It’s time to talk about accessing your stash in retirement.
Before we do that, though, it is necessary work through some prerequisites.
Understand the 4% Rule
This rule comes from the Trinity Studies and sets the generally accepted safe withdrawal rate (SWR) at 4% of your total assets. The original study was completed in 1998 and there was a follow-up in 2009 to include more available periods of data and also consider additional scenarios such as large 1-time unexpected expenses.
- The goal here is to withdraw from your pool of assets in such a way that the principal is not depleted prior to the conclusion of retirement (read: your death).
- Money left = Success.
- No more money + You’re not dead yet = Epic Fail.
- The methodology examines all available 30 year periods historically for which there is data. If an individual retired in 1941 with your asset sheet and allocation, and spending rate X, would they have made it? How about ’42 to ’72? And so on.
- The “4%” figure assumes a 50% bond, 50% US Equity mix in your asset allocation. The safe withdrawal rate varies somewhat if you are holding a different set of assets. The study shows that if you hold a more aggressive allocation (i.e. a higher percentage of stocks) your success rate actually goes up.
- The definition of safe is a success rate higher than 95%.
- Any yearly taxes you expect to pay are to be considered an expense and will need to be withdrawn.
- This assumes no benefits from social security. It strictly analyzes your asset sheet and allocation, and the resulting behavior in response to historical market fluctuations combined with your periodic withdrawals.
- There’s an excellent post by jlcollinsnh which discusses the 4% rule in more detail. (The link is to a web archive version of his blog because the live site is currently down.)
It’s useful but not entirely necessary to read entire Trinity study to get the full picture before executing any plans. There’s a lot of additional data and context in there which, once absorbed, may make you feel more comfortable with the research and conclusions.
And speaking of optional reading, you may also want to re-read the entirety of his stock series as a refresher prior to creating your own plan.
Judge Your Risk Tolerance and Choose an Asset Allocation
You must understand and accept your risk tolerance. It’s one thing to think that you’re going to go into all stocks because they promise the best long-term return, but it’s quite another to ride through a multi-year storm of volatility and declines.
On that note, I’m going to diverge a bit and talk about how the Great Recession played out in the US markets, since this is the major downturn I’ve personally experienced.
In January of 2007, the S&P was around 1500. It’d been steadily climbing for some time, but suddenly there were signs of resistance on further growth. For the entire year, the value bounced around that level, reaching peaks of 1550 and ultimately ending the year down a bit at 1450.
As an individual, you can accept this easily. Maybe you lose about 4% on the year. You do some loss harvesting, maybe rebalance. You might even think: Great. That was the correction the market needed. Your expectations for the next year go up.
In 2008, the mortgage crisis hit. The year starts at 1450 and by the end of it, it’s down to 927, shedding 36% of its value.
If you had half a million completely invested in the US Domestic Market a the start of the year, you are now down to 320, a loss of a hundred and eighty thousand dollars.
Here’s what it feels like to live out the year:
If you watch the news at all, half of the stories are about how this recession is a “new normal.” Advisers are telling people to sell. Your coworkers are all selling. The market goes down even more when everyone sells, which creates a violent vortex of still more selling.
Still, at the end of the year, you think:
Everyone’s wrong. The market will come back. I’ll just keep my money in there, it’ll be okay. Right?
But you’re a little uneasy, because you’ve just lost 180K. You do the math on how long it took you to save that amount of money and it makes your heart feel like it’s submerged in ten feet of bog water.
In March, the shit really hits the fan. The S&P is now at 624. Money has stopped moving between businesses. Your local grocery store may not be able to secure the types of overnight loan it needs to pay shippers and keep stocking shelves. The banks are frozen. Some failed. The government steps in, but no one is sure whether or not their plan (TARP) is going to work. There’s more cynicism than we’ve seen in our lifetimes. Everything is doom and gloom. Will the US economy completely fail? It seems like a distinct possibility.
Coworkers talk in hushed voices about how screwed everyone is, how there’s no solution. They check their 401(k) balances and proclaim retirement to be impossible. Cash4Gold commercial frequency quadruples on all television channels.
Your 500K is now down to 215K.
Sell or Hold? What are you thinking? You haven’t seen any hope of growth in the economy for two and a half years. So for 800 straight days, you’ve been feeling like your entire life savings and worth is being incrementally flushed down the toilet, a few thousand at a time. You brush your teeth in the morning, getting ready to go into the office for yet another day in a series of seemingly endless days of toil, and you’re not even sure why you’re saving money anymore if you’re just going to lose it all in the market. What’s the point of all of this anyway?
Trust me. No matter how logical and stoic you are, these thoughts will flit through your mind. Some of them will take root unless you are vigilantly weeding.
Your friends are selling. The government appears to be collapsing. There is open panic.
You know the markets always go up. But you start to think maybe that isn’t true anymore. You begin to feel like this time is different. This time we’re going to break the rules and the country is going to fall off a cliff into the darkest abyss we’ve ever seen. Everyone is saying it. How can all of those really smart economists be wrong?
Sell? Hold? Exchange for cash or bonds? Everyone tells you bonds are doing great. What about silver? It’s quadrupled in the past year.
Do you still want a 100% stock allocation in retirement?
I like to repeat myself when making these points because when you’re living through these scenarios, you will be similarly and much more harshly smashed with information over and over again that tells you that staying put is absolutely the worst thing you could do. Your mammalian limbic system will try to kick you into flight mode. You must have the confidence and energy to continually fight this perfectly natural urge.
When people talk about “stock market risk” what they are really saying is that you need to stay in the market in order to realize the expected returns of 7% or so. Sometimes that risk looks like a 5% drop over a week, or even a 20% drop over a year. And sometimes that risk looks like a slow steady decline over several years, or perhaps a full decade of garbage returns. If you can’t emotionally deal with watching your assets vanish or do virtually nothing over an extended period of time, your risk tolerance may not be as great as you think.
I think of it like this: You are getting paid a higher return to deal with the emotional impact of watching your money bounce around a lot.
And that’s not easy.
The Bottom Line:
You must understand yourself before you can reliably select the proper asset allocation. And you must pick an asset allocation that you will stick to over time. It’s a critical component to planning your drawdown strategy and predicting your overall chances of success.
Because if you went into all stocks and then got out near the bottom (say, 700) and re-entered at 1200, you’d have lost a lot of money.
If you’d done this in retirement, while further depleting your assets to cover living expenses, you’d almost definitely be looking for a job at this point.
So, if you lived through this period yourself, how did you handle everything? Be honest with yourself here. If you’re more conservative and risk-averse, it’s better to confront the truth, stay on the work/save treadmill for a few extra years, while selecting a less volatile allocation with lower historical returns.
The Asset Sheet
Have your current set ready. Break it into the following categories:
2. Taxable Accounts
3. Non-Taxable Account 401K plus Traditional IRA
4. Non-Taxable Account Roth 401K plus Roth IRA
5. Home Equity
The sheet I’m going to use for this series of posts follows:
|Non-Taxable Account A401(k), 403(b), plus Traditional IRA||250K|
|Non-Taxable Account BRoth 401(k), plus Roth IRA||100K|
In order to determine your FIRE number, you need to know your annual spend rate. This includes the average dollar cost of ‘unexpected’ expenses that come up every year. It also needs to include taxes, health insurance, and periodic large purchases (Example: You need to get a new $6,000 vehicle with 80K miles on it every 10 years, running you an average of $600/yr amortized over the decade.)
Most people saving for retirement focus on the 4% rule mentioned to start this post.
However, I’ve been aiming for a somewhat more conservative target, which is a 3% withdrawal rate off of my paper assets, plus a paid-off residence, so that’s what I’ll be primarily focusing on in this series as I work through examples.
Annual Spend Rate: 18K per year
Monthly Spend rate: $1500
FIRE Number at 3% target: 600K
Note 1: FIRE Number is reached by multiplying the monthly spend rate by 400.
Note 2: If you were aiming for a 4% withdrawal, you would instead multiply the monthly spend rate by 300.
- Understand the 4% Rule: Check.
- Understand Risk Tolerance and have chosen an asset allocation: Check
- 70% VTSAX (US Domestic Stocks), 20% VBTLX (US Total Bond Market), 10% VGSLX (REIT)
- I stuck through the downturn with roughly the above allocation so I know I can stomach the next one when it comes.
- Fire Number: 600K. Check.
- Annual Expenses: 18K. Check.
Outline of Posts in the Series
Part 2: Simulation
Part 3: Strategy
- Methods to access tax-advantaged accounts prior to retirement
- Holding a percentage of cash
- How and when to pull funds out of accounts
- Health Care
Part 4: Examples
Running through various scenarios using the sample numbers generated from previous posts.
I will explore :
- How I expect retiring in 2015 will play out given numbers listed above in the summary section
- How retiring right before major downturns would have gone. I’m going to specifically explore 1927 (Great Depression) and 2007 (Great Recession.)
- Differences between a) staying in my current residence and expense sheet versus b) downsizing and reducing monthly living expenses
Part 5: Validation
>> Drawdown, Part 2 : Simulation
A Few Notes on the Drawdown Series
- I currently own too much house. I’m planning on downsizing to a paid-off residence within the next year. In order to work through my anticipated ‘new’ situation next year, I’m simulating what I believe will be my real situation come March 2015. This is why my asset sheet in these posts does not match that which is listed in my monthly net worth reports.
- Some of my real base asset numbers will be fudged a bit order to make the math clearer in these posts. Personal Rule: No more than 5% fudging.
- Disclaimer: There are lots of ways to go about doing this, and there’s no one right answer. I’ve read a thousand different forum threads and blog posts on the subject and pulled bits together that make the most sense for my own situation. (By my own situation, I mean doing the RE thing with all paper assets, i.e. no rental income or other streams…) If you want to borrow this model and use it yourself, be my guest, but you assume all risk and responsibility for the outcome. My suggestion would be to take the bits you like and work for you, while ignoring the rest.
Really looking forward to parts 3 and 4! Side question: will retiring affect your health insurance situation (e.g. will you need to start paying for it)?
Yep, I’ll need to start paying for insurance. Turns out, it’s not as bad as you think. I have a strategy worked out and will re-validate it and then include it as part of post #3. A bit of a spoiler alert: Whatever you think of Obamacare, there’s no question that it helps out early retirees.
Cool, thanks! Looking forward to seeing both your plan and (later) how it goes!
(raising hand) oohhh! oohhh! Question from the audience for one of your future posts! Supposing you have an excellent return on investments during your first few years of retiring, how do you know when it is acceptable to increase your withdraws (above and beyond the annual inflation rate)? Conversely, if you have a bad first couple of years, how do you know if you need to decrease your withdraw? Most articles I’ve read don’t have good objective answers for these questions, other than it might happen. That isn’t really useful at all because that is based almost entirely on pure emotion, which probably isn’t the best way to plan our futures.
BTW, nice post! I’m really enjoying your articles. Keep up the great work!
Hey Moooser, awesome question and one I’ve put a fair amount of thought into. There are a few things I consider here: 1) If the markets have gone up to the point where my core expenses are significantly lower than my allocated 3% inflation-adjusted annual drawdown, I will probably still pull the full 3% off and use the extra to travel. Might even go a bit higher years if the extra draw is absolutely necessary to help achieve a goal. 2) Personally I would tie spending roughly to the Schiller P/E on the S&P 500. Historically it sits around 16.5 and right now it’s close to 25. If the Schiller P/E is higher than average then your money is probably “inflated” and it’s therefore safer to spend a bit more. Lower than average and stocks are likely on sale and ready to go up dramatically, making it more valuable to hold on to your money. But this is just my own conclusion; while I trust the CAPE as a measure of market valuation, many do not.
I know I keep referencing Jlcollinsnh, and it probably gets tiresome, but I’ll do it again here because I agree with his experience and wisdom. He says that you’ll automatically and intuitively adjust your spending based on the current economic conditions. When times are good and you’re beating average returns, you’ll instinctively spend a bit more. And when times are bad, you’ll pull back. It’d be nice if there was a formula for everything but on this, I think you can wing it a little…
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Your spend numbers are incredible. Massachusetts is an expensive place to live. I’d like to understand more how you’re able to do that, I’m constantly analyzing ways to trim overhead. It’ll be a multi-year project for me. Trying to think creatively, not my strength, and escape programmed assumptions, meaning “that category is what it is, no way to trim it”. I imagine others experience that too when they start FI planning.
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I just discovered your blog recently after having read MMM and jlcollinsnh. I’ve been glued to the Job Experience posts for the past week; it seems like our careers (especially the parts with useless and micromanaging managers) and our attitude towards them are very much in line.
Regarding the SWR and the Trinity Study: jlcollinsnh discusses the 4% SWR and how it’s already got a safety factor built in. But those studies look at 30 year horizons, correct? You, on the other hand, are 38 and are looking at a 60+ year horizon. Does that mean the 4% SWR still applies?
Look for me on the MMM Boards (DoofusOfErasmus). Thanks for sharing your story with us; it’s both informative and inspiring!
A few notes:
1. I should have labeled it “4% WR” instead of “4% SWR” as there is really no WR that can unequivocally be stated to be “safe”. Conditions can always occur which invalidate historical data’s projection into the future.
2. There was an update to the original Trinity studies in 2009. There’s a summary here, which is pretty good reading.
3. Wikipedia has a fairly good analysis of the 4% rule and its caveats
4. The success rate doesn’t vary much with time horizons longer than 30 years. You can effectively simulate Trinity Study results by playing around with cFIRESim and changing the retirement duration and your portfolio allocation. You’ll see that increasing years from 30 to, say, 50, doesn’t do much to the result set. If your stash is built to last 30, most runs will last pretty much forever (the sustainable portfolio.)
5. If you’re at 3% instead of 4%, your portfolio can withstand a lot of unexpected pressures over the years and still turn out pretty good.
In the end we’re all trying to evaluate risk; if you’re looking at broader strokes, the message of the Trinity studies is that if you can live off 4% then the odds are overwhelmingly in your favor that you’ll be fine over the long haul.
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