As the Mad Fientist, I take it upon myself to analyze common financial advice to determine how it applies to those of us retiring very early in life.
Since our financial lives are drastically different from the normal work-until-65 employee, most mainstream thinking isn’t relevant so I’m left to investigate the data myself and form my own conclusions (for example, when I showed that a Traditional IRA is better than a Roth IRA for early retirees and that a Health Savings Account should actually be used as an additional retirement account).
Today, I’m going to tackle the Safe Withdrawal Rate (SWR) and it is my hope that this post becomes the definitive guide to the SWR for early retirees.
Most of the conclusions in this article are based on the great research that Michael Kitces, one of the internet’s most respected retirement planners, has done on this topic. I’ve cited the source material below so I highly encourage you to read through the articles that I link to because they are packed with additional information that will help you feel even more confident about the conclusions of this post.
What is the Safe Withdrawal Rate?
Before we dive into the really good stuff, a bit of background…
The Safe Withdrawal Rate is simply the rate that you can withdraw from your portfolio every year that ensures you have a high probability of never running out of money.
The SWR of 4% per year (inflation-adjusted) is the rate that Trinity Study researchers recommended for 30-year retirements and is the rate you most often see quoted.
Why it’s Safe (Very Safe)
Many people like to challenge the Safe Withdrawal Rate and warn that “this time is different and if you start withdrawing 4% from your portfolio every year, you’ll be forced to eat cat food before you know it.”
Fear sells much better than math and reason so ignore the fear-mongering and instead continue reading.
Disclaimer: It must be said that although this article will show that the SWR is safe, past performance cannot guarantee future outcomes. If you’re looking for certainty, you won’t find it here. Nothing in life is certain though except for death and…well that’s it. Some people say there’s also certainty in “taxes” but since you’re a Mad Fientist reader, that’s not the case ;)
Kitces highlights some impressive stats to show how safe the SWR actually is:
- “the safe withdrawal rate actually has a 96% probability of leaving more than 100% of the original starting principal!”4
- “In fact, even when starting with a 4% initial withdrawal rate, less than 10% of the time does the retiree ever finish with less than the starting principal. And it has only happened four times in the ‘modern era’ of markets: for retirees who started a 30-year retirement time horizon in 1929, 1937, 1965, and 1966.”1
- “Over 2/3rds of the time the retiree finishes the 30-year time horizon still having more-than-double their starting principal. The median wealth at the end – on top of the 4% rule with inflation-adjusted spending – is almost 2.8X starting principal. In other words, it’s overwhelmingly more likely that retirees will have opportunities to ratchet their spending higher than a 4% rule, than ever need to spend that conservatively in the first place!”1
But This Time is Different
That’s great the safe withdrawal rate worked so well in the past but surely now with the great recession, recent flash crashes, etc., this time is different?
I know it seems like the financial world has been crazy over the last decade but recent retirees aren’t actually looking too bad.
In his post, How Has the 4% Rule Held Up Since the Tech Bubble and the 2008 Financial Crisis?, Kitces explains that “the 2008 retiree – even having started with the global financial crisis out of the gate – is already doing far better than any [of the worst] historical scenarios! In other words, while the tech crash and especially the global financial crisis were scary, they still haven’t been the kind of scenarios that spell outright doom for the 4% rule.”1
So what would the future have to look like for the 4% rule to fail for recent retirees?
It would only be appropriate to assume a safe withdrawal rate lower than the historical 4% – 4.5% rate if you believe that equities will fail to deliver even a 1% real return over the next 15 years, implying (given current dividend and inflation levels) that the S&P 500 price level will be lower in 2027 than it was in 2007 (which would also be lower than it was in 2000, resulting in no appreciation for 27 years!).4
Do you think the stock market will remain flat for 27 years? Are companies no longer innovating enough to eke out some growth in nearly three decades? Unlikely.
So why aren’t these scary crashes and recessions spelling the end of the Safe Withdrawal Rate?
To answer that, we have to investigate how a portfolio actually gets depleted too quickly.
Sequence of Return Risk
When you consider that the average real market return is 7%, you would think that withdrawing 4% every year would never deplete a portfolio because the growth would more than cover your inflation-adjusted spending (7% – 4% = 3% portfolio growth every year).
It’s actually not the average that matters though. Rather, it’s when the ups and downs happen that determine how likely your portfolio will survive longer.
Kitces gives the following easy-to-understand example:
imagine a retiree with $1,000,000 who needs to take a big $500,000 withdrawal at the end of the first year. With the “good” sequence, the portfolio grows 100% from $1,000,000 to $2,000,000, easily funds the $500,000 withdrawal, and after the 50% drop in year two finishes with $750,000. By contrast, with the “bad” sequence, the portfolio falls 50% to $500,000, the $500,000 withdrawal completely depletes the portfolio down to $0, and the subsequent 100% return is now irrelevant because you can’t compound an account balance of zero!3
As you can see, it’s the sequence of returns that matter. As he states, “once cash outflows are occurring, it’s not enough for returns to average out in the long run, if the portfolio could be completely depleted before the good returns finally show up.”3
So you need to survive the first part of retirement so that the inevitable gains that occur are meaningful enough to your portfolio to offset the down years.
First Decade Matters Most
In Kitces’ research, he analyzed the historical data to see what metrics actually matter when it comes to the SWR and portfolio longevity. Here’s what he found…
Overall, the correlation between the safe withdrawal rate and the first year’s return is a mere 0.213
A correlation of 0.21 is low so if the markets crash right after you retire, don’t freak out. There’s very low correlation between your first year’s return and the success of the SWR.
10-Year Nominal Return
The correlation between the safe withdrawal rate and the 10-year return is 0.443
The 10-year return’s correlation is also low but that’s because the nominal return doesn’t factor in inflation.
If the market returns 7% but everything you buy gets 10% more expensive, it’s easy to see how the nominal return on its own can’t be a good predictor of portfolio longevity.
30-Year Real Return
on a 30-year real return basis, there is a solid 0.43 correlation to the safe withdrawal rate, which actually means 30-year real returns are just as predictive as 10-year nominal!3
This one really surprised me. You’d think that after factoring in inflation and looking at the 30-year returns, you’d be able to easily predict if a withdrawal rate would have been successful but it’s not because the 30-year returns don’t have enough information about the sequence of returns.
10-Year Real Return
When the time horizon is consolidated to view just the first 10 years and is evaluated on a real return basis, the correlation spikes to a whopping 0.79, with a clear predictive trend.3
As Kitces describes, “it turns out 10 years really is the ‘sweet spot’ for sequence of returns risk; a bad decade at the start of retirement is more predictive than 1-year returns and is also more predictive than 30-year returns”3
Therefore, if your first decade of retirement goes smoothly, you’ll likely end up with a lot of money leftover when you die (or you can increase your spending during retirement). If your first decade isn’t great and you deplete a big chunk of your portfolio early on, you may be in trouble.
Since the real returns during the first decade of retirement are a good indicator of how likely a retiree’s portfolio will last, wouldn’t it be great if you could predict the next 10 years of real returns?
As Kitces describes, to some extent, you can!
measures like Shiller P/E10 actually do a good job predicting real returns over a decade or more, which is the exact time horizon that matters for sequence of returns risk. In fact…if we look at the earnings yield of stocks using Shiller methodology (E10/P, or CAEP) and compare it to the 30-year SWR, the correlation is a remarkable 0.77! Market valuation and earnings yields at the start of retirement are remarkably predictive of 30-year safe withdrawal rates!3
Here’s a graph Kitces created that shows the historical Shiller E/P 10 (inverse of P/E 10) and the maximum sustainable withdrawal rates for the same period.
As you can see, there is actually a strong correlation between the two so you can use the Shiller P/E 10 (a.k.a. Shiller CAPE) to predict safe withdrawal rates!
This exciting realization prompted me to use my programming skills to create a new Safe Withdrawal Rate indicator for the FI Laboratory. Now, you can log in at any time and see an up-to-date safe withdrawal rate estimate based on the most-recent Shiller CAPE value!
The Safe Withdrawal Rate tool assumes an 80/20 stock/bond split for a portfolio expected to last 40+ years and is only an approximation so please don’t rely on it alone for your retirement planning but instead use it as a gauge to get an idea of the current market environment.
To access the new indicator, log into the FI Laboratory, click the Calculators tab, and then click the new Safe Withdrawal Rate option.
If you aren’t already using the FI Laboratory to track your progress to financial independence, you can sign up for free here to get access to the new Safe Withdrawal Rate indicator, the FI tracker app, and the other FI calculators I’ve created!
Safe Withdrawal Rate for Early Retirees
If you’re like me, everything up until this point should make you feel warm and fuzzy inside. Not only is the 4% rule safe, it’s actually very safe and exactly how safe it is is somewhat predictable at the time of retirement.
You may be saying to yourself though, “MF, I’m not a normal retiree so these conclusions don’t affect me because I’m retiring so early in life! You promised to analyze the SWR for early retirees so give me the bad news.”
Thankfully, the news is not bad at all!
Longer Time Horizon
If you are retiring in your 30s or 40s, you’ll hopefully have 50 or 60+ years of life left so that’s a very long time for your portfolio to last. While withdrawal duration does factor into the equation, it’s not as big of a deal as you may think.
Quite a few researchers have looked into how longer time horizons affect the SWR and Kitces describes some of their conclusions: “increasing a time horizon from 30 years out to 45 years reduced the safe withdrawal rate from 4.1% down to 3.5%”2. He goes on to say that, “it appears that the safe withdrawal rate does not decline further as the time horizon extends beyond 40-45 years (given the limited research available); the 3.5% effectively forms a safe withdrawal rate floor, at least given the (US) data we have available”2
So why doesn’t even longer time horizons result in lower SWRs?
Kitces explains (hint: it goes back to the sequence of return risk discussed earlier):
over long time horizons, even balanced portfolios generate returns significantly higher than 3.5%, and consequently the primary constraint of safe withdrawal rates is just having a withdrawal rate low enough to survive an early 1-2 decade stretch of poor returns. If the withdrawal rate is low enough to survive the first two decades of bad returns, then eventually the good returns arrive, the client recovers and gets ahead, and adding more years to the time horizon is no longer a risk.2
So 3.5% is the floor, no matter how long you expect your retirement to be.
Is that the number all early retirees should use in their planning then? Not necessarily. I think there’s a lot of other factors going for us that still makes 4% a reasonable figure to use.
Early Retirees Can Still Work
Unlike most normal retirees, early retirees are much more capable of picking up work after retirement.
If you’re 70 and you just retired, going back to work is a very daunting prospect. Your skills probably aren’t as in-demand as they once were and your energy level has likely diminished as well.
What about if you’re 35 instead? You’re still young and active, your skills are probably still up to par with your working peers, and you have a great interview story about how you spent the last x years doing whatever cool stuff you did during your early retirement preview!
Now, I’m not saying you need to plan on going back to work but it is an option and that option can influence your asset allocation and long-term returns, which would affect your SWR success rate.
More Aggressive Allocation
Bonds are great in a portfolio because when stocks go down, your bonds hopefully don’t go down as much so when you rebalance, you can use the proceeds from your bond sales to buy cheaper stocks.
Stocks are the driving force behind your portfolio though so if you want your portfolio to last a long time, you need to have a good amount of stocks to fuel that growth. The more bonds, the less volatility but the less growth as well.
Therefore, it makes sense to increase your stock exposure if you’re hoping to increase the probability your portfolio will survive a longer time horizon. As Kitces states, “Bengen and Blanchett’s research suggests the optimal equity exposure for a 30-year time horizon is approximately 50%-60%, a time horizon stretched to 40+ years merits a slightly more aggressive 60%-65% equity exposure”2
What if you’re young, employable, and still willing to work (if necessary). Why not juice your portfolio by being predominately in stocks? You put yourself at risk of experiencing bigger upfront decreases but if you have other options that allow you to avoid selling shares when prices are depressed and you have ways to make money so that you can buy stocks when they’re cheap, maybe it’s worth the risk?
That’s actually my strategy. Since I’m not opposed to going back to work (and can actually think of many part-time jobs I’d actually enjoy doing), a high percentage of my money is in stocks. If the markets tank and my portfolio drops a lot in the first decade after leaving my full-time job, I’ll just pick up some part-time work doing something that I enjoy. After all, what better way to appreciate your freedom than to go back to work for a bit to remember what you’re (not) missing.
Another difference between early retirees and normal retirees is that they are younger and likely more flexible and adventurous (no offense to my older readers).
If the United States experiences a period of high inflation, my grandparents wouldn’t consider moving to another country for a few years to escape the higher costs but you better believe my wife and I would!
Our flexibility would allow us to drastically lower our spending in tough times whereas that may not be an option for most standard retirees.
There are many other reasons early retirees can be more aggressive with their withdrawal rate (e.g. hardworking people who achieve FI will likely earn money in many unexpected ways after retiring, inflation doesn’t affect low spenders as much, most early retirees don’t even factor Social Security into their retirement calculations, etc.) but the main thing is, if you were resourceful and intelligent enough to amass enough money to retire very early in life, I have no doubt you’ll be able to figure out how to navigate the rough investment waters you’ll inevitably encounter at some point during your early retirement.
There is a lot of information in this post so to summarize:
- The 4% rule is actually very safe for a 30-year retirement
- A withdrawal rate of 3.5% can be considered the floor, no matter how long the retirement time horizon
- The sequence of real returns matters more than average returns or nominal returns
- The real returns during the first decade of retirement are most predictive of withdrawal rate success
- When you’re about to retire, take a look at the Safe Withdrawal Rate indicator to see an approximation of the current SWR
- After retirement, remain flexible, embrace challenges, don’t stress out about things you can’t control, adjust spending when necessary, and enjoy life :)
Thank you again to Michael Kitces for doing all the analysis and number-crunching that I referenced throughout the article. Here are the links to his articles so that you can check out the excellent research he’s done:
1 How Has the 4% Rule Held Up Since the Tech Bubble and the 2008 Financial Crisis?
2 Adjusting Safe Withdrawal Rates to the Retiree’s Time Horizon
3 Understanding Sequence of Return Risk – Safe Withdrawal Rates, Bear Market Crashes, And Bad Decades
4 What Returns Are Safe Withdrawal Rates REALLY Based Upon?
5 Resolving the Paradox – Is the Safe Withdrawal Rate Sometimes Too Safe?
What Do You Think?
I’d love to hear your thoughts in the comments below. Is there anything I missed? What withdrawal rate are you planning to use when you eventually quit your job?