Foolishness of the 4% rule

Linton

itwasntme001 said:

bostonerimus said:

itwasntme001 said:

Deleted_User said:

Equities do normally protect from inflation.  Very well.  Over long term, as per usual.  In the short term they could fall as the inflation and interest rates go up.  

Try telling that to someone who retired in 1970 at the age of 60, heavily invested in a 60/40 portfolio, and was about to start on a 10 year spending spree to enjoy retirement before they became less able.

Yes thought you would change your mind about "equities do normally protect from inflation".

I think the the critical word here is "normally".

What does normally even mean?  How do we know it is normal?

Nothing in the future is absolutely guranteed so you have to base your future plans in general and investing strategy in particular on assumptions about the world that you are prepared to accept.  A reasonable assumption backed up by theory and history is that equities will broadly over the long term increase by more than inflation.  If you did not wish to assume this it is difficult to see why you would rationally invest in equities at all.

Normally could be taken to be significantly greater than 50% probability historically. 

[Deleted User]

itwasntme001 said:

Deleted_User said:

itwasntme001 said:

Deleted_User said:

Equities do normally protect from inflation.  Very well.  Over long term, as per usual.  In the short term they could fall as the inflation and interest rates go up.  

Try telling that to someone who retired in 1970 at the age of 60, heavily invested in a 60/40 portfolio, and was about to start on a 10 year spending spree to enjoy retirement before they became less able.

Yes thought you would change your mind about "equities do normally protect from inflation".

Firstly, I said “equities”.  Bonds are terrible when dealing with unexpected inflation.  So, “60/40” isn’t relevant.  

Secondly, William Bernstein has dealt with this better than I would in his “investing for adults” series.  It included this and other examples from a range of countries which experienced high inflation. Get back to me once you had a chance to read it. You’ll find that a globally diversified equity portfolio provides an excellent long term hedge against inflation.

But it is reasonable to expect a 60 year old retiree to have a decent chunk in fixed income assets and I think 60:40 is quite appropriate.

I am just giving an example where your thesis fails.  Even assuming a 100% stocks portfolio for a 60 year old in 1970 spending 4% a year.  That is a depletion of more than 40% of the value over a 10 year period.  Even more so if you adjust the 4% by inflation.  I haven't done the numbers, but I imagine it would be significantly more than a 40% depletion, probably in the region of 60%?

And all because equities did not keep up with inflation.  They fell.  I even assumed above equities did keep up exactly.

So Mr or Mrs 70 year old retiree in 1980 now has a pot that has depleted at least by half in nominal terms, even more in real terms and the favourable returns that are about to occur in the next few decades won't help a huge amount given the capital has been depleted so much.  Sequence of returns risk is very real.

You are a writer and not a reader but please read at least the title of this thread.  Whats the point of you telling me that a constant 4% withdrawal didn’t work?   The rest of my comments basically say that bonds are an inappropriate  form of fixed income for a retiree and you still insist on bonds in trying to prove something to me.  

Now, global stock market returned 132% in USD in the 1970s. Which beat inflation of 112%. So, by 1980 a 1970 retiree with a flat annuity covering his basic needs would have had to dip in his 100% stock portfolio.  In the early 70s the “dipping” would have been minimal.  By the late 70s inflation was a problem for his flat annuity.   His stock portfolio provided an excellent hedge against inflation.  

In the 70s “inflation” included house prices. Retirees do not buy bigger houses. Personal Inflation for the 1970 retiree would have been a lot less than 112%. 

Having said this, my personal opinion is that long term inflation at the 1970s levels isnt plausible. Central banks can behave badly for periods of time, but if really high inflation becomes a problem they know what to do. Now. They didn’t then. 

Do read the Bernstein series.  

bostonerimus

itwasntme001 said:

bostonerimus said:

itwasntme001 said:

Deleted_User said:

Equities do normally protect from inflation.  Very well.  Over long term, as per usual.  In the short term they could fall as the inflation and interest rates go up.  

Try telling that to someone who retired in 1970 at the age of 60, heavily invested in a 60/40 portfolio, and was about to start on a 10 year spending spree to enjoy retirement before they became less able.

Yes thought you would change your mind about "equities do normally protect from inflation".

A counter example would be the last 30 years in the USA. a 60/40 portfolio delivered average annual growth of 9% and average annual inflation was 2.4%. There is no guaranteed inflation link or protection from equities, bonds or a combination of the two, but many times they do beat inflation considerably. This is the bedrock of the 4% rule. Bengen did not come up with 4% for 1970s Japan.

The key point being last 30 years.

We have history of financial markets (that represents more or less the current form) going back a 100 years or so.

Yes and "normally" (more often than not in MonteCarlo simulations using the 100 years of data) a 60/40 portfolio has beaten inflation. 

[Deleted User]

We have history of financial markets (that represents more or less the current form) going back a 100 years or so.

Given that money was different for most of the 100 year period, I would question this assertion. 

OldScientist

MK62 said:

Thanks for the rather comprehensive reply......it pretty much sums up my current view too (despite my temporary inability to calculate 4% of 500k....😉).....

That said I'm genuinely interested in alternative views.....it would be interesting to see how the above compared to taking an annuity back in 1965......the rates on offer then might have been quite different.

I'm not against the concept of annuities, per se, just the current rates on offer........

No worries - I managed to lose a rather more comprehensive reply than this one. In the meantime, the rate for a level annuity in the UK was 11.3% for a 65 year old male in 1965 (higher mortality and higher interest rates ~6.5%) - see http://people.exeter.ac.uk/ipt201/research/Cannon and Tonks FHR Final Version.pdf.

I am just about finished incorporating annuities into my code, so may be able to provide a quantitative response in due course, but in the meantime a qualitative approach with current annuity rates might go as follows for your scenario (i.e. 5% from the portfolio/annuities for 7 years, 3% thereafter)

First, noting that (with US inflation), the income from a level annuity bought in 1970 by a 70 year old and one with 3% COLA is as follows

In other words, while a level annuity has an initial advantage in income, inflation soon eats that away so after about 7 years the annuity with a 3% COLA has the advantage and even after the inflationary disaster of the 70s and early 80s has a real income somewhere between half and two thirds of the initial income even after 35 years. Note that the 3% COLA is applied annually, and it is this that results in the sawtooth pattern in the monthly income.

therefore, if we only consider the purchase of an annuity with escalation, then courtesy of HL, the current rates (UK) with 3% escalation (COLA) are 3.2, 4.1, and 5.3% (at 65, 70, and 75 years old, respectively)

In the first 7 years (ages 60-67) there is no point buying a 3% COLA annuity since the rate (somewhere between 3.2 and 4.1%) is well below that being drawn from the portfolio (5%) - purchase of an annuity will mean that the portfolio has to work even harder to deliver the required income.

After SP kicks in, the portfolio and annuities only need to provide 3% - at this point (say at age 70) purchasing an annuity with part of the portfolio will mean, at least until inflation has had a bit of time to do its work, that the fractional withdrawal from the portfolio will be decreased. Purchase of a further annuity at 75, will also help drive the portfolio withdrawal down.

[Deleted User]

In general, someone with limited assets at the point of retirement is forced to take major bets.  For someone with a basic state pension and a couple of hundred Ks, assuming that market will behave the same in the next 50 years as over the last 100, or that the retiree won’t live long enough for money to run out, might be a reasonable strategy.  Even so, varying withdrawals based on market performance would improve the odds.  The “bucket” strategy works particularly well for someone with more assets, say 1M on top of state pension.  Then a flat annuity can compliment the state pension to address basic needs while the third, still substantial, bucket can be aggressively invested in 100% stocks.  Variable withdrawal strategy wouldn’t involve any hardship in this scenario.  Its important to treat any DB pension and annuity you may have as the fixed income portion of your portfolio.

bostonerimus

There's a natural tension in retirement planning between the income you need and the income you can genrate. A lot of thought goes into the income generation side of the equation and often very little into how much you really need to spend. I believe the spending side should get far more attention as big savings can be made in costs like housing, food, energy, taxes and insurance without much pain and often with actual well being gains.

michaels

bostonerimus said:

There's a natural tension in retirement planning between the income you need and the income you can genrate. A lot of thought goes into the income generation side of the equation and often very little into how much you really need to spend. I believe the spending side should get far more attention as big savings can be made in costs like housing, food, energy, taxes and insurance without much pain and often with actual well being gains.

I think the issue there is that if you 'run a tight ship' then any reductions in income resulting form a variable drawdown strategy will directly hit standard of living as there is no 'fat to trim'.  So yes in theory you need a smaller pot but in reality it is the minimum not the average of the return distribution that matters if you are not in a position to cut your expenditure.

Thrugelmir

itwasntme001 said:

Deleted_User said:

Equities do normally protect from inflation.  Very well.  Over long term, as per usual.  In the short term they could fall as the inflation and interest rates go up.  

Try telling that to someone who retired in 1970 at the age of 60, heavily invested in a 60/40 portfolio, and was about to start on a 10 year spending spree to enjoy retirement before they became less able.

Yes thought you would change your mind about "equities do normally protect from inflation".

A 60/40 portfolio wasn't an option back then. A more recent invention. 

A lot has changed in the past decades. Assuming that the 70's 80's 90's  were the same as today is erroneous. Very very different in so many ways. 

bostonerimus

Thrugelmir said:

itwasntme001 said:

Deleted_User said:

Equities do normally protect from inflation.  Very well.  Over long term, as per usual.  In the short term they could fall as the inflation and interest rates go up.  

Try telling that to someone who retired in 1970 at the age of 60, heavily invested in a 60/40 portfolio, and was about to start on a 10 year spending spree to enjoy retirement before they became less able.

Yes thought you would change your mind about "equities do normally protect from inflation".

A 60/40 portfolio wasn't an option back then. A more recent invention. 

A lot has changed in the past decades. Assuming that the 70's 80's 90's  were the same as today is erroneous. Very very different in so many ways. 

In the US the 60/40 Wellington fund has existed since 1929. Also it was perfectly possible to own a portfolio of equities, even equity index funds, and US T-bills in the 1970s, but few people were using that to fund retirement. The "SWR" work by Bengen (1994) and the Trinity study (1998) was a response to the increase in people using DC plans to fund retirement using portfolios of stocks and bonds which had been created in the US in 1978 in Internal Revenue Code Section 401(k). Those studies are exactly what this thread is all about and they claim to be nothing more than an analysis of the historical US stock and bond data applied to the funding of retirement. They present the probabilities of "success" given numerous arrangements of that data. Someone retiring in the 1970's might well fall into the 5% "failure" bucket, but picking out a single scenario misunderstands what Bengen and Trinity are saying. The studies can help you plan for your retirement, but you still have to live that retirement and you only get one shot at it rather than the thousands of shots created in the studies.