I’ve written about the 4% rule before. I’ve pointed out that the underlying assumptions behind the original “Trinity Study” (the basis for the 4% rule) don’t exist today, but everywhere I look people continuing to quote the “4% rule” as gospel. I’m sure you know the rule – if you withdraw 4% of the value of your next egg at retirement and annually update the initial withdrawal amount for inflation, you’ll never run out of money in retirement. You’ll play with unicorns all day and dance in meadows and have a perfect retirement, free of financial concerns.
It’s complete bullshit.
Research published in 2013 by Michael Finke of Texas Tech University, Wade Pfau of The American College, and David Blanchett of Morningstar Investment Management found that using historical interest rate averages, a retiree drawing down savings for a 30-year retirement using the 4 percent rule had only a 2 percent chance of running out of money. But using interest rate levels from January 2013, when their research was published, the authors found that retirees’ savings would grow so slowly that the chance of failure rose to 57 percent.
Reread that paragraph again. Using historical interest rate averages the 4% rule had a 98% chance of resulting in 30 years of income. But using interest rates from today the chance of failure rose to 57%.
“The 4 percent rule cannot be treated as a safe initial withdrawal rate in today’s low interest rate environment,” they concluded.
Interest rates – 2013 vs today
Well, that doesn’t sound good, does it?
“But wait!” you say. “That’s based on interest rates from 2013, not interest rates today.”
I can’t argue with you there. Interest rates in 2013 were at historically low levels due to the Great Recession. Surely they are higher now, which means the 4% rule DOES apply today…right?
Well, let’s check the US Treasury website to pull historical interest rates from 2013 and compare them to early 2017.
Uh oh. That doesn’t look good for us at all, does it?
Interest rates are lower in every category than they were in 2013. This means we’d have even LESS income today from our bond allocation, meaning the 4% rule is even LESS likely to work today than it was in 2013.
Market valuations – 2013 vs today
“Ah”, you say, “but everybody knows bonds suck. Who would invest in bonds at today’s ridiculously low rates? Those lower interest rates don’t matter. Smart retirees will have higher equity exposure.”
Let’s investigate that line of thinking.
First, we have to understand the relationship between the market’s valuation and future returns. Thankfully for us, Vanguard has already done that for us. In October 2012 Vanguard published a study where they looked at a number of indicators used by market prognosticators to predict future market returns.
It’s worthwhile to note that nothing was very accurate in the short-term (1 year), but if you look at page 7 of the study you’ll see that the 10-year Shiller CAPE (Cyclically Adjusted Price/Earnings ratio) explained about 43% of the return of the market over the next 10 years. Here’s the graphic from that report:
Now look at Figure 5 from page 13:
This shows a regression analysis of the relationship between the 10-year Shiller CAP and the average real returns over the next 10 years. The word “real” is important here – this means we are looking at returns after inflation. If you’re not familiar with a regression analysis it’s just a statistical way of creating a formula/relationship/line on a graph that’s the best fit for various data points.
The regression analysis resulted in 2 lines on the graph above – the blue line is the fit for the Shiller CAPE 10 (which averages the last 10 years of earnings) and the red line is the fit for the Shiller CAPE 1 (which looks at just the most recent year of earnings).
The valuation is along the horizontal axis and the expected average return over the next 10 years is on the vertical axis. To use this graph you find the current valuation along the horizontal axis and then look up to see what the prediction is from the blue and/or red lines.
The downward sloping line shows that as valuations increase the expected return for the next 10 years decreases. For example, when the PE is 1o we expect to get around 10% real returns per year for the next 10 years (about a 2.6x total return). When the PE is 30 we see returns of around 0% annual returns according to the red line and 2.5% according to the blue line.
So what was the CAPE in 2013 and what is it now?
Well, from multpl.com we have:
- January 1, 2013 – 21.9
- January 1, 2017 – 28.03
- March 10, 2017 – 29.24
The valuation of the market today is 33.5% higher than in January, 2013.
And what did we learn from the Vanguard study? Higher valuations equal lower future expected returns. Looking at the red and blue lines we see that we can expect average returns of between 0% and 2.5% per year over the next 10 years based on today’s valuation.
Lower future returns result in higher chances of the 4% rule failing over a 30-year timeframe.
Fine, Pfau, and Blanchett determined that lower interest rates result in higher chances of the 4% rule failing over a 30-year timeframe.
So if the 4% rule had a 57% chance of failure at 2013 interest rates and the 2013 market valuation, what do you think the chance of failure is with today’s interest rates being 18% lower than in 2013 and the stock market valuation being 33% higher?
It’s hard to say without all of the data from the original study, but if the odds of failure were 57% when just considering higher interest rates, the addition on lower expected equity returns clearly increases the odds of failure even further.
Let me just reiterate what that means – if you retire today and withdraw 4% of your initial nest egg and then update that amount annually to match inflation, there’s more than a 57% chance you’ll run out of money in 30 years.
Implications for early retirees
I’m guessing that the vast majority of people reading this blog are aiming for early retirement or early financial independence. This means your money will almost certainly need to last for significantly longer than 30 years.
Checking the Social Security actuarial tables, we can see how much longer you can expect to live based on any given age:
- Male @ 40 – 38.53 years
- Female @ 40 – 42.43 years
- Male @ 50 – 29.58 years
- Female @ 50 – 33.16 years
A key thing to note – this is the average life expectancy, which means that 50% of the people will live longer and 50% will die sooner. I think it’s the height of folly to base your retirement plan on the average life expectancy – by definition there’s a 50% chance you’ll live longer (and possibly run out of money).
To be safe let’s add 10 years to each of the above estimates. This means the average man who retires at 40 should plan for about 48 years of retirement and the average woman should plan for about 52 years of retirement. If you’re 50 you’d expect to live about 40 more years for men and 43 more years for women.
In all of the above cases your planned retirement period is significantly longer than the 30 years of the Trinity Study. Let’s look at the actual conclusions from the Trinity Study:
For any given mix of stocks/bonds, we see 2 irrefutable trends:
- As the withdrawal rate increases (as you move to the right in the table) the chances of running out of money increases
- As the timeframe increases (as you move down the table) the chances of running out of money increases
As an example, look at the section for 75% stocks/25% bonds. For a 15 year time horizon we see that the money lasted 100% of 15 year scenarios at a 3% withdrawal rate, it lasted 96% of the time at a 7% withdrawal rate, and 46% of the time at a 12% withdrawal rate.
Looking at the same information we see that at a 7% withdrawal rate the money lasted for 96% of 15 year periods and 88% of 30 year periods.
(And remember – these calculations were all done in periods of higher bond rates and lower equity valuations).
You’ll note that 40 and 50 year timeframes aren’t in this table. I’m guessing this is because the authors of the study didn’t envision people needing to live off their retirement income for that long.
Now let’s put this all together.
- Large numbers of people are pinning their retirement on the idea that a 4% withdrawal rate is sustainable in retirement. They are literally banking on the conclusion from the Trinity Study that showed that a 4% withdrawal rate was sustainable for 30 years for 98% of the studies periods
- Today’s lower interest rates have, according to a recent academic study, raised the failure rate to 57% rather than 2%.
- Today’s higher equity valuations strongly imply lower returns over the next 10 years. This further increases the chance of failure.
- Early retirees will need to live off their investments for longer than the 30 year timeframe studied in the Trinity Study. This further increase the chance of failure.
Add that all up and I believe that an early retiree today who relies on the 4% withdrawal rate will have a 75%+ chance of running out of money in retirement.
Ok, we’ve established that retiring today and relying on the 4% rule to get you through retirement is not going to work. So what should you do?
First, you should rely on something lower than 4% as your withdrawal rate. I’d recommend somewhere around 3%. If you look at the Trinity Study results again you’ll see that a 3% withdrawal rate succeeded in every timeframe and with every mix of stocks and bonds.
Based on my research I believe a 3% withdrawal rate is safe indefinitely. A 3% withdrawal rate should literally last forever.
Second, you might consider working another year or two, or at least until the stock market cools down a bit and interest rates move towards their historical norm. This might have the effect of a stock market correction. Basing your initial withdrawal rate on a lower portfolio value will have much the same effect as initially withdrawing 3% instead of 4%.
If you’re close to retirement age or thinking about pulling the plug early and starting on early retirement using the 4% rule, you need to reconsider.
Have you thought about your planned withdrawal rate when you retire? Have you been planning on using the 4% rule? Do you think the 4% withdrawal rate still applies in today’s market environment?