[Editor’s Note: Here’s an update on the Public Service Loan Forgiveness program (and this one is NOT an April Fools’ Joke like Monday’s post): PSLF certifications have been paused from May 2024 to July 2024. This should not affect people getting PSLF but rather just when they get notice that their student loans have been forgiven.]
By Dr. Jim Dahle, WCI Founder
I’ve written numerous times about the concept of a safe withdrawal rate (SWR), including these posts:
However, the silliness of it all continues, and today I’m going to rant like never before on this topic in the hopes of realigning how people think about this concept.
What Is a Safe Withdrawal Rate?
The concept of a safe withdrawal rate is that a retiree can withdraw a certain amount of the portfolio value at retirement each year (usually indexed to inflation) with little risk of running out of money. That amount is the safe withdrawal rate. Note that it is NOT a GUARANTEED withdrawal rate. It is a SAFE withdrawal rate. If you want guarantees, look into insurance products such as Single Premium Immediate Annuities (SPIAs). Unfortunately, you can’t really get inflation-indexed SPIAS anymore. Your best option there is to delay Social Security to 70.
Where Does the Safe Withdrawal Rate Concept Come From?
While not the first people to look at the concept, the SWR concept was popularized by the Trinity Study in the 1990s. Back then, financial advisors were telling their clients that if their portfolio was earning 8% a year on average, they could spend 8% a year without any fear of running out of money. Some were even more aggressive with spending because of the outsized equity returns of the late 1990s. However, the problem with this approach (aside from the fact that late 1990s equity returns were far above average) was that it did not address the problem of Sequence Of Returns Risk (SORR). In a nutshell, SORR is when, despite having adequate (again, let’s say 8%) average portfolio returns throughout retirement, the portfolio will run out of money prior to death if the crummy returns show up first during early retirement. Withdrawing a large amount from a portfolio while it is falling in value can decimate a portfolio relatively quickly.
The Trinity researchers looked at the best database available (US stock and bond returns from 1927 on in rolling time periods), applied various time periods (15, 20, 25, and 30 years) and various asset allocations ranging from 100% bonds to 100% stocks, and then applied withdrawal rates from 3%-12% to see what percentage of the time the portfolio survived. This is what the data showed:
For a 30-year retirement with a 50/50 portfolio, a 3% withdrawal rate survived 100% of the time, a 4% withdrawal rate survived 96% of the time, a 5% withdrawal rate worked 2/3 of the time, a 6% withdrawal rate worked half the time, and an 8% withdrawal rate worked 10% of the time. Thus, advisors telling clients they could take out 8% were doing a huge disservice to them.
This is the birth of the 4% Rule. Four percent is a “safe withdrawal rate.” Maybe you could call 3% a “guaranteed withdrawal rate” (although there is never a guarantee in life, especially when it comes to market returns).
More information here:
4 Methods of Reducing Sequence of Returns Risk
What Is the Problem with the Safe Withdrawal Rate?
The problem with the SWR is engineers. What do I mean by that? Well, nothing too sinister. My father is an engineer. But engineers love to solve problems. And they love data. And they love spreadsheets. And they love planning way in advance. We need engineers for many things in life. But we don’t need them when it comes to planning your retirement. What happens when you get engineers involved? You get people arguing about whether 3.67% or 3.74% is the correct safe withdrawal rate. Reminds me of the old joke:
“How do you know economists have a sense of humor?
They use decimal points.”
If you think economists use decimal points, you should check out engineers.
Injecting precision that doesn’t exist into a process might make you feel better, but it certainly doesn’t make the data any more useful. Consider the source of the data: less than 100 years of market returns in a single country. While there might be dozens of rolling 30-year time periods, there are fewer than four independent 30-year data points. You can’t use a dataset like that and then pretend you can get some sort of precise answer out of it. The correct answer to “what is a safe withdrawal rate?” is “something around 4%, probably in the 3%-6% range.” Not 3.59% or 4.21%.
Pessimism Is Sexy
The other problem with the folks that get into this SWR stuff is that they like to look at all the possible reasons why a SWR could be much less than 4%. Maybe they project lower equity returns or bond yields are lower or the world seems scarier or whatever. They forget that the Trinity Study database (including updates) includes events such as:
- The Great Depression
- World War II
- The inflation of the 1940s
- The stagflation of the 1970s
- The Cold War
- October 19, 1987 (look it up)
- The Asian Contagion
- The meltdown of long-term capital management
- The dot.com bubble and bust
- The Global Financial Crisis
- Several cryptocurrency winters
- The COVID pandemic
That’s a lot of bad stuff. So, when people are saying that the future will be worse, wow, that’s pretty pessimistic. Especially since economic history should be titled “The Triumph of the Optimists.” But pessimism is sexy. In his excellent book “The Psychology of Money,” Morgan Housel wrote:
“Optimism sounds like a sales pitch. Pessimism sounds like someone trying to help you.”
“Pessimism just sounds smarter and more plausible than optimism.”
“Pessimism isn’t just more common than optimism. It also sounds smarter. It’s intellectually captivating, and it’s paid more attention than optimism, which is often viewed as being oblivious to risk.”
“It’s easier to create a narrative around pessimism because the story pieces tend to be fresher and more recent. Optimistic narratives require looking at a long stretch of history and developments, which people tend to forget and take more effort to piece together.”
“The intellectual allure of pessimism has been known for ages. John Stuart Mill wrote in the 1840s: ‘I have observed that not the man who hopes when others despair, but the man who despairs when others hope, is admired by a large class of persons as a sage.’”
Get a bunch of engineers cranking numbers using past data and current yields, and, all of a sudden, they start competing to see who can be the most pessimistic. Some small percentage of them might even be neurotic, maybe even a little OCD. But all of a sudden, people are talking about 2% being the safe withdrawal rate. Maybe 1.5% if you retire early. It’s bonkers. That’s what that is.
The Silliness of Safe Withdrawal Rates
If you go down this rabbit hole too far (and you don’t have to go very far to go too far), you will meet a lot of strange people who try to convince you otherwise. They are mistaken. That’s God’s honest truth about withdrawal rates. Go back to that chart. Take a look at the 75/25 30-year line. It’s 100%. In all of recorded financial history, a 4% (adjusted for inflation) withdrawal rate NEVER ran out of money. In fact, on average after 30 years. the portfolio was 2.7X the original portfolio value. Even if you decide you’re going to do 5% of the original portfolio value (again, adjusted upward each year with inflation), it worked more than four out of five times.
How Long Is Retirement?
The average American retires at 64. The average life expectancy of a 64-year-old is 17 (male) to 20 (female) years. What’s the table look like for a 20-year retirement? The 75/25 20-year line shows that you can withdraw 9% a year and only run out of money half the time. Nine percent! And you’ve got these crackpot engineers running around telling people they can only take out 2% a year. By the way, if you’re a financial advisor and you’re telling your 92-year-old client she can only spend 4% a year, you’re a jerk. You can have very aggressive withdrawal rates for short time periods without any problem. There’s a reason the RMD for a 92-year-old (9.8% of portfolio) is more than twice as large as that of a 75-year-old (4%).
More information here:
The Risk of Retirement
The TIPS SWR
Financial advisor Allan Roth took a look at a portfolio that was 100% TIPS at our current yields and determined that one could take out 4.36% a year, adjusted to inflation, and your money would be guaranteed to last 30 years. You don’t even have to take any risk, and you can get 30 years of 4%+ inflation-adjusted withdrawals. You’re not immortal. It’s OK to spend some principal. Now, maybe you’re retiring at 45, and 30 years isn’t quite enough to feel comfortable. Fine. The difference in withdrawal rate between a portfolio that will last 30 years and a portfolio that will last forever is pretty trivial. Besides, how many 45-year-old retirees do you know who NEVER earn another dollar? There are not very many of them. Even the most diehard physician FIRE dude I know left medicine at 43, and he is still earning a little income.
Larimore vs. Pfau and Big ERN on SWR
I have three friends. We’ll call the first one Taylor Larimore. Let’s say he’s a 100-year-old World War II vet who retired in 1980 at 55 on $1 million, and he has been living on it ever since. His philosophy on spending money in retirement is to “adjust as you go.” You simply take a look at how much you have and adjust how much you spend based on that. In a year when you earn a lot, you spend more. After a bad year or two, maybe you spend and give a little less. He bought a couple of SPIAs in his ninth decade of life and mostly lives off those and Social Security these days.
Let’s call my second friend Wade Pfau. Let’s just say he’s a “retirement researcher” who makes his living off publishing study after study about safe withdrawal rates. Boy, does he ever like to get into the weeds on this stuff! Publish or perish you know, and this area of research has been fertile ground over the years. He has argued that the SWR is 2.4%.
Let’s call my third friend Big ERN. While not an engineer (he’s an economist by training), he has published a long, detailed blog series about safe withdrawal rates that rivals Pfau’s work. He has also argued for a sub-4 % withdrawal rate.
Who’s right and who’s wrong? People say Taylor was just lucky. He retired at the beginning of the longest bull market in history. He won’t be the last person who retires at the beginning of a bull market. If Pfau likes 2.4%, he’s going to love the 0% withdrawal rate many retirees are currently using. Big ERN says adjusting as you go might mean a 15- or 20-year adjustment in spending, and he calls that “failure.” Calling having to make an adjustment “a failure” seems overly harsh to me. That’s just how life works, both in accumulation and decumulation.
More information here:
Let’s Celebrate Taylor Larimore’s 100th Birthday by Asking Him 4 Questions About Money
SPIAs
If you go down the rabbit hole and end up with something like a 2% withdrawal rate, you need to seriously reconsider your approach. If you are so worried about running out of money that you are only willing to spend 2% a year, you should do something to reduce that anxiety. Here are some great
