4% rule (paper by Sharpe, Scott, and Watson)

Maybe I need to read the paper a second time, but Sharpe lost me. He criticizes the Monte Carlo type results often used to explain the 4% rule, not liking the idea that one can run out of money (very small chance) or have 2X their starting value. But what I seemed to miss is what method he proposed to use instead. Having one's income swing wildly as they vary withdrawals based on prior year return makes little sense to me, but it would seem some adjustment is in order, the 4% not being cast in stone. JOE

Yeah, the paper didn't seem to be very prescriptive. I do like the point, though, that it's folly to expect to be able to withdraw a fixed amount per year (or an amount that increases only with inflation) for the rest of your life; because the likely outcome is feast or famine.

Indeed, the feast-or-famine situation will apply to any strategy in which the withdrawal amount does not depend on the portfolio's performance.

So here's an alternative. Suppose we pick a percentage and say that at no time can the maximum withdrawal exceed that percentage. We have now changed our main criterion from being a specific dollar withdrawal to one that depends on the portfolio's value.

That change guarantees that we will *never* run out of money. Of course, if the portfolio tanks, we will asymptotically approach running out, and we won't be able to withdraw very much; but that would have happened if a fixed withdrawal had exhausted the portfolio also.

To make things more specific, suppose we say that our desired withdrawal rate is 4%, but that we will never allow it to exceed 6% in any given year. So we start with a 4% withdrawal, and adjust it up or down each year depending on the portfolio's performance. If the portfolio goes down, we will allow ourselves to withdraw up to 6% if we need it, but we will consider this to be a "we're in trouble" situation and do our best to limit spending until the portfolio recovers.

Over the long term, this strategy will always give us more money than we need, so long as the portfolio's long-term performance exceeds inflation +

6%. Moreover, if we can limit our withdrawals to 4%, the likely eventual outcome is that the portfolio will grow to the point where we don't have to worry about it any more.

Of course, if we have several bad years, we may have to scrimp. But that's true whether you're living off your investements or working -- if your job goes away, or you decide to change careers, you may have to scrimp too. The good news is that by matching your spending to your investment performance, you can avoid ever running out of money.

On statements in the 2007 paper "Efficient Retirement Financial Strategies":

Aside: For a free, downloadable MS Word version, see

The questions that came to my mind:

-- Can someone render a practical version of equation (13) (at least) in that paper? Equation (13) could also be said to be a guide to spending. It relies on yearly returns. I am really not sure how to use it or its concepts here.

-- does planning for a "rainy day" no longer make sense? We just can't know what the future will hold. Yet the solutions this paper proposes do seem to assume that planning for a rainy day is not necessary.

-- The paper seems also to celebrate some of the concepts of "consumption smoothing" financial planning. The more I read about this, the more I think it's a sales pitch by Laurence Kotlikoff to sell his software. See

. Columnist Scott Burns jumps on this bandwagon, abetting Kotlikoff, too.

So far I think the science on which the 4% rule relies is little different from that on which this 2007 paper's themes rely. To insist one approach will be more accurate than the other when all is said and done, and one is on one's deathbed, is wild speculation.

Recently* the Wall Street Journal reported that, according to a 2005 survey, "an estimated 34% of adults aged 19 to 64 face problems with medical bills or have accrued medical debt. A majority of those people, 62 percent, had health insurance." Would either the 4% rule or what this paper proposes have saved these people?

*This article was printed in my local paper today. I figure it's likely the WSJ printed it sometime in the last seven days.

"Andrew Koenig" wrote

Tell me how this works for the past few years. It's the end of June, and this is when one Jane Smith examines her yearly portfolio returns. For the year ending June 30 2007, Jane's portfolio has skyrocketed. It's up around 25%, because she owns mostly the ETF SPY. It would seem from your proposal, she can start spending way more than previous years. She starts doing so. Then the market dives. We do not know how low it's going. Might it correct to the relative lows of early 2006? It could. Does Jane keep spending her precious principal?

Only with several important assumptions.

Increasingly perhaps the "rainy day plan" is best. Not perfect (no plan is), but "best." To heck with someone critical of the "rainy day plan" because a person who uses it /might/ actually die with money to her name.

Also see many of the papers at

for many more papers on the same subject (although some refer specifically to Canadian retirees).

The bottom line is that if your portfolio is suitably allocated you can safely withdraw about 3.5 - 4% of your principal and have a high probability that the your money will last your lifetime. Some of the earlier analysis assumed that you initially withdrew the 3.5-4% and then allowed the withdrawal rate to increase only at the rate of inflation. Other analysis reset the clock annually.

13 years into retirement I have found that one normally does not vary ones spend rate much from year to year (except for inflation) but there are unexpected events - the trip to China, a funeral, a new car, etc that occur from time to time. My retired friends have had similar experiences. If your withdrawal rate never exceeds 3.5 - 4% you should be fairly safe. If the market does suddenly increase by 25% you can take some of the money and blow it on a new car but this is not the time to run out and learn to like eating at Elaines all of the time (it also isn't good for your waist line)

If your withdrawals are bounded by a fixed percentage of each year's total, then the order in which the returns occur doesn't matter.

In other words, suppose that one year your portfolio drops 20% and the next year it rises 30%. Then your balance at the end of that period will be exactly the same as it would have been if it rose 30% and then dropped 20%, even after withdrawals. Of course, your total withdrawals will be less in the first scenario than they would have been in the second, but that's to be expected.

The notion that an early run of bad luck might exhaust your portfolio goes away if you let the portfolio's value determine how much you're willing to withdraw.

I think it is helpful to demonstrate that certain commonly recommended strategies are poor.

I think proportion-of-current-capital withdrawal scheme is better than the 4% rule based on initial capital, but as I have written before, the proportion should depend on life expectancy. If annually consuming

4% of capital is optimal for an 80-year-old widower, it almost certainly is not optimal for a healthy couple of 65-year-olds -- the money must last for both of them. There is no simple analytical solution to this problem. What's needed is a computer program that takes inputs such as life expectancy, expected mean returns and volatilities, and risk aversion and generates suggested spending/ investment plans based on these. Many retirees would not be able to use such a program directly, so a financial planner could run it for them. Elle would remind us that the inputs for such a program must be estimated and are not known. Because of this, one would want a plan that is robust to changes in assumptions, to the extent that is possible.

**snip**

I had a reply which must have been lost.

Here goes:

1) Everything I understand about 4% is that it is a starting withdraw rate (SWR) and not a fixed withdraw rate (FWR). The 4% needs to be adjusted for inflation, market performance and spending.

For example, if someone needs a new car in retirement (show me a car which lasts 30 or 40 years...), the spending the year of a car purchase will increase.

2) The final comment suggests rules of thumb (4% SWR) are not as effective as tailored results and detailed financial planning. Agreed. 4% is a basic planning tool. Someone might want more cash, so a 3% or 3.5% SWR is needed. Someone might plan on dying young, so a 5% or 10% SWR could be used. An annuity might allow a FWR to be used as well.

When did the 4% rule become something other than the above?

Elizabeth Richardson

I am not advocating a position, just answering the question:

BWS quote states 4% withdrawal each year, whether it's 1%/qtr, or 4% of prior 12/31 balance, it's a fluctuating number.

I believe Trinity used a $40K withdrawal on a million dollar sum, and each year that $40K was adjusted for inflation regardless of market return or current value of portfolio.

I personally think BWS quote is appealing to those who can break out the 'needed' income from the 'extra' that can be skipped in down years. When my wife and I discuss this, she asks for the number that can keep our lifestyle the same, no skipping anything in a down year. So we shall work a bit longer and go closer to my interpretation of Trinity, the ever increasing withdrawals. JOE

So what we'll then have is exquisitely analyzed output based on exquisitely guessed input. The beauty of the 4% rule is that is simple and basically works. Obviously, there are good reasons for adjusting it up or down. My current favorite approach is here:

It has the advantage that it is transparent -- you can see the assumptions you are making and how they are affecting the results. Computerized black boxes worry me because I spent years developing such.

-- Doug

Tables 1 and 2 of the paper are devoted to withdrawals where the annual amount withdrawn is not adjusted for inflation. In these instances, it's truly a fixed income, based strictly on (for a withdrawal rate of say 4%) 4% of the /initial/ portfolio value and not subsequent values of the portfolio. So we see the line after the section titled "What About Inflation?" referring to purchasing power being halved after 25 years of 3% inflation. Table 3 shows the outcome where the annual withdrawal rate is adjusted for inflation and deflation.

The news is bad for those who adust for inflation and start with a high withdrawal rate. But staying at a withdrawal rate of 3-4% still suggests, if history is a guide, that a retiree will be fine.

I presume the much quoted 4% rule uses as its basis Table 3. But the WD rate does not depend on portfolio size; it depends on inflation, at least according to the study's authors. Whether that's good or not remains to be seen. Merriman's proposal (as quoted by Bread with Spam) may be superior.

At the moment, I lean towards the rainy day plan, due in particular to the uncertainty in health care costs. My heirs may be very wealthy, or I'll be in ruins and on Medicaid yada when I die.

Nit pick: Not well-known.

I do continue to think the crude guidelines are useful with even the "not well-known" inputs, whether the guidelines derive from a program like B suggests above; the 4% rule; what Douglas suggests from the fpanet article below; living off dividends until D-day (that is, catastrophic medical costs) arrives; or maybe something else.

Indeed, the key words to me being "to the extent that is possible." Time and again I think that, once one realizes a change in assumptions is needed, it may be too late, and she or he may have spent too much of her or his portfolio to avoid financial ruin and living in some gosh-forsaken poorhouse of a nursing home. At least one may be enough out of sorts at this point not to care much, I guess.

I would say the one disadvantage of both proposals is the costs one might pay a financial planner for such services. Maybe these costs are trivial. Maybe not, especially given that, if one is not smart enough to pick and choose a suitable crude gage for withdrawals in retirement, gosh knows how much other stuff said financial planner can sell him/her. Just a little caveat, and not that all financial planners are nefarious.

Lately I wish financial planning academia would pursue a study of what educational approaches work best to keep people invested safely and with a view towards retirement and/or other needs. I wonder at the number of seemingly smart folks I know who take a momentary hit in their stock portfolios and then exit, hook line and sinker, for a few years, missing gains for the long term, and trusting gambles on, say, real estate over stocks.

Joe, do you expect your retirement portfolio to have average returns of at least 4% plus 3% inflation, or 7%? Were you planning on using the Trinity 4% of the beginning balance or the BWS 4% ever-adjusting balance?

As you know, we have pension income, what amounts to a fixed annuity in this conversation, but what we need/want over and above that is affected by this

4% discussion. But I don't think most of you pre-retirees realize that being on a "fixed" income, isn't really a fixed income. What we're doing is drawing on our IRA to the extent we need to, which is a different amount from month to month. Vanguard IRAs allow you to sell shares whenever, so I'm not stuck deciding in January how much I'll want/need in October (or even February). Periodically, but not on a rigid schedule, I monitor these withdrawals against the portfolio balance to ensure we're not living too high on the hog. So far, so good, as the market has been very kind. At some point, I'll look at starting social security - another factor in the equation.

Elizabeth Richardson

I was planning to go with my understanding of Trinity, 4% of initial balance, and add inflation each year. FWIW, I am 45, the missus is 51. She plans to retire in 4 years, and I would follow when we hit the number, about 2 years after. SS is not in the equation at all. So that's alot of wiggle room, I'd think. I am open to working longer, if needed, and if the market blows up, a black swan event, I have a few things I can go back to, to make up the difference. JOE

Guys, do you realize how valuable is the older wife/younger husband scenario? The lower health costs of a married life versus a single/widowed life are just the tip of the iceberg.

Anyway, if I understand this discussion, a projected portfolio return of 7%, would, in fact, provide for your wife's request of keeping your lifestyle the same, would it not?

Elizabeth

About what? That the 4% rule basically works or my slightly nasty dig at simulations based on estimates of critical parameters such as date of death?

How do you know the results make sense? You need to have some external model to compare your results to.

My skepticism comes at two levels. First, if I were sitting across from a planner and his program spits out "you can spend 4.523% the first year and adjust up for the CPI (Urban) after that." How can I have any confidence?

Second, it ain't that hard a problem. All the important factors are unknown: date of death, market performance, inflation, taxes, health care costs... The benefit of any really detailed analysis is going to be swamped by uncertainty in the input data.

-- Doug

If the portfolio returned precisely 7%, the 4% withdrawal and 3% inflation would work perfectly. The problem is risk/volatility/standard deviation. Trinity was done with data looking back for a return of 10%+ and concluded the 4% was good. That extra 3% covered volatility. Given that I've gone on record that I'd use 8% as a projected market return for the next decade or two, I may be deluding myself that 4% is the right number. That's why I figure if I don't count SS, that when it kicks in for both of us, I am really using a lower rate, maybe 3.5% or less.

FWIW, a fixed 7% return can allow an initial 4.8% withdrawal, and last

40 years. At 90, I doubt my wife will have the energy to powershop or go to her trainer.

JOE

You underestimate the power of compounding. It works in life, too! I racewalked a 5k in the heat in August, which nearly got me, and beat an 84 year old woman by only 3 minutes. Get in shape now, stay in shape. At 62, I get my heart rate up to 85% of maximum for an extended time at least once a week, in addition to several days with an hour or more of lower intensity aerobic work, add in some weights for an overall fitness routine. I'm hoping my coach will still be alive and working when I'm 90, 'cause I'm going to still want to train.

Anyway, thanks for the clarification on the extra allowance for volatility.

Elizabeth Richardson