January 3, 2022
Happy New Year, everybody. I hope you had a relaxing and healthy Christmas and a good start to the New Year!
Last month was the 5th anniversary of the Safe Withdrawal Rate Series! In December 2016, I published the first part of that series. I had material for maybe four or five parts but one thing led to another and with new ideas, most of them due to reader feedback, the series took off. It’s been running for 5 years and I obviously opened a bottle of bubbly last month to celebrate.
So, what’s the deal with the title then? Very simple: Blogging 101. You need a catchy title! I might have called the post “What I’ve learned in 5 years and 50 posts” or something along those lines. But to shake things up and get everybody’s attention, this is the title I went with. Think of this post as a natural extension of Part 26 “Ten things the “Makers” of the 4% Rule don’t want you to know” or the equally “tongue-in-cheek” posts “How to ‘Lie’ with Personal Finance” – Part 1 and Part 2.
So, after 5 years, 50 posts, what have I learned? What do I think others in the FIRE community are missing? What can you learn from my series that you may not have seen elsewhere? Let’s take a look…
1: We’re taking the “Simplicity Mantra” way too far!
We are all familiar with JL Collins’ work “The Simple Path to Wealth” or Mr. Money Mustache’s post “The Shockingly Simple Math Behind Early Retirement“. I mostly agree with the “simplicity” part. I kept my retirement savings very simple, too. Invest in index funds. Automate your investments and take the emotions out and watch the money grow. If the market keeps rallying that’s great. But even if the market tanks like in 2007-2009, that’s not the end of the world either. Keep investing and make Dollar-Cost-Averaging work for you. Some of my best investments with the highest IRR are the contributions from March 2009, right around the market bottom! If this kind of simple index investment style is OK for someone with six letters (Ph.D., CFA) behind his name and years of experience in the asset management industry, it should work for the vast majority of FIRE enthusiasts.
But just to be sure, not everything is simple while saving for retirement! The more serious challenge during the accumulation phase is the psychological part. Staying on course, resisting the overconsumption and conspicuous consumption temptations, and not losing your nerves during volatile markets.
But in retirement, this all flips. The psychology of retirement is pretty simple. The math is more complicated than before as evidenced by my 50-part series. If there is a bear market early on, then the Dollar Cost Averaging effect that previously helped you in the accumulation phase will now hurt you because you are now selling shares at discounted prices and this will likely hamper your portfolio’s recovery. That’s the definition of Sequence Risk (see Part 14 and Part 15). But I often get the impression that a large part of the FIRE community misses this distinction and extrapolates the investing simplicity mantra into withdrawal math simplicity during retirement. After 50 posts and 5 years of my time dedicated to this issue I certainly don’t find the withdrawal phase simple!
Further readings: Part 27: Why is Retirement Harder than Saving for Retirement?
2: Passive investing? Don’t throw out the baby with the bathwater!
Related to the previous point, asset allocation considerations become more complicated in retirement. Even if you stay away from outright stock picking and use a simple index fund allocation, retirees should consider shifting the weights of those passive index funds over time. In other words, while accumulating assets, it’s not unheard of for people to just run with a 100% equity allocation (see Part 43 of the series). I did so while saving for retirement. But 100% equities may not work so well for the average retiree. A few years before retirement and, at the very latest, upon reaching retirement, you will have to make some decisions about shifting your asset allocation to take some risk off the table. And there is no generally accepted “passive index” for the Stock/Bond allocation. And much less the stocks vs. long-term bonds. vs short-term fixed income vs. commodities vs. real estate vs. crypto percentage allocations.
Even if you settle on one specific retirement asset allocation, it doesn’t mean that this allocation should be set in stone all the way to eternity. Quite the opposite, financial experts agree that Sequence of Return Risk can be slightly mitigated through an equity/bond glide path both before and after retirement. See Michael Kitces’ work on the “Bond Tent” and my work on pre-retirement and post-retirement glidepaths (Part 19, Part 20, Part 43 of this series).
And again, notice that this glidepath or bond tent over time has nothing to do with the often maligned and pooh-poohed stock picking or market timing strategies. It’s still an unconditional passive shift of asset weights, like in a target-date fund and the underlying assets may as well be index funds, so there is no stock picking either. I wouldn’t call this active investing.
Also getting lost in the whole simplicity/passive-investing craze is the opportunity to invest in some not-so-passive styles like real estate or trading options with very attractive return profiles and diversification potential and probably less sequence risk than your good old 60/40 or 75/25 portfolio or 100/0 portfolio.
3: The stock market is no random walk!
One of the most dangerous fallacies in the personal finance world and especially the FIRE community is the incessant claim that the stock market is a Random Walk. It’s not. The stock market is certainly hard and even impossible to predict on a day-to-day or month-to-month basis, but over longer horizons, returns are surprisingly highly correlated with equity valuations, like Prof. Robert Shiller’s CAPE ratio.
And here again, there is a stark contrast between young investors just starting out their FIRE path vs. people close to or in retirement. Expensive equity valuations shouldn’t pose too much of a headache for young investors. But retirement success is very correlated with the equity multiples at the start of retirement. In the chart below, I plot the inverse of the Shiller CAPE ratio on the x-axis (think of it as the earnings yield, i.e., low values indicate expensive equities) and the realized safe withdrawal of a 75/25 portfolio rate over a 30-year horizon on the y-axis. I simulate this for retirement cohorts starting withdrawals between 1926 to 1991. (and the last retirement cohort covers 1991 to 2021, which is the last year for which I have return data). All the failures of the 4% Rule occur when equities are expensive (low CAPE yield). And likewise, the 4% Rule is way too conservative if earnings yields are high. Because the stock market is no random walk!
The implication from this simulation exercise is that the unconditional failure probabilities like those in the Trinity Study or some of the online retirement calculators are meaningless if you currently find yourself in a high-CAPE world, i.e., a low earnings yield environment.
I always use the analogy of a researcher trying to calculate the probability of encountering a traffic jam. He studies the traffic patterns by leaving his home at the top of the hour each hour from midnight to 11pm. Out of the 24 attempts, he got into a traffic jam 6 times. Does that mean the probability of a traffic jam is 25%? If all the traffic problems always occur during rush hour, 7am, 8am, 9am and 3pm, 4pm, and 5pm, then the unconditional probability of 25% is pretty meaningless. If you already know that you drive to and from work during rush hour times you might face a 100% probability of a jam. And likewise, if you leave at 2am, you have a much smaller probability of traffic problems. Same with the failure rates of the 4% Rule! That’s why I built a tool (see Part 28) to report not just the unconditional failure probabilities but also those conditional on market conditions. For example conditional on high CAPE ratios and/or an equity index at or close to its all-time-high (asin early 2022!). Readers of my series know that the failure probabilities conditional on expensive equity valuations are very different from the crude and useless figures floating around in the Trinity Study and the FIRE blogosphere.
In summary, the underlying confusion about failure and success probabilities is all based on the misplaced Random Walk assumption and the confusion between unconditional and conditional probabilities. For some additional evidence of the non-random walk properties of the stock market check out this post: “How much of a Random Walk is the Stock Market?”
4: Rules are useless!
A byproduct of the simplicity mantra is that if index investing is so easy, then everything else in personal finance must be simple enough to distill into a bumper-sticker-size rule. Some examples:
- The 4% Rule
- “Pay down your debt first”
- “Keep X months’ worth of expenses in an emergency fund”
- “Keep bonds in a tax-deferred account”
- … and many more
All those rules are useless. Personal Finance should be custom-tailored to your personal needs. It’s called “personal” finance for a reason. I’ve been dealing with the 4% Rule fallacy for over 5 years now. I often make the case that the word “Rule” is actually more offensive than the 4% part. That’s because I have done some case studies for FIRE volunteers with significant cash flows later in retirement where I justified much higher withdrawal rates than 4%, sometimes North of 5% or even 6%. Who knows, some of the folks would still be working today to chase that dumb 25x rule if they hadn’t found me to do the math right!
And all the other rules are equally useless:
- Pay down debt? Young investors tend to benefit from keeping the mortgage and turbocharging their equity investments early on to hedge the (sequence) risk of missing out on strong returns early during their investing career. And in retirement, reducing your mandatory expenses is also a hedge against sequence risk (Part 21). But even this “adjusted” conditional debt paydown rule may not be 100% universal.
- I’m not a big fan of emergency funds, as many of you know. In fact, the first claim to fame of my blog was my controversial $0 emergency fund post back in May of 2016. For most young investors it’s more important to build up their equity portfolio as quickly as possible to hedge against Sequence Risk. And for most older investors who have a large enough portfolio, there isn’t really a need to have a designated emergency fund in a low-risk and low-yielding account (e.g., money market, short-term CDs, etc.) either. But just to be sure, I did concede in the most recent installment that if the need of tapping your funds is highly correlated with the stock market, you probably want to keep your emergency fund in a low-risk investment outside the stock market. I don’t want to replace a useless emergency fund rule with an equally nonsensical rule of my own. If you want to have an EF and how much money you need is again a function of your own financial parameters!
- The often-cited rule of keeping bonds in the tax-advantaged accounts is also not 100% accurate, as I pointed out in Part 35 of the series. It depends on interest rates, expected stock gains, dividend rates, and certainly your current and expected tax rates. There are potential cases where it’s better to keep bonds in the taxable account!
5: Uncertainty does not justify “winging it”
As I outlined in Part 46 and Part 47, the presence of market uncertainty is no excuse to be sloppy with your retirement withdrawal analysis. Quite the opposite, the substantial market uncertainty and potential additional uncertainties, like idiosyncratic spending shocks and policy uncertainty about future Social Security benefit levels, tax policy etc., likely call for more precision in your analysis today, not less. That’s because “winging it” adds even more uncertainty to the existing one.
I always like to use the medical analogy of Dr. Wingit, MD who has to inject medicine into a patient. He looks up the dosage information, 3.5ml. But Dr. Wingit says, “3ml, 4ml, 5ml, this patient has a very uncertain outlook anyways, so who cares, right?!” Well, it’s the opposite; because there is already a lot of uncertainty about the health and survival chances of the patient, we want to be extra-cautious and not compound that risk even more by winging the dosage.
In other words, critics of my analytical approach try to sneak in the stereotypical Strawman argument: I never claimed that with my tools I can eliminate any of the market uncertainty. I merely don’t want to compound the risks even more.
6: We are not very good with percentage calculations!
Related to item #5, I often hear people say “3%, 4%, 5% withdrawal rate, who cares, it’s only a 1% difference, right?!” Or this one: “It makes no sense pinning the safe withdrawal rate down to the significant digits after the decinal point!”
Do you notice the flaw in these statements? Going from a 3% withdrawal rate to a 4% withdrawal rate is indeed a one percentage point difference in the rate. But it’s a 33.3%(!) increase in the withdrawal amount. For example, with a $1,000,000 initial portfolio, you’d raise your withdrawals from $30,000 to $40,000. The last time I checked, $40,000 is not 1% but 33.3% higher than $30,000.
So, did you notice what our mathematically inept Dr. Wingit did here? He claims that going from a 3ml dose to a 4ml dose is only a 1% difference. If it’s expressed relative to the 100ml bottle in the medicine cabinet! But the increase in the dosage injected into the patient was still a 33.3% increase! So, to all the internet influencers out there rolling their eyes when I display safe withdrawal rates with a 0.25% or even 0.01% precision: I roll my eyes right back at you for not understanding 5th-grade percentage calculations! 😉
If you’re still not convinced, take a look at this simulation from Part 27. Here’s the path of a $1,000,000 portfolio over 50 years for the Jan 1965 retirement cohort using withdrawal rates between 3.2% and 3.7% in 0.1% steps. Notice how sensitive the final outcome is when changing the withdrawal rates by a mere 0.1 percentage point. My best advice: Do the math right up to the last 0.01%. You can then always round it up/down later, folks!
7: We can be nonchalant about failure probabilities. But you can’t!
I don’t remember exactly who it was but one fellow FIRE blogger once confidently declared that a retirement strategy with a 20% failure probability is totally fine for him. It’s certainly the kind of tough talk that invokes a lot of “ooooh”s and “aaaah”s from the podcast audience or at a FinCon cocktail party. But it’s also BS! The particular FIRE blogger who I think said this (99% sure) has a zero percent chance of depleting his portfolio because of his wife’s income and revenue from his blog. And don’t call me the “retirement police” because I have no problem with FIRE bloggers monetizing their blogs. I monetize my blog, though I still generate the overwhelming majority of our retirement budget from investment. If anything, we actually make way too little money in the FIRE community considering the services we provide. But we want to avoid giving 99.9% of the FIRE community the impression that we can all ignore Sequence Risk because the top 0.1% of the most profitable influencers face no such risk. It has a bit like Marie Antoinette’s “let them eat cake!”
If this blogger or anyone else indeed faced a 20% failure probability I have a hard time believing they would be OK with that. Ask yourself, would you be OK with a 20% chance of…
- Being late for a flight? (not talking about a connecting flight, but going from your home to the airport to catch a flight)
- Running out of gas?
- Being late for a wedding? How about your own wedding?
- Being late for a funeral?
How about your own funeral?Oh, wait, that last one didn’t work so well!
Maybe some people will still maintain that they are, but I have never met anyone who has missed 20% of their flights or missed 20% of important family gatherings or shows up to work late 20% of the time. If you’re like me and you leave for the airport early enough to absolutely never miss a flight, it’s because there is an asymmetric risk profile. There is a small cost because you waste 15-30 minutes sitting at the airport gate, but missing a flight by 1 minute is asymmetrically costlier. If I’m not willing to accept a 20% chance of something as trivial as missing a flight, then why would I risk a 20% chance of running out of money in retirement? I know that I will likely end up with excess assets when I die, but that’s a good problem to have!
8: Flexibility in retirement raises more problems than it solves
The last resort of Dr. Wingit to push back against a more careful retirement analysis is that we can just be flexible in retirement. Well, count me in on that one. I’m certainly flexible. We have a retirement plan with the flexibility to cut our budget by 15%, even 20%+ and still have a comfortable retirement. We also have the flexibility to go back to work. But flexibility is no panacea. Some really bad flexibility headaches are often ignored when living in the FIRE la-la-land where people can make sweeping claims about flexibility but never quantify anything. I made an honest attempt at measuring how flexibility would have worked out in some of the historical simulations and there are (at least) three unpleasant issues:
1: How flexible do I have to be? Skip the Starbucks Lattes for a while? Skip the CPI adjustment for a few years? I did the simulations in Part 23 and found that in order to have a meaningful impact on cushioning Sequence Risk, you’d have to lower your withdrawals by probably closer to 30%.
2: How long do I have to be flexible? A common misunderstanding is that tightening the belt only has to last until the end of the Bear Market, 1-2 years, right? False! If you start withdrawing your full initial retirement budget again at the start of the next bull market, keep in mind that at that point, your portfolio is still at the bottom, when you are facing the maximum Sequence Risk impact! To alleviate Sequence Risk, we’d need to wait until the portfolio has made up the losses plus inflation! And that can take a lot longer, sometimes decades. 30% lower consumption for 20 years is not really that palatable.
3: How about false alarms (Type 1 errors)? In that same post, Part 23, I showed that some of the historical cohorts whose portfolios would have survived a 4% Rule in the end, still had a scary ride along the way. Take the example of the Dec 1972 retirement cohort using a 4% Rule. Less than 10 years into retirement, you had depleted roughly 70% of the portfolio (in real terms). But thanks to the stellar performance of the U.S. stock market during the 80s and 90s, your portfolio survived all the way until 2002. But this lucky (unlucky?) retiree probably would have done the flexibility thing, trying to find work in the 80s to supplement his/her retirement, for 10+ years. That’s because nobody had any idea how well the stock market turned the corner eventually.
So, again, I’m onboard with flexibility, but it’s overrated once you look at the historical simulations. You don’t really eliminate the failures, you simply reshuffle them. You replace “running out of money” with “going back to work” for very extended periods. Even worse, you create false alarms, i.e., failures of sorts where the 4% Rule didn’t even fail in the absence of flexibility.
9: CPI adjustments in retirement may be insufficient!
The premise of the Trinity Study and much of my Safe Withdrawal Rate Series is that you adjust your withdrawal amounts by the CPI index. It ensures that you can keep your standard of living without slowly eroding your purchasing power over time. As I have previously pointed out, foregoing inflation adjustments for maybe one or two years is not a big deal, but over longer horizons, 30 years for traditional retirees and potentially 50 or even 60 years for early retirees, the purchasing power erosion would be disastrous!
But some retirees, certainly early retirees, might want to consider whether CPI adjustments are truly enough. Let’s look at the chart below for the 1991 to 2021 path of per capita real consumption. It increased by 70%, which means that if you had merely increased your consumption with CPI+0% only, the people around you would now be consuming 70+% more than you. Or, equivalently, you would have fallen 42% behind your peers, i.e., your neighbors, friends, and relatives. And foregoing even the CPI adjustments, you’d be 71% behind the average American, now that’s a non-starter! I can certainly see that a traditional retiree, at 65-years old, could feel comfortable slowly falling behind the average U.S. per-capita consumption path, at least in the absence of health problems. But as an active early retiree, I’d like to still participate in the per capita real consumption growth for a few decades and update my gadgets and buy improved creature comforts. In other words, I don’t want the same consumption basket from the 1990s today. Remember: there were no smartphones back then! And, likewise, in 2051 I probably don’t want the 2021 CPI consumption basket either!
By the way, this CPI+x% creep in expenses will be even more pronounced for the folks who retire abroad in a (currently!) low-income country. The per-capita real consumption increases in some of the popular retiree destinations like Thailand, Cambodia, Philippines, Costa Rica, Panama, etc. are even greater than in the USA. I wonder what kind of apartment you’ll be renting in Phuket in 20+ years if you apply only a CPI+0% adjustment to your budget each year!
But just to be sure, my Safe Withdrawal Rate Toolkit has a feature for you to tweak the simulations and model withdrawals that grow faster (or slower) than CPI inflation. To my knowledge, my toolkit is the only one out there with that kind of modeling flexibility.
10: Reliance on the government may backfire!
A good chunk of the FIRE content on blogs and podcasts deals with optimizing government policies and benefits. Obamacare subsidies, Roth conversion ladders, the 0% bracket for long-term capital gains and (qualified) dividends, etc. And that’s all really helpful advice. I’ve written about the awesomeness of the 0% tax bracket and retirement tax optimization myself (Part 44 and Part 45). But I feel a bit uneasy about all this. Will this government generosity last? Have you looked at the government deficit and debt figures lately? Could there be a backlash against the FIRE community? Recall, that most of the media coverage of our community has been positive and admiring, even fawning at times. The “worst” coverage I recall was about that Seattle lawyer who took her frugality a little bit too far. But could there be a harsher backlash if people find out that multi-millionaire retirees in their 30s and 40s collect not just zero-tax qualified dividends and capital gains but also Obamacare subsidies and get low-income subsidies for their cable TV and internet? Maybe our FIRE community needs to hire some lobbyists in Washington D.C. to keep our party rolling?!
I certainly wish that we won’t become a target of any jealous social justice redistribution mob and we can keep our low-tax and benefit party rolling. But I wouldn’t bet my retirement security on it. Here in the ERN household, we don’t even receive ACA subsidies (yet), but the tax landscape certainly benefits us greatly. Let’s hope it stays this way. But if not, our retirement would still be safe and comfortable. But I am worried a bit about the folks who retire on a bare-bones budget and only just made their 25x rule of thumb work – but only because of ACA subsidies. You are setting yourself up for a rug pull by the government! My recommendation: try to be not just FI but aim for an even safer acronym. Here are some suggestions:
- FINAL = Financially Independent, Not a Leech
- FINDOG = Financially Independent, Not Dependent on Government
- FINISH = Financially Independent, Not In State’s Hands
- … any other suggestions, please post in the comments section and I will add to this list! 🙂 for sample:
- Reader “Mapleton” came up with a nice acronym of what we don’t want to become: FIBBING = Financial Independence Blindly Based on Individual Naive Guessing. Very nice!
- Reader “J Acorn”: Don’t be “FIDDLE (while Rome burns)” – Financial Independence Drained, Didn’t Listen to ERN. That’s awesome. Why didn’t I think of this?!
OK, let’s wrap it up here. Happy Anniversary! Thanks to all readers that have come along with me on this amazing 5-year run! Not sure I am going to make it to 100 posts over the next five years but I got notes for at least another 10 posts. Also, I hope I didn’t ruffle any feathers with today’s post. Again, I don’t mean to accuse any of my fellow-FIRE bloggers of any malice or wrongdoing. And for the three or so people who might still be offended I like to point out that the concept of F-You Money worked not just when leaving my corporate job in 2018 – it works equally well or even better with the online outrage troll mob today. 😉
So, Happy New Year everybody. Let’s a have healthy and prosperous 2022!