Foolishness of the 4% rule

NedS

I am playing devils advocate here, but it's kind of a serious question too...

Given a well diversified portfolio of global assets, why wouldn't 4% increasing with inflation be achievable.

I am going for a different less popular approach, of only drawing the natural yield from my portfolio. I hold CTY as a core holding in my portfolio, a UK equity income investment trust currently yielding 4.95%. Compared to a globally diversified portfolio, it is very poorly diversified, only holding 60-100 predominantly UK based equity holdings, and mostly higher dividend payers at that. Yet over the last 50+ years they have been able to increase the dividend yield every year and those rises have beaten inflation over the long term. Being an investment trust, the manager is able to hold back some income in reserve to cover periods of distress (Covid) thus minimising sequence of return type risks. Capital appreciation is up around 3-fold over the last 30 years, and depending on the time of purchase you would have got anywhere from around 4 to 5.5% initial dividend yield on your investment. So my question is if they can achieve the holy grail of a 4-5.5% starting yield rising with inflation over 30 years AND grow capital 3-fold from a severely limited investment universe of FTSE UK dividend paying equities, why is it so hard to imaging that the same would not be achievable from a globally diversified portfolio of assets given everyone tells me a natural yield approach is far less optimal that a total return strategy over the long term.

Given that my natural yield strategy gives me the income I need from my portfolio with little risk of ever running out of capital as I'll never be required to sell any units (and I actually plan on buying more by reinvesting anything over a 5% yield and I'm currently achieving a 6% yield), why would I take the extra risk of a SWR total return approach where no one can agree on what a sensible SWR is or how it should be adjusted over time.

Note: I use CTY as an example of what is achievable, and I hold it as part of a well diversified income portfolio. I also hold growth-based assets as part of a diversified growth portfolio too.

[Deleted User]

It is quite possible and likely that more than 4% in real terms is achievable, particularly in a well diversified equity portfolio.  “Likely” isn’t good enough when we are talking about pot number 1.  For essentials we need a guaranteed income to the end, something a state pension, DB income or annuity can provide. 

And then you can enjoy high returns in your discretionary pot, and draw much more liberally, based on todays value.  Drawing at a small fraction of what portfolio was worth 30 or 40 years ago does not make any sense at all. 

michaels

Deleted_User said:

Anything that happened decades ago isn’t relevant,  There were fundamental changes to the system since the Bank of England was given an inflation target of 2% and declared independent.   

One can argue that historic inflation isn’t relevant in the US at all because the Feds have recently changed their objective to “average inflation targeting”. It is, however, a minor change compared to much more fundamental changes that happened at the end of 1970s. 

I do not believe that inflation would be allowed to run above the objective for long periods of time. Neither does Mr Market. Could be wrong but by a large margin?  The chances are very low.  You deal with low probability scenarios by staying diversified. 

Also, please keep in mind that RPI, CPI and all the other official measures of inflation will not reflect your exact inflation any more than 2% will.  For example they account for mortgages and the cost of rent. Will you have either when you retire? 

Look at the UK over the last 15 years, there have been several inflationary 'blips' to which the central bank has not responded.

Given the current economic situation I can't see any rapid monetary response to any inflationary spike because hitting the economy when it is in recession would just be politically unacceptable.

OldScientist

Deleted_User said:

Anything that happened decades ago isn’t relevant,  There were fundamental changes to the system since the Bank of England was given an inflation target of 2% and declared independent.   

One can argue that historic inflation isn’t relevant in the US at all because the Feds have recently changed their objective to “average inflation targeting”. It is, however, a minor change compared to much more fundamental changes that happened at the end of 1970s. 

I do not believe that inflation would be allowed to run above the objective for long periods of time. Neither does Mr Market. Could be wrong but by a large margin?  The chances are very low.  You deal with low probability scenarios by staying diversified. 

Also, please keep in mind that RPI, CPI and all the other official measures of inflation will not reflect your exact inflation any more than 2% will.  For example they account for mortgages and the cost of rent. Will you have either when you retire? 

I don't know what will happen to inflation (and I'm not sure Mr. Market does beyond, perhaps, the immediate future) and I hope that the BoE and Fed continue to meet their inflation targets. However, events (whether predictable, like the pandemic, or otherwise) may very well throw a spanner in the works at some point in the next 30-40 years. 

I completely agree with you on diversification - this may mean holding more contentious things like gold and other commodities.

Inflation measures are interesting in themselves - I agree that personal inflation may be very different to the official measures (because the personal 'basket' of goods and services differs significantly from the official 'basket') and may also be different to wage inflation (although I note that UK annualised wage inflation and RPI from 2000-2021 are similar at 2.9 and 2.8%, respectively).

OldScientist

michaels said:

Deleted_User said:

Anything that happened decades ago isn’t relevant,  There were fundamental changes to the system since the Bank of England was given an inflation target of 2% and declared independent.   

One can argue that historic inflation isn’t relevant in the US at all because the Feds have recently changed their objective to “average inflation targeting”. It is, however, a minor change compared to much more fundamental changes that happened at the end of 1970s. 

I do not believe that inflation would be allowed to run above the objective for long periods of time. Neither does Mr Market. Could be wrong but by a large margin?  The chances are very low.  You deal with low probability scenarios by staying diversified. 

Also, please keep in mind that RPI, CPI and all the other official measures of inflation will not reflect your exact inflation any more than 2% will.  For example they account for mortgages and the cost of rent. Will you have either when you retire? 

Look at the UK over the last 15 years, there have been several inflationary 'blips' to which the central bank has not responded.

Given the current economic situation I can't see any rapid monetary response to any inflationary spike because hitting the economy when it is in recession would just be politically unacceptable.

Yes - RPI getting on for 5% for two years (2010 and 2001) albeit after a deflationary year in 2009.

The recent large increase in energy prices is a good example of something that the UK government and BoE have little or no control over.

OldScientist

NedS said:

I am playing devils advocate here, but it's kind of a serious question too...

Given a well diversified portfolio of global assets, why wouldn't 4% increasing with inflation be achievable.

I am going for a different less popular approach, of only drawing the natural yield from my portfolio. I hold CTY as a core holding in my portfolio, a UK equity income investment trust currently yielding 4.95%. Compared to a globally diversified portfolio, it is very poorly diversified, only holding 60-100 predominantly UK based equity holdings, and mostly higher dividend payers at that. Yet over the last 50+ years they have been able to increase the dividend yield every year and those rises have beaten inflation over the long term. Being an investment trust, the manager is able to hold back some income in reserve to cover periods of distress (Covid) thus minimising sequence of return type risks. Capital appreciation is up around 3-fold over the last 30 years, and depending on the time of purchase you would have got anywhere from around 4 to 5.5% initial dividend yield on your investment. So my question is if they can achieve the holy grail of a 4-5.5% starting yield rising with inflation over 30 years AND grow capital 3-fold from a severely limited investment universe of FTSE UK dividend paying equities, why is it so hard to imaging that the same would not be achievable from a globally diversified portfolio of assets given everyone tells me a natural yield approach is far less optimal that a total return strategy over the long term.

Given that my natural yield strategy gives me the income I need from my portfolio with little risk of ever running out of capital as I'll never be required to sell any units (and I actually plan on buying more by reinvesting anything over a 5% yield and I'm currently achieving a 6% yield), why would I take the extra risk of a SWR total return approach where no one can agree on what a sensible SWR is or how it should be adjusted over time.

Note: I use CTY as an example of what is achievable, and I hold it as part of a well diversified income portfolio. I also hold growth-based assets as part of a diversified growth portfolio too.

While I am not going to comment on dividend vs total return, I will comment that the FTSE100 has also seen an approximate 3-fold increase in capital over the last 30 years and has paid dividends over 4% (sadly at 3.5% today). I also note that the last 30 years is one of the good retirement periods - the SWR is well over 4% (around 8% for a US retiree with a 60/40 portfolio), although we only know that now (which is one of the weaknesses of the SWR approach). If the data are available, how did someone living on dividends from CTY do in the 30 years from 1965-1995?

MK62

NedS said:

I am playing devils advocate here, but it's kind of a serious question too...

Given a well diversified portfolio of global assets, why wouldn't 4% increasing with inflation be achievable.

I am going for a different less popular approach, of only drawing the natural yield from my portfolio. I hold CTY as a core holding in my portfolio, a UK equity income investment trust currently yielding 4.95%. Compared to a globally diversified portfolio, it is very poorly diversified, only holding 60-100 predominantly UK based equity holdings, and mostly higher dividend payers at that. Yet over the last 50+ years they have been able to increase the dividend yield every year and those rises have beaten inflation over the long term. Being an investment trust, the manager is able to hold back some income in reserve to cover periods of distress (Covid) thus minimising sequence of return type risks. Capital appreciation is up around 3-fold over the last 30 years, and depending on the time of purchase you would have got anywhere from around 4 to 5.5% initial dividend yield on your investment. So my question is if they can achieve the holy grail of a 4-5.5% starting yield rising with inflation over 30 years AND grow capital 3-fold from a severely limited investment universe of FTSE UK dividend paying equities, why is it so hard to imaging that the same would not be achievable from a globally diversified portfolio of assets given everyone tells me a natural yield approach is far less optimal that a total return strategy over the long term.

Given that my natural yield strategy gives me the income I need from my portfolio with little risk of ever running out of capital as I'll never be required to sell any units (and I actually plan on buying more by reinvesting anything over a 5% yield and I'm currently achieving a 6% yield), why would I take the extra risk of a SWR total return approach where no one can agree on what a sensible SWR is or how it should be adjusted over time.

Note: I use CTY as an example of what is achievable, and I hold it as part of a well diversified income portfolio. I also hold growth-based assets as part of a diversified growth portfolio too.

Timing is key though.......if you'd bought CTY in 2000 for instance, the annual yield was around 3% (using the annual dividends paid Aug00-Aug01 (7.5p per share) against the share buy price on 31/8/00 (249.5)) - an income of 4% would only have been possible by selling shares.....

In fact, tracked against an RPI linked 4% income in 2000, the income from CTY's yield would not catch up until c2017........and that's before you've sold any shares along the way.

Of course, it may well work some of the time......

[Deleted User]

A year ago in Canada Vanguard introduced an ETF to deal with retirement withdrawal needs. Called VRIF. Its made up of stocks and bonds (50/50) and has a stable allocation to world trackers with extra weighting assigned to home market. The “dividend” is designed to start at 4% and then increase or decrease, depending on market movements. But the change is limited not to exceed X. 

So, its a much more sensible strategy than the 4% SWR. Not a bad product. Costs around 30 basis points, I think.  A bit high but tolerable (no other “platform” or trading charges  and you wouldn’t use an advisor if you buy this product). Quite popular, I believe. 

Still, I prefer “the bucket” approach and to manage non-DB withdrawals myself according to a transparent system.  

itwasntme001

27 pages of time and effort spent on trying to come to some sort of conclusion on a "safe" withdrawal rate and how best to accomplish it.  Surely time better spent actually enjoying life by spending some of the money?  If there is a 1 in 2 or 1 in 3 chance of getting cancer in a lifetime, surely time better spent keeping fit and healthy and not stressing or worrying over safe withdrawal rates?  And so what if you run out of money into old age.  You will be cared for by the state anyway.

Better to just have a very rough sense of how much you can spend and set appropriate allocations.  No need to get so accurate about these things and certainly no need for 27 pages.

Perfection is the enemy of good/action/progress etc.

arnoldy

michaels said:

Inflation will hit 5-6% by the end of this year or early next so that 2% annuity is worth 4% less next year and thereafter.

So to an extent will your DB - most are capped at 2% and 5% - and that's if the funding situation allows. Most DBS going into payment now will have a small bit with no rises, and half 2% and half 5% cap.

[That's private DBs, Publics Sector ones are a different universe and well done if you have some dibs in those.]