Anyone who is serious about their future has probably wondered more than once what their life will be like in retirement. Many people believe that can’t rely on a state retirement pension and you need to save and invest your financial surplus. It’s hard to disagree with that. So how much money do we need to achieve a similar live level during retirement as now, when we work? How much can we pay out of the accumulated savings to cover living costs? Below, I will try to present some best practices and show you the tools that can help you create a retirement plan.
4% only that much? and so much!
The 4% rule is commonly used by financial advisers to determine the amount of accumulated capital, which should be enough for us to live a peaceful life during 30 years retirement period. What is the 4% rule means? In other words, if your annual expenses are 4% of your accumulated capital, and the total is at least 60% invested in stocks and 40% bonds, you can live for another 30 years by withdrawing the initial inflation-adjusted amount from your portfolio each year. For example, a person whose living costs are EUR 40 000 per year, needs 25 times this amount (100% / 4% = 25), or EUR 1 000 000. Then we can withdraw EUR 40 000 in the first year, and in the following years the amount of our payments will adjusted by inflation rate. So if the inflation in the previous year was 5%, the payment for the next year would be EUR 42 000 etc.
Why 4%? The 4% rule is the result of a 1994 study by William P. Bengen based on historic returns in the stock and bond markets. These studie shows that each portfolio with the initial withdrawal rate of 4% will survive for at least 33 years. In 1998, three professors from Trinity University in Texas also conducted a 4% study. This research is commonly known as the Trinity Study. In total, many studies concern Safe Withdrawal Rate (SWR). These studies more or less criticized the 4% rule. Criticism mainly concerned assumptions such as the length of the payment period or the amount of the annual payment, which are difficult to predict depending on unforeseen expenses such as medical costs. Additionally, there is an argument that the rule is based on constant (inflation-adjusted) payouts based on investments in highly volatile assets such as equities.
What if we want to retire early?
The 4% rule is an indicative value and its direct application without taking into account additional factors may turn out to be incorrect. It does not take into account additional income or a payout period of more than 30 years. People inspired by the FIRE (Financial Independence Retire Early) movement would probably like to calculate exactly what safe percentage of capital can be withdrawn and what capital needs to be raised to achieve financial independence. Such calculations can be made with use of toll created by Karsten “Big Ern” from the earlyretirementnow.com blog. I recommend a whole series of articles about SWR. The subject is literally broken down into atoms.
The link to the calculator you will find below (save your own copy for editing) EarlyRetirementNow SWR Toolbox v2.0
The calculator may seem complicated, but all you need to do is set the proportions of your portfolio in the “Parameters & Main Results” tab and enter the expected cash flows in the “Cash Flow Assist” tab. As a result, we obtain a table showing the failure probability for a given SWR for different periods starting from 1871. Additionally, the SWR results are presented depending on the CAPE ratio and drawdowns on the S&P500.
Other useful tools
You can find many different tools on the Internet which can help you plan your early retirement. Below is a list of the tools I have tested. If you know of any other interesting sites, post the link in the comment at the end of this post.
cfiresim.com Another calculator to simulate your retirement portfolio with success rate.
engaging-data.com/fire-calculator When can you retire? A calculator showing years to your retirement, taking into account the amount of expenses and savings opportunities.
engaging-data.com/will-money-last-retire-early Will you have enough money for the rest of your life?
portfoliovisualizer.com/financial-goals A very good tool that takes into account deposits and withdrawals over time. You can choose different simulations based on historical, statistical or predicted returns. Possibility to include sequence of return risk, i.e. the risk that results from the order in which the returns on investment appear in the analysis (e.g. worst 3 years at the beginning, etc.). Analysis are based on Monte Carlo simulation for 10,000 scenarios.
portfoliocharts.com/portfolios Lots of useful statistics for ready-made portfolios, including the ability to create your own portfolio where SWR is one of the results.
Other interesting sites about FIRE movement
What is the SWR for different TAA (Tactical Asset Allocation) strategies?
TAA are active strategies that use market anomalies such as momentum in order to allocate to an individual assets. I describe and present such strategies on my blog.
To check the Safe Withdrawal Rate (SWR) value for these strategies, I used the Monte Carlo simulation tool available in the Portfoliovisualizer. Based on the monthly performance of each strategy for 2000-2020, the program generates 10 000 random portfolios. In addition, I checked how the strategy would handle regular payouts and obtained the percentage of portfolios that withstood payouts over a certain period of time called Success Rate.
- Initial Amount = 500 000$
- Withdrawal Amount = 30 000$ / yearly
- Withdrawals are Inflation Adjusted
- Simulation Period = 40 years
- Sequence of Return Risk = 2 worst years at the beginning of the period
On the end we get results divided into percentiles, i.e. a percentage value that determines how many results were higher or lower than the given value. Below I present the results for the 10th percentile, which means that 10% of the results (out of 10 000 possible) were lower or equal than the presented values. On the other hand, as much as 90% of the results were equal or better than the presented ones. You could say that this is a fairly conservative approach, but if you prefer, you can change the percentile ranges to 1, meaning 99% of the portfolios performed better than the 1st percentile.
Below are the 10th percentile SWR values for each strategy, sorted from lowest to highest (click to enlarge chart).
Remember that SWR is calculated regardless of the initial portfolio value or payout amount. The SWR is based on historical performance and tells us how much we can theoretically withdraw yearly without getting bankrupt (final portfolio value must be greater than 0).
Now let’s look at the Success Rate, which tells us how many portfolios out of 10 000 for each strategy survived a given payout value ($ 30 000 per year). The assumed $ 30 000 out of the starting value $ 500000 is nothing more than 6%, which is quite optimistic withdrawal rate 😀. Below I present strategies that achieved a success rate above 95%, i.e. at least 9 500 out of 10 000 portfolios survived the assumed payouts. Below are the strategies sorted by SWR.
W sumie 33 strategie zdały test. Wiele ze strategii prezentowanych powyższej opartych jest o instrumenty lewarowane co nie do końca może być dobrym pomysłem gdy jesteśmy na emeryturze czyli w okresie gdy powinniśmy ograniczyć zmienność naszego portfela.
Poniżej znajdziecie strategie z wynikiem powyżej 95% success rate bez instrumentów lewarowanych.
A total of 33 strategies passed the test. Many of the strategies above are ussing leveraged ETFs, which may not be a good idea when are retired. In such a period we should lower our portfolio volatility and use non leveraged strategies.
Below you will find strategies with more than 95% success rate without leveraged instruments.
The above analysis shows that the SWR for various TAA strategies is higher compared to SWR for passive portfolios. Some values are several times higher, especially for aggressive strategies which use leveraged instruments. However, I am cautious about these results and, as is in case of all financial analyzes, you must use common sense. Nobody knows what the future will be like, and be sure that SWR values will be different than presented above. You should be careful when designing your retirement plan and take a more conservative approach i.e. take 3.5% or 3% instead of 4%. An additional aspect that should be taken into account is the relatively short period of data for the presented strategies compared to the passive strategies. I checked the 60/40 portfolio for 1987-2020 (34 years) and 2000-2020 (21 years) and the SWR value were worse for the shorter period 4.7% (34 years) and 3.47% (21 years) respectively. This shorter period is identical to all of the TAAs above. Nevertheless, I cannot say whether this has an impact on the final evaluation of the results of the analysis.
Additionally, we must remember that SWR analyzes refer to the period of declining interest rates. This can have impact on future results especially on passive portfolios (buy & hold) where bonds are sometimes are significant part of the portfolio. It can be said with high probability that the rates of return on the bond part of the passive portfolio will be lower than those achieved in recent decades.
The period of low/increasing interest rates has a smaller impact on TAA strategies (including those presented on the blog) due to the fact that the goal of the TAA strategy is to invest in the most prospering assets and reduce exposure to the weaker ones.
The 4% rule, despite of its drawbacks, tells us what value of capital we should save to think about early retirement. If you collect 25-30 times the annual living costs and invest them in a chosen, well-thought-out strategy, there is a fairly high probability that you will not go bankrupt or even have more than you initially invested. Of course, everyone must choose their own path to financial independence. It doesn’t mean that you need to quit your job. Someone who enjoys their job can only work part-time and spend the rest of their time on a hobby. I like the term “work as an option” 😄
I also tested my own investment portfolio and according to all the analyzes and calculators available, there is a high probability that my portfolio will survive withdrawals needed to cover ma usual yearly expenses to the rest of my life. However, I have not yet decided to quit my job for a number of reasons. Or maybe I don’t have enough “grande cojones” to make such a decision? In any case, the goal is 2027. Hopefully then I’ll be ready to make that decision 😊