How to Retire Early (The 4% Rule?)


hey i recorded this video well before the coronavirus situation really started to play out and the reason that i'm mentioning that now in this introduction is that i think it ties in really well with the topic the new york times had a piece on how the fire movement is being or is expected to be impacted by the coronavirus situation and the expectation is that it could have a big negative impact on people who were retired very early and living on the four percent rule and a lot of the reasons why uh are going to be discussed in this video why the four percent rule might not be sufficient for a very early retiree with like a you know 60-year time horizon now with everything going on in the world this just hasn't felt like the right video to release and i've been trying to work on more relevant content but why am i releasing it now well i'm out of content and not because i'm out of ideas i've just been out of time recently my wife and i had a new baby our fourth about a month ago and so yeah well i've just been strapped for trying for a time and i had this recorded so i'm releasing it with this introduction to make it a little bit more relevant and then i'll be coming out with more new content soon but i just didn't want the channel to get stale i do hope you enjoy this video nobel laureate william sharp has referred to retirement income as the nastiest hardest problem in finance the four percent rule for retirement spending has gained popularity as a simple answer the rule says that you can safely spend four percent of an investment portfolio in the first year of retirement and then adjust that amount for inflation each year for the rest of your life distilling a complex problem down to a simple rule of thumb can be useful but the four percent rule for retirement spending has some serious flaws and even beyond those flaws the retirement income problem is complex enough to warrant a more involved discussion i'm ben felix portfolio manager at pwl capital in this episode of common sense investing i'm going to tell you how to fund an early retirement [Music] the four percent rule makes retirement math exceptionally easy take your required expenses and divide by four percent if you want to spend forty thousand dollars per year in retirement divide forty thousand by four percent and you have a one million dollar required portfolio to meet your retirement income goal in its design the four percent rule is meant to deal with the main risks that a retiree faces once you've decided to stop working or stop working for money you will likely be relying on relatively risky assets like stocks and bonds to sustain a steady stream of income this introduces a unique retirement risk called sequence risk funding a steady stream of income using a volatile asset like stocks poses some big challenges sequence risk is based on the fact that repeated negative returns especially early on in the distribution period can have a meaningful long-term impact on your ability to fund your lifestyle as if sequence risks weren't enough to deal with we were also planning for an unknown period of time nobody can predict how long they're going to live this risk is called longevity risk together sequence risk and longevity risk make planning for a secure retirement a unique challenge let's come back to the four percent rule the supposedly simple solution to the retirement income problem the four percent rule was designed to address sequence risk and it did touch on longevity risk i'll explain the genesis of the rule william bengen a financial planner wrote a paper in 1994 with the creative title determining withdrawal rates using historical data bengan took historical data for u.s stocks and intermediate term u.s treasuries and tested how long a portfolio of 50 stocks and 50 bonds would be able to sustain various levels of withdrawals bengal modeled withdrawals starting as a percentage of the portfolio and increased with inflation each year the result was constant inflation-adjusted spending he tested withdrawals starting each calendar year from 1926 to 1976 and observed how long the portfolio lasted at each starting point for a 30-year retirement period with a 50 stock and 50 bond investment portfolio bengan found that a four percent withdrawal rate was always sustainable this research was further supported by the 1998 paper retirement savings choosing a withdrawal rate that is sustainable by coulee hubbard and waltz commonly referred to as the trinity study instead of using intermediate term treasuries as fixed income the trinity study used long-term high-grade corporate bonds this decision to use riskier bonds ended up resulting in a four percent withdrawal rate being successful only 95 percent of the time in the historical data a 95 success rate sounds great but this is only true in the historical data a retiree today should not expect a 95 chance of success with a four percent starting withdrawal rate i'll explain why that's true in a minute but first we have to come back to one of the most important assumptions built into the original four percent rule the time frame the four percent rule was based on testing a 30-year time horizon this video is about retiring early how many early retirees are planning for a 30-year horizon probably not many bengan based 30 years on a 60 to 65 year old investor and added roughly 10 years onto normal life expectancy to plan for longevity a 40 year old retiree would usually expect to live for more than 30 years if we repeat the same analysis for a 40-year period the 4 rule only has an 87 rate of success with a 50 stock and 50 bond portfolio longer time periods will see even more failures one consideration might be increasing the weight in stocks to improve the outcome the paper safe withdrawal rates a guide for early retirees by earlyretirementnow.com looked at longer retirement periods and higher equity weights expanding the analysis to longer time periods and more aggressive stock allocations they found that while anywhere between 50 and 75 stock exposure resulted in great results for a 3.5 percent spending rule over 30 years moving out to 60 years required much higher stock exposure in order to reach a comparable success rate they found that for 60-year horizons higher equity weights gave better results anything below 70 in stocks became precarious over such long time frames to quote early retirementnow.com over longer horizons bonds are bad this finding is extremely important for any early retiree in the historical data bond exposure over very long periods of time is arguably riskier than stock exposure this looks fine on paper but investors are myopic they evaluate long-term decisions with a short-term view you have to live with the volatility of stock exposure in your investment account i'm not saying that you shouldn't have an aggressive portfolio if it makes sense for the situation but i am saying that an aggressive portfolio can be stressful even if it does make sense i think that we have established that the four percent rule is probably not useful when it comes to retirement planning in general and especially early retirement planning increasing the weight in stocks might support a 3.5 percent withdrawal rate in the historical u.s data but we're still missing some important pieces everything that we have covered so far centers on historical u.s stock and bond data there is a good chance that the historical experience of u.s financial markets might not be representative of expected future returns there are a couple of different ways that we can think about this the first one is looking at the four percent rule based on stock market data from other countries wade fow documented this analysis in his book how much can i spend in retirement using data going back to 1900 through 2015 for 20 developed market countries he found that the only other country that could have historically sustained a 4 withdrawal rate for a 30-year retirement period was canada 18 other countries would have had failure rates between 8 and 62 percent over that time period the global stock market as a whole would have sustained a 3.5 percent withdrawal rate historically it is also important to point out that the 20 countries and faust data set are the countries that made it into the data set there is survivorship bias potentially making things look better than they actually are countries like argentina russia and china did not make it into the data but you can be sure that they would not have historically sustained a four percent withdrawal rate and they would pull down that 3.5 safe withdrawal rate for a global portfolio getting our heads out of the u.s data was important but we are still stuck in history today stock valuations are high relative to the past bond yields are historically low or even negative depending on where you look nobody can predict the future but stock valuations matter a lot to expected future returns in the 2019 edition of aswath de motaren's annually updated paper equity risk premiums determinants estimation and implications demoteron demonstrated that the earnings yield is the best predictor of the future equity risk premium it's still far from perfect but it is the most reliable metric that we have for forecasting future stock returns the earnings yield can be found by taking the inverse of the shiller cyclically adjusted price earnings for example if the shiller cape for us stocks is currently 29.71 we take one divided by 29.71 to find the earnings yield this currently gives us the result of 3.36 percent which is the expected real return for u.s stocks the geometric average real return for u.s stocks from 1900 through 2019 was 6.5 percent interestingly 6.5 percent is roughly what the historical average shiller cape ratio would predict think about that for a moment we're looking back at 119 years of data for u.s stocks during which the 4 withdrawal rate was sustainable for 30-year periods but over that period valuations were considerably lower and the average historical returns that we can see for that time period are commensurate with those lower valuations today's high stock valuations forecast much lower future returns applying any historical analysis to today's starting point does not make sense knowing the limitations of historical data due to currently high valuations one approach to testing spending rules involves using current expected returns and simulating future periods using monte carlo simulation using monte carlo for a 60-year period with current expected returns for a 100 stock portfolio consisting of canadian us and international stocks and ignoring fees and taxes like the original four percent rule analysis i find the 2.5 percent safe withdrawal rate where safe means a 5 chance of failure this analysis is interesting for more than just observing the safe withdrawal rate it also allows us to see the range of outcomes in the worst 10 of outcomes our 60-year spending period left the investor with 1 million adjusted for inflation well in the best 10 percent they were left with around 30 million dollars adjusted for inflation that massive range of outcomes and big potential surplus seems inefficient and it is inefficient in a 2008 paper titled the 4 percent rule at what price william sharp and two co-authors explain supporting a constant spending plan using a volatile investment policy is fundamentally flawed a retiree using a four percent rule faces spending shortfalls when risky investments underperform may accumulate wasted surpluses when they outperform and in any case could likely purchase exactly the same spending distributions more cheaply in simple terms retirees who use a fixed spending rule from a portfolio of risky assets to fund their inflation-adjusted lifestyle needs are probably overpaying for the potential of investment gains that they do not need to meet their retirement income goals more efficient solutions to this problem are mathematically dense and often involve complex financial products like options leverage and annuities but there are some simple spending rules out there that approach a more efficient solution without getting too complicated to implement in a 2017 paper vanguard explained one potential approach the authors explain that there is a spectrum of spending rules that depend on the preferences of the retiree constant spending rules like the four percent rule cater to the preference of spending stability while risking premature portfolio depletion or inefficient consumption at the other extreme spending a constant percentage of the portfolio each year results in no chance of depleting the portfolio and a more efficient consumption but it also results in potentially wild swings in the annual spending amount the vanguard paper suggests a middle ground where spending is a percentage of the portfolio but is only allowed to increase up to a ceiling or decrease down to a floor each year the ceiling and floor can be tailored to the needs and preferences of any retiree keeping in mind the trade-offs at each extreme in their paper they use a five percent ceiling and a 2.5 floor for spending changes it is important to note though that in bad markets there could be multiple years of spending reductions required to follow the rule finally i think that one of the most important considerations for any early retiree is their own ability to earn an income that might sound counterintuitive are you really retired if you're still earning an income if you're able to do something that you love and earn a little bit of income by doing it you are effectively introducing a large safe asset to your portfolio this changes all of the retirement math maybe you only need a two percent withdrawal rate from the portfolio to supplement your earned income plus work is important for humans martin seligman's perma theory of well-being suggests that there are five building blocks that enable flourishing positive emotion engagement relationships meaning and accomplishment working at something that you love to do even if it doesn't make a ton of money is a great way to get engagement meaning and accomplishment for early retirees the four percent rule is not useful based on a longer time period global data and current market valuations a more reasonable guideline might be closer to 2.5 percent and even then constant inflation-adjusted spending is both risky and inefficient alternative spending strategies like vanguard's dynamic approach might be part of the solution but any early retirees should also keep in mind the possibility of finding ways to turn themselves into a safe asset by continuing to earn at least a bit of income thanks for watching i'm ben felix of pwo capital and this is common sense investing if you enjoyed this video please share it with someone who you think could benefit from the information and don't forget if you've run out of common sense investing videos to watch you can tune into weekly episodes of the rational reminder podcast wherever you get your podcasts [Music]

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