already, but as I pointed out in the SWR Series, Part 6, that’s in nominal dollars (file that one as another example of #7 above: folks confounding real and nominal numbers!). In real dollars, that cohort is still severely underwater. Time will tell if they make it all the way to the year 2030 (and 2040, 50, etc. for early retirees). If we assume that the stock market keeps chugging along with double-digit returns for another twelve years everything will be OK. But I’m not that hopeful; even a short recession and shallow bear market over the next few years and the year 2000 cohort will be in trouble!
9: We won’t have to rely on the 4% Rule ourselves
Do you ever have the suspicion that the folks on TV marketing the newest exercise equipment or diet pill or whatever product have never actually used that product themselves? They probably looked this fit and slim and healthy way before that product ever existed. Could that also be true about the “Makers of the 4% Rule?” Who are these “makers” anyway? They are the academics, the financial planners and quite a few of the FIRE loggers. The tenured professors have their nice lifetime employment guarantee and cushy university pensions. The financial planners are probably far from retirement themselves and once they retire they might still have some side income as a senior partner of their advisory business. And the bloggers that market the 4% Rule most aggressively are probably raking in more money from their blog than they need to withdraw from their portfolio. I doubt that any of the “Makers of the 4% Rule” actually fit the model assumptions of the Trinity Study: a guy or a gal who has a pile of money invested in stocks and bonds and tries to make that pile last for 30+ years without much (or any?) additional cash flows. Of course, just because the “makers” don’t fit the model assumptions of the Trinity Study doesn’t mean they can’t write credibly about the challenges of the safe withdrawal math. But sometimes when I read “oh, don’t worry about the 4% Rule” and “yeah, just be flexible” as the “solution” to a 4% Rule failure it has the ring of a “why don’t they eat cake” attitude.
10: The “small-cap value bias” may or may not work in the future
Pssst, do you want to know a secret? All of this talk about running out of money, 4% Rule, etc. is completely moot! If you had only invested your equity portfolio with a tilt toward small-cap and value stocks you would have done so much better! 5.25% would have been the failsafe rate for all 30-year retirement windows! (assuming a 30-year horizon, 60/40 portfolio and the 60% small-cap and 60% value tilt using the well-known Fama-French factors) That’s right, you could have not just saved the 4% Rule but withdrawn a cool additional 30%, for life (well, a 30-year life), even during the tumultuous 1930s and 1970s!
The only problem: Who knew that in advance? If you had bet on the opposite side (large-cap growth stocks) your safe withdrawal rate would have been below 3%! The advice “small-cap value would have saved the day” is about as dubious and suspect as telling yourself that Amazon and Google beat the index over the last few years. Quite intriguingly, Bill Bengen (one of the “Makers of the 4% Rule) now tours around and does just that: he advocates for upping the safe withdrawal rate to 4.5% if you shift to small-cap and value! But there is no guarantee that those styles will continue to outperform. Especially after Eugene Fama won the Economics Nobel Prize in 2013 and the advent of lots of ETFs targeting value and size tilts. Once you go mainstream – and you can’t get much more mainstream than the Nobel Prize – any anomaly will eventually be arbitraged away! Sure enough, small-cap value has not outperformed the overall market since 2004! As much as I appreciate Bengen’s early work on the topic, I think his most recent musings should be taken with a grain of salt!
We hope you enjoyed today’s post! Please check out the other posts in this series and leave your comments and suggestions below!
- Part 1: Introduction
- Part 2: Some more research on capital preservation vs. capital depletion
- Part 3: Safe withdrawal rates in different equity valuation regimes
- Part 4: The impact of Social Security benefits
- Part 5: Changing the Cost-of-Living Adjustment (COLA) assumptions
- Part 6: A case study: 2000-2016
- Part 7: A DIY withdrawal rate toolbox (via Google Sheets)
- Part 8: A Technical Appendix
- Part 9: Dynamic withdrawal rates (Guyton-Klinger)
- Part 10: Debunking Guyton-Klinger some more
- Part 11: Six criteria to grade dynamic withdrawal rules
- Part 12: Six reasons to be suspicious about the “Cash Cushion“
- Part 13: Dynamic Stock-Bond Allocation through Prime Harvesting
- Part 14: Sequence of Return Risk
- Part 15: More Thoughts on Sequence of Return Risk
- Part 16: Early Retirement in a low return environment (The Bogle scenario!)
- Part 17: Why we should call the 4% Rule the “4% Rule of Thumb”
- Part 18: Flexibility and the Mechanics of CAPE-Based Rules
- Part 19: Equity Glidepaths in Retirement
- Part 20: More thoughts on Equity Glidepaths
- Part 21: Mortgages and Early Retirement don’t mix!
- Part 22: Can the “Simple Math” make retirement more difficult?
- Part 23: Flexibility and Side Hustles!
- Part 24: Flexibility Myths vs. Reality
- Part 25: More Flexibility Myths
- Part 26: Ten things the “Makers” of the 4% Rule don’t want you to know
- Part 27: Why is Retirement Harder than Saving for Retirement?
- Part 28: An updated Google Sheet DIY Withdrawal Rate Toolbox
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