Foolishness of the 4% rule

[Deleted User]

Interesting discussion of withdrawal strategies in this  podcast from Rational Reminder. https://rationalreminder.ca/podcast/164

This includes Moshe Milevsky’s entertaining demonstration of the foolishness of picking a spending level and blindly increasing it by inflation each year without any regard for how your portfolio grows or shrinks.

tacpot12

The 4% rule is foolish in the context of retirement in the UK because of the State Pension. Once you add the State Pension into someone's retirement portfolio, the SWR for the invested assets can be well above 4%.

The impact of the seqence of return risk is well known, but the SWR is the response to this risk.  

Sea_Shell

Personally we've used the 4% rule as a bit of a yardstick as to what is possible - ie early retirement.   We would not stick to it religiously if we felt that it wasn't sustainable for current market conditions.

4% would currently give us £25,000, if we took today as "day-one".    Our usual annual spending is more like £13,000 (excluding capital expenses), so plenty of room on the broom for some discretion and wiggle.

This is without factoring in DB pensions and State Pensions as stated.

kuratowski

As described above this is a pure strawman.  How many people would just blindly pick a number the day they retire and then draw that much down forever, refusing to take any other precautions such as 3 years' cash buffer, and stubbornly refuse to adjust despite their portfolio shrinking.

The rule, as sea_shell says, is more of a yardstick to use for long term thinking i.e. to help answer the questions like am I saving enough? how many years before I can retire?  You're not planning to actually use this strategy, it just makes back of the envelope calculations easier.

I'm pretty keen on retiring early, so I have been working on the basis of 3%, i.e. to cover a longer time period than 4% was designed for.  This is despite being on track for full new state pension, and having a deferred DB pension amount to about half SP, together these two would cover my basic needs, so I like to believe my plans are pretty cautious.

DT2001

As tacpot12 says not applicable to the U.K. however if it makes you question the size of your ‘pot’ and your strategy for withdrawal it is a starting point.
Bill Bengen said it was actually 4.2% and I think he used 4.5% personally by diversifying into more asset classes.

It would be foolish to apply the rule and then ignore what is happening around you for the set 30 years of your retirement!

It was for the US market and written in the early 90’s.

As the discussion says flexibility is the key. In the U.K. how many people only have an investment pot to fund their retirement?

What strategy does the OP use?

[Deleted User]

DT2001 said:

What strategy does the OP use?

https://www.finiki.org/wiki/Variable_percentage_withdrawal

Thrugelmir

Someone that blindly draws a fixed % probably has little understanding of their investments either. Has been fortunate to have benefited from a bull market and assumed (incorrectly) that making money is easy. 

cloud_dog

Thrugelmir said:

Someone that blindly draws a fixed % probably has little understanding of their investments either. Has been fortunate to have benefited from a bull market and assumed (incorrectly) that making money is easy. 

With the number of informed and experienced posters on this forum I think it is sometimes easy for people to lose sight that some of these basic and obvious aspects are not well know or understood in the wider world, and I would imagine an awful lot of people fall under the above banner.

There is a cohort of those people who are knowledgeable enough to know they don't understand and to seek guidance but again I would guess there is a significant proportion who will see 4% safe withdrawal rate and simply embrace it.

jamesd

VPW is a poor rule IMO because it produces very large swings in income during adverse market events, courtesy of multiplying a predetermined and invariant percentage for age by the market value of investments: both change every year. In exchange for that it does ensure that it's impossible for capital to fall to nil before age 99, by allowing income to fall to a pittance instead; at 99 all remaining capital seems to be spent. There's also no inflation adjustment so the real income can fall without restraint. On the positive end it responds rapidly to market increases. US or Canadian drawing at age 65 with 50:50 equities:bonds seems to be 4.8%, I don't know if there are UK-based coefficients for the non-US people to use. However, I'm not greatly familiar with the intricacies of the rule and may have some details wrong.

By contrast in almost all countries the constant inflation adjusted income (commonly called 4%) rule works and produces unchanging real incomes at a before costs percentage that depends on the country, planned drawdown time and intended asset mix, in the core case being solely in the equities and bonds of that country. The exceptions being countries which nationalised assets (Soviet Union) or to a severe but not unlimited extent suffered terribly in war to devastate assets. In those exceptional cases there have been times of nil or extremely low safe withdrawal rates. In the UK this one is 3.7% using UK investments and a 30 year timeline. Describing a rule that works to produce a stable income in almost all countries as foolish doesn't seem like a good idea. Main disadvantage is the very low starting rate - set by the worst historic case considered - that requires recalculation if you do't live through a repeat of those worst times.

Better than either in my opinion are rules like Guyton Klinger which I recommend because they have a degree of controlled variability and start closer to historic 7% average of the 4% rule in the US, improving both the early years performance and the chance of drawing maximum achievable income during life. In the UK with UK investments that's 5.5% initial then varying for a 40 year plan at 99% or 100% success rate, the source is unclear.

However, rules and variability tolerance and related desires vary by individual and it's entirely viable to favour VPW or constant inflation adjusted or Guyton-Klinger depending on a specific individual's preferences. Just takes understanding how their behaviour works to make the appropriate choice for the individual.

jamesd

DT2001 said:

Bill Bengen said it was actually 4.2% and I think he used 4.5% personally by diversifying into more asset classes.

He's using 5% personally, based on the cyclically adjusted price/earnings ratio being high in the US but inflation being low. Me:  meaning mediocre but not bad conditions. If I recall correctly the original was 4.1% or 4.2% (hence 4% is after cheap charges in the US) and 4.5% with 35% large cap, 20% small cap and 45% intermediate duration bond mixture. Higher equities for longer terms, he said "For 45 years, I calculated 65% equity exposure as optimal, with a 4.1% SWR".

He was extremely complementary about the work Kitces did on varying drawdown rates based on cyclically adjusted price/earnings ratio, effectively saying it was one of the best innovations since the 4% rule.

jamesd

kuratowski said:

As described above this is a pure strawman.  How many people would just blindly pick a number the day they retire and then draw that much down forever, refusing to take any other precautions such as 3 years' cash buffer, and stubbornly refuse to adjust despite their portfolio shrinking.

...

I'm pretty keen on retiring early, so I have been working on the basis of 3%, i.e. to cover a longer time period than 4% was designed for.  This is despite being on track for full new state pension, and having a deferred DB pension amount to about half SP, together these two would cover my basic needs, so I like to believe my plans are pretty cautious.

People are expected to use the constant inflation-adjusted income rule though it is recommended by assorted people including me to recalculate income since it doesn't incorporate market gains and assumes you're living through the historic worst case. If you do live through something worse you'd be expected to notice and react. But US average for this rule is 7% and it starts at only 4.1 or 4.2%, both for 30 years, so it's extremely cautious. Start at the UK 4% rule level and blindly follow it and your chance of failure is very low.

At 3% you're planning on either worse than historic UK performance or living more than 45 years or using less than optimal investments, since 45 years US calculated 4% rule starts at 4.1% with 65% equities. Deducting the usual 0.3 for the UK that's 3.8%. Deducting a third* of say 0.6% in total costs cuts it to 3.6% for 45 years.

*you don't deduct 100% of the costs on the initial balance because the balance and hence the costs decrease during the almost but not quite failing worst case. The right number turns out to be around a third of costs but there is variation. I pretty uniformly use a third or 30% because it's close enough, correct for the common 30 year US case and the error margin is lost in the market unpredictability noise.