Hey. I recorded this video well before the Coronavirus situation really started to play out.
And the reason that I’m mentioning that now in this introduction is that I think it ties in
really well with the topic. The New York Times had a piece on how the FIRE movement is being or
is expecting to be impacted by the coronavirus situation and the expectation is that it could
have a big negative impact on people who were retired very early and living on the 4% rule
and a lot of the reasons why are going to be discussed in this video why the 4% rule
might not be sufficient for a very early retiree with sixty
year time horizon. Now with everything going on in the world this just hasn’t felt like the right
video to release. I’ve been trying to work on more relevant content. But why am I releasing it now?
Well I’m out of content, and not because I’m out of ideas, I’ve just been out of time
recently. My wife and I had a new baby, our fourth about a month ago.
And so yeah. I’ve just been strapped for time. And I had this recorded so I’m releasing it with
this introduction to make it a little bit more relevant and then I'll be coming out with more new
content soon. But I just didn’t want this channel to get stale. I do hope you enjoy this video.
Nobel Laureate William Sharpe has referred to retirement income as the “nastiest, hardest
problem in finance.” The 4% rule for retirement spending has gained popularity as a simple answer.
The rule says that you can safely spend 4% of an investment portfolio in the first year
of retirement, and then adjust that amount for inflation each year for the rest of your life.
Distilling a complex problem down to a simple rule of thumb can be useful,
but the 4% rule for retirement spending has some serious flaws. And even beyond those flaws,
the retirement income problem is complex enough to warrant a more involved discussion.
I’m Ben Felix, Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing I am going to tell you how to fund an early retirement.
The 4% rule makes retirement math exceptionally easy.
Take your required expenses and divide by 4%. If you want to spend $40,000 per year in retirement,
divide $40,000 by 4% and you have a $1m required portfolio to meet your retirement income goal.
In its design, the 4% rule is meant to deal with the main risks that a retiree faces.
Once you have decided to stop working, or stop working for money,
you will likely be relying on relatively risky assets, like stocks and bonds, to sustain a
steady stream of income. This introduces a unique retirement risk called sequence risk. Funding
a steady stream of income using a volatile asset like stocks poses some big challenges.
Sequence risk is based on the fact that repeated negative returns early on in the distribution
period can have a meaningful long-term impact on the ability to fund your lifestyle.
As if sequence risk weren’t enough to deal with, we are also planning for an
unknown period of time - nobody can predict how long they are going to live.
This risk is called longevity risk. Together,
sequence risk and longevity risk make planning for a secure retirement a unique challenge.
Let’s come back to the 4% rule - the supposedly simple solution to the retirement income problem.
The 4% rule was designed to address sequence risk, and it did touch on longevity risk. I’ll explain
the genesis of the rule. William Bengen, a financial planner, wrote a paper in 1994
with the creative title Determining Withdrawal Rates Using Historical Data.
Bengen took historical data for US stocks and intermediate term treasuries and tested how long
a portfolio of 50% stocks and 50% bonds would be able to sustain various levels of withdrawals.
Bengen modelled withdrawals starting as a percentage of the portfolio
and increasing with inflation each year. The result is constant inflation adjusted spending.
He tested withdrawals starting each calendar year from 1926 to 1976 and observed how long
the portfolio lasted at each starting point. For a 30-year retirement period with a 50% stock and 50%
bond investment portfolio, Bengen found that a 4% withdrawal rate was always sustainable.
This research was further supported by the 1998 paper Retirement Savings:
Choosing a Withdrawal Rate That Is Sustainable by Cooley, Hubbard, and Walz, commonly referred to as
the Trinity Study. Instead of using intermediate term treasuries as fixed income, the Trinity Study
used long-term high-grade corporate bonds. This decision to use riskier bonds ended up resulting
in a 4% withdrawal rate being successful only 95% of the time in the historical data.
A 95% success rate sounds great, but this is only true in the historical data. A
retiree today should not expect a 95% chance of success with a 4% starting withdrawal rate.
I’ll explain why that’s true in a minute, but first we have to come back to one of
the most important assumptions built into the 4% rule: the time frame.
The 4% rule was based on testing a 30-year withdrawal rate in the historical data. This
video is about retiring early. How many early retirees are planning for a 30-year horizon?
Bengen based 30 years on a 60-65 year-old investor
and added roughly ten years onto normal life expectancy to plan for
longevity risk. A 40-year-old retiree would usually expect to live for more than 30 years.
If we repeat the same analysis for a 40-year period, the 4% rule has a success rate of
87% with a 50% stock and 50% bond portfolio. Longer time periods will see more failures.
One consideration might be increasing the weight in stocks to improve the outcome.
The paper Safe Withdrawal Rates: A Guide for Early Retirees
by earlyretirementnow.com looked at longer retirement periods and higher equity weights.
Expanding the analysis to longer time periods and more aggressive stock allocations,
they found that while anywhere between 50 and 75% stock exposure resulted in great results for a
3.5% spending rule over 30 years, moving out to 60 years required much higher stock exposure in order
to reach a comparable success rate. They found that for 60-year horizons, higher equity weights
give better results. Anything below 70% in stocks becomes precarious over such long time frames.
To quote earlyretirementnow, “Over longer horizons, bonds are bad!”
This finding is extremely important for any early retiree. In the historical data bond exposure over
very long periods of time is arguably riskier than stock exposure. This looks fine on paper,
but investors are myopic. They evaluate long-term decisions with a short-term view.
You still have to live with the volatility of stock exposure in your investment account.
I’m not saying that you shouldn’t have an aggressive portfolio if it makes sense for
the situation, but I am saying that an aggressive portfolio can be stressful even if it makes sense.
I think that we have established that the 4% rule is probably not useful when
it comes to retirement planning in general and especially early retirement planning.
Increasing the weight in stocks might support a 3.5% withdrawal rate in the historical US data,
but we are still missing some important pieces. Everything that we have covered so far centers
on historical US stock and bond data. There is a good chance that the historical experience
of the US financial markets might not be representative of expected future returns.
There are a couple of different ways that we can think about this. The first
one is looking at the 4% rule based on stock market data from other countries.
Wade Pfau documented this analysis in his book How Much Can I Spend in Retirement
using data going back to 1900 through 2015 for 20 developed market countries. He found that the
only other country that could have historically sustained a 4% withdrawal rate for a 30-year
retirement period was Canada. 18 other countries would have had failure rates between 8 and 62%.
The global stock market as a whole would have sustained a 3.5% withdrawal rate historically.
It’s also important to point out that the 20 countries in Pfau’s data set
are the countries that made it into the dataset - there is survivorship bias potentially making
things look better than they actually are. Countries like Argentina, Russia, and China did
not make it into the dataset, but you can be sure that they would not have historically sustained a
4% withdrawal rate, and they would pull down that 3.5% safe withdrawal rate for a global portfolio.
Getting our heads out of the US was important, but we are still stuck in history.
Today stock valuations are high relative to the past.
Bond yields are historically low, or even negative depending on where you look. Nobody
can predict the future, but stock valuations matter a lot to expected future returns.
In the 2019 edition of Aswath Damodaran’s annually updated paper Equity Risk Premiums,
Determinants, Estimation and Implications Damodaran demonstrated that the earnings yield
is the best predictor of the future equity risk premium. It’s still far from perfect,
but it is the most reliable metric that we have for forecasting future stock returns.
The earnings yield can be found by taking the inverse of the Shiller cyclically adjusted
earnings. For example, if the Shiller CAPE for US stocks is currently 29.71, we take one divided by
29.71 to find the earnings yield. This gives us a result of 3.36%, which is the expected real return
for US stocks. The geometric average real return for US stocks from 1900 through 2019 was 6.5%.
Interestingly, 6.5% is roughly what the historical average Shiller CAPE ratio would predict.
Think about that for a moment. We are looking back at 119 years of data for US stocks during which
the 4% withdrawal rate was sustainable, but over that period valuations were considerably lower,
and the average historical returns that we see are commensurate with those lower valuations.
Today’s high stock valuations forecast much lower future returns.
Applying any historical analysis to today’s starting point does not make sense.
Knowing the limitations of historical data due to currently high valuations,
one approach to testing spending rules involves using current expected returns
and simulating future periods using Monte Carlo simulation. Monte Carlo
involves randomly sampling returns from a defined distribution of potential outcomes.
Using Monte Carlo for a 60-year period with current expected returns for a 100%
stock portfolio consisting of Canadian, US, and International stocks, and ignoring taxes, I find
a 2.5% safe withdrawal rate where safe means a 5% chance of failure. This analysis is interesting
for more than observing the safe withdrawal rate. It also allows us to see the range of outcomes.
In the worst 10% of outcomes our 60-year spending period left the investor with $1m adjusted for
inflation, while in the best 10%, they were left with around $30m adjusted for inflation.
That massive range of outcomes seems inefficient, and it is.
In a 2008 paper titled The 4% Rule—At What Price?, William Sharpe and two co-authors explain:
“Supporting a constant spending plan using a volatile investment policy is fundamentally
flawed. A retiree using a 4% rule faces spending shortfalls when risky investments underperform,
may accumulate wasted surpluses when they outperform,
and in any case, could likely purchase exactly the same spending distributions more cheaply.”
In simple terms, retirees who use a fixed spending rule from a portfolio of risky
assets to fund their inflation-adjusted lifestyle needs are overpaying for the
potential of investment gains that they do not need to meet their retirement income goals.
More efficient solutions to this problem are mathematically dense and often involve complex
financial products like options, leverage, and annuities, but there are some spending rules out
there that approach a more efficient solution without getting too complicated to implement.
In a 2017 paper, Vanguard explained some potential approaches. The authors explain that there is a
spectrum of spending rules that depend on the preferences of the retiree. Constant spending
rules like the 4% rule cater to the preference of spending stability while risking premature
portfolio depletion or inefficient consumption. At the other extreme, spending a constant percentage
of the portfolio each year results in no chance of depleting the portfolio and more efficient
consumption, but it also results in potentially wild swings in the annual spending amount.
The Vanguard paper suggests a middle ground where spending is a percentage of the portfolio,
but is only allowed to increase up to a ceiling or decrease down to a floor. The ceiling and floor
can be tailored to the needs and preferences of any retiree, keeping in mind the trade-offs at
each extreme. In their paper they use a 5% ceiling and a 2.5% floor. Keep in mind, though, that in
bad markets there could be multiple years of spending reductions required to follow the rule.
Finally, I think that one of the most important considerations for any early retiree
is their ability to earn an income. That might sound counterintuitive - are you really retired
if you are still earning an income? If you are able to do something that you love and earn a
little bit of income doing it, you are effectively introducing a large safe asset to your portfolio.
This changes all of the retirement math - maybe you only need a 2% withdrawal rate
to supplement your earned income. Plus, work is important for humans!
Martin Seligman’s PERMA theory of well-being suggests that there are five building blocks that
enable flourishing – Positive Emotion, Engagement, Relationships, Meaning, and Accomplishment.
Working at something that you love to do, even if it doesn’t make a ton of money,
is a great way to get engagement, meaning, and accomplishment.
For early retirees, the 4% rule is not useful. Based on a longer time period,
global data, and current market valuations a more reasonable guideline might be closer to 2%,
and even then, constant inflation adjusted spending is both risky and
inefficient. Alternative spending strategies like Vanguard’s dynamic approach
might be part of the solution, but any early retiree should also keep in mind the possibility
of finding ways to turn themselves into a safe asset by continuing to earn a bit of income.
Thanks for watching. I’m Ben Felix of PWL Capital and this is Common Sense Investing. If you enjoyed
this video please share it with someone who you think could benefit from the information.
And don’t forget, if you’ve run out of Common Sense Investing videos to watch, you
can tune into to weekly episodes of the Rational Reminder podcast wherever you get your podcasts.