Yes, there were vinyl, 45 RPM records. Really. And yes, we did dress and wear our hair as shone in this video (I kept my shirt buttoned, though - that’s not ever been my style).
There is an ongoing conversation about safe withdrawal rates. Are these conversations useful? I think they are. Can you set it and forget it in terms of your income if you are relying on income from marketable securities? Maybe. You cannot have ongoing portfolio income, for an unknown period, any way you want it, and you definitely should not rely on “the 4% rule”, especially if your potential lifespan is greater than 30 years. And for most of us this is the fact of the matter.
Do you want your income when you are no longer getting a paycheck to be “maybe?” I thought not.
The Attraction
Our brains like simple. They do everything they can to conserve energy and appreciate heuristics. And boy, is this a nice heuristic.
How simple is this? Your investment portfolio is $4 million at the outset. Your investment mix is 50% stocks and 50% fixed income. You draw 4% in this first year - $160,000. Each year, you can increase your withdrawal by 3% - so the second year you can withdraw $164,800 (and if you don’t take the increase, you can increase it more in later years - but that takes some fancier math). The following year, increase by 3% again, to $169,744. Why do this? To maintain your purchasing power given inflation. The model says you can maintain this income pattern for 30 years. This research, named SAFEMAX, was developed by Bill Bengen and published in The Journal of Financial Planning in 1994 (find it here). Pretty simple, including the name.
Need to draw for more than 30 years? Reduce the withdrawal rate or increase the rate of return on the portfolio. Simple.
Complications
The 4% approach feels good. It is easy to understand. The math is well done, tested, and elegant.
When you burn the midnight lamp on this, you find a number of complications.
Foremost, it was a finding in 1994, based on history. Subsequent media, let’s call it marketing in disguise, has resulted in calling it a rule. Bengen himself has revised the research (here), noting that 4.5% or so is now the “rule”. I’ve seen “rules”, based on similar research, including that of Morningstar (see it here), ranging from 2.8% to 5%, and in our experience we’ve had some clients successfully draw higher percentages (against our recommendation - but it has worked - so far!). Much depends on Social Security, inflation, your age, your actual lifespan, your real, experienced inflation, Social Security inflation, other sources of income, your actual spending, inheritance(s), and experienced portfolio yield and rate of return.
Most of the people I talk to intend to be financially independent in their 50’s, and at latest 60.
What this chart tells us is that life expectancy in the US has recently dropped to 74.2 years. So, you say: “I quit earning an income at 55 and I need to finance my life for about 20 years then, and maybe 25 years if I live 25% longer than average. Seems like it will work”.
The problem with this thinking? I hate to break this to y’all - you are not average. Not in the slightest. The average contains coal miners, addicts, deep sea fishermen, the chronically unhealthy, suicides, and on and on. You are likely far above average in income and education, with access to better healthcare, work in a lower-risk occupation, and probably grew up in a stable, well-fed, and mostly low stress household (certainly, some or our readers are exceptions to this statement, and I bet if we survey you we will find that is a low percentage). Expecting an average lifespan when you are far above average in our world is a fallacy. If you are married at age 65 you have something like a 50% chance of one of you making it to age 92. From our perspective, 30 years is the minimum lifespan we can plan on if you are in your early 60’s. Minimum. That means we really have to plan to age 100 for most of you, and even that has some tail risk.
I know I am a sample size of one - but my father, born in 1923, with an expected lifespan when he was 40 of probably 25-30 years, lived to age 100. My mother died at age 89. My father-in law was 87, and mother-law was the exception, dying at 63 (she was a lifelong smoker and alcoholic). How dissimilar is your situation?
Even if this works, and you die in year 29, how comfortable were you in those last years, knowing that you are out of money in year 30?
If you want to leave a legacy or at least have a chance of doing so, there is no allowance for that in this research. So you say you don’t care? Tell me that in 20 years. I can’t for sure say you will change your mind. I cannot predict your future. I can say I’ve seen people want to change their mind and be saddened when they have no options.
In real life and out of the spreadsheet lab, sequence of returns matter (look here). A lot. In particular, a 10%+ downturn just prior to your initial withdrawal can have a dramatic, long-term impact. The sequence of inflation matters, too. Unusual expenses happen, resulting in lumpy withdrawals. The sequence of withdrawals matters, too. Health care cost can be significant and is unpredictable.
Our mindset is that the future is always great. Today? It stinks. The past? Also great. The fallacy when doing very long range planning like this is that we often fool ourselves into being certain of terrific outcomes:
Our spending is consistent and we can reduce it in the future if needed.
Returns and yield will support our spending desires.
We will die peacefully in our sleep with no expensive, long-running health issues.
It will all work out.
There are many variables. Most of them are not controllable by you. The ones you can control?
How much you withdraw.
When you withdraw.
Investment strategy and allocation.
Is There Anything That Works?
My snarky answer is: Save a lot more than any model says you need to save. For most people, this is not at all reasonable. There are solutions, though.
When I went thought the Retirement Income Certified Professional® program, we studied 11 income models, and I have no doubt that we could design another 11. Here are some alternatives (note: there is nothing simple about designing for and sustaining income over an unknown period with variable inflation and investment returns. There is much more to each of these alternatives):
Annuitize your “keep the lights on” expenses. Your controllable/“variable” expenses (things you could live without) would then be covered by earnings and withdrawals from you investment portfolio. Inflation raises would also be covered this way (there are annuities that have increasing payouts, and these should also be reviewed at the time when you are annuitizing your income need).
Maintain a two to five year income reserve in cash or equivalent(s), with the remainder in an actively managed portfolio (FYI - just because your portfolio is all ETFs does not make it inactive/“passive”. It makes it lower cost in most cases). The point here is to maintain enough cash (and you might use an ultra-short municipal bond fund or bond ladder or treasury bills here, and there are other alternatives) to cover your income needs through the peak to trough to peak cycle (which is itself unpredictable. For a 60% equity portfolio, this tends to be not longer than 38-40 months). The higher your equity allocation, the higher your income reserve allocation. We like to draw all income from the cash reserve and then refill it quarterly in good markets. In bad markets, you intentionally draw this down.
Annuitize your entire income need rather than only your fixed expenses. Depending on the annuity tool used, you might need dollars invested for inflation raises and unplanned expenses.
Create a bond ladder so that the maturing principle serves as your income for the year. You could ladder in such a way as to give yourself an inflation pay raise each year.
Have a bucket strategy (example here) where you set aside buckets of money, say in 5 or 10-year increments, and the farther out you go in years the more aggressive the investment strategy becomes. Then you adjust the bucket’s strategy, much the same as a target date fund, as each bucket “matures”. You could use annuities in this scenario, as well.
This is by no means a comprehensive view of income models. These 5 are the ones we see and use most often, with number two being the most common in our practice. What works best for you cannot be determined here, and the pros and cons of the various options are, in and of themselves, a long conversation - this is why you should have your own financial plan and spend at least a few years thinking about and planning your post-career, lifetime income.
Now, should most people be their own surgeon in this instance and do their own income planning? Well, I am biased, of course, but I think not. Income planning and dealing with all the variables are technically complex, with many choices, just like many surgeries. It is an emotional topic, too, and a textbook case for employing a professional.
Sundry
Most moving song of the week.
Clapton’s cover of Burning of the Midnight Lamp, which is amazing