I read The Dhandho Investor last week on your recommendation so I am getting closer to being ready for another serious investing post.

My question on this point is the following: Suppose I can create a portfolio by buying quality low cost broad indexes and/or ETFs that are yielding better than 4% when they are out favor with market or in times of market stress. Should I still stick with 4% figure, I would in theory not need to touch the princible? (I have also eliminated the the risk of any one firm dropping it dividend in the future.)

I am not sure what I really think of the 4% rule for withdrawels as it impacts sales of princible. I am thinking it more about developing a monthly income from dividends and interest that exceeds monthly expenses.

I’ve thought about the 4% SWR (annually adjusted for inflation) strategy a bit and it actually seems a little dangerous to me. When the economy encounters a period of inflation (which typically hurts stocks in the short term) the strategy would have you *increase* your withdrawal rate with likely devastating effect. I like how the endowments think about this. They are tasked with providing income to the institutions they serve in perpetuity. Usually they draw about 5% of their total portfolio balance every year. In good years they get more than bad years, but you technically can never go broke with this strategy because you’re drawing a fixed percentage. The trade off is that there will be more volatility in annual income (I welcome this trade off personally as it grants you income longevity).

Thinking along the lines of an endowment’s time horizon (infinite or at least very, very long term), if you expect 8% annual returns over 30+ years then you could withdraw about 5% a year and (assuming 3% inflation) keep a constant inflation adjusted income. And the bonus I see is that you can retire when your portfolio hits 20x your income needs as opposed to 25x as the 4% rate calls for.

Does this make sense to anyone else? I’d rather make assumptions about the very long term returns on stocks and the very long term rate of inflation than try to get them right at the beginning. Seems especially pertinent to ERE.

I don’t think it is a good idea to rely on outsize returns in retirement. Getting to the number you want with outsize returns is one thing when you have the income of your job to fall back on. Relying on outsize returns for your entire income isn’t a good plan.

Maybe if you had other income streams, but even then it seems to be overly optimistic.

@ George: You’re not going to have a loss every year. Itd be good to have an emergency fund (12 months or so) so you can weather a bad year.

The idea of the inflation-adjusted SWR is that you have a consistent income but will likely draw on your principal in any one year.

The “take-a-%-of-principal” method will leave you vulnerable to income shortages.

How is having a large cash emergency fund that’s drawn down during income shortages any different than the inflation-adjusted SWR?

Alex – I’m not sure I follow you. If the cash is your own, then it is most certainly part of your portfolio. By definition, it is the cash portion of your portfolio. I can’t see how you would have cash available, that you own, and it not be considered part of your portfolio?

Okay, I understand where you’re coming from, but mathematically, I would assert that it is no different than counting all of your portfolio and taking a lower SWR. However, if it makes you sleep more comfortably at night, then that’s fine 🙂

I noticed for the near entirety of the blog you’ve written 4% withdrawal as the magic number, and then for the last couple months 3% has slowly replaced it. What changed? I’m gonna guess your expenses recently got down to 3% 🙂 But also that during the low end of the business cycle (right now) 3% is probably a more accurate magic number.

From a value perspective your real passive income is equal to the sum total of your share of your company’s net income each year. Now, some of this is paid to you in dividends, the rest is retained earnings which will eventually be reflected in the company’s value providing that it remains a healthy operation. Some years this will equal 15%, and other years it might be 0 or even negative (like if you owned a lot of financials in 2008). There are many ways to strategically implement this. One is a flat withdrawal rate of a magic percentage. Another is pumping your “emergency fund” during the good years (I don’t like that term at all, current assets or cash and equivalents are much better terms, to borrow from the common balance sheet terminology) and living off it in the bad years. My personal strat will be to retire in the good years, and to work and invest more during the bad. I.e. these market fluctuations that can kill your early retirement can be solved by doing some part time work for a couple years if the market crashes in the first decade of your retirement at whatever magical withdrawal rate.

Right George – I’m young and have always been able to find work quick when I want it. I can’t imagine not being able to make $9000 a year even in a bad downturn. I was just pointing out that real earnings are the underlying factor in why a magic number withdrawal rate can eventually fail. And that a savvy investor would be willing to withdraw more during a year when their companies had high earnings than in a year when they made nothing.

What I meant was that after someone gets below that 4% withdrawal rate, they can just pump up their savings in the event that their companies make less than 4% per year for a period. Even if they don’t find work for years, they would (theoretically – again hinging on the continued health of the companies) only have to make up the deficit that the companies failed to earn during those years and the long term viability of that withdrawal rate is safe again. I.e. if somebody retires at 4% withdrawal and the stock market crashes the next month, or next year, or performs poorly over the first decade, or even two decades, they can go back to work (sometime, whenever) to get the withdrawal rate back down to 4%.

I see what you were getting at though, since I left it open in my original post. Namely, would it be possible to “retire” at 5% withdrawal, or 6% or 7% as long as you were willing to go back to work if things went bad? And yeah it would be, except that your probability of needing to go back to work is getting higher and higher, in which case, you’re not really retired.

For me specifically, I’m gonna semi-retire at about 3-4% and then keep working part-time until I get down to the 1% level. I was just saying that I can’t watch an economic downturn go by without the investor in me earning some income and investing it. This will keep my capital always going up.

There is no magic to the 3% or 4% debate. It is simply derived from backcasting historical returns – and thus lies it’s dangerous premise…

Jacob makes an important point above about volatility of returns that I would like to elaborate on first. Compound returns is the only return you can spend, yet most studies quote average returns. The greater the volatility the lower the compound return will be relative to the average return.

This is very important to understand and relates to my first point above…

Long-term (30 year+) historically derived average returns for the S&P 500 range from 7% upwards to 11% depending on time period analyzed and whether or not dividends are included.

When you net out inflation you get a return somewhere North of the 3% or 4% rule. That would imply you could spend more than 3% or 4% based on average returns, but every backcasting study and Monte Carlo simulation will tell you otherwise. Why?

The reason is simple – they are quoting average returns but you can only spend compound returns. The difference is the high volatility of the stock market causing compound returns to be lower than average returns. Again, this is very important to understand to get your retirement planning right.

One more thing to note – all the above is meaningless anyway because it is based on a false premise – that historical returns have any relationship to future returns.

The historical returns for all these simulations are based on a period of mass industrialization, cheap energy, and world economic domination by the U.S. (and U.S. corporations for the stock in the study).

If you believe all those tailwinds will continue to favor economic growth then you can bet your retirement on enjoying the passive growth that is required. If you are concerned that those tailwinds could be changing into headwinds then you may want to re-assess your assumptions.

In other words, I believe all retirement planning is based on a false premise – that you can bet your future on a backcasting study.

Only time will tell the truth, but it seems to me the massive government debt, entitlement program problems, demographic changes, and shifts in world economic power all point one direction – a more problematic, less stable, economic environment for the next 30 years than would be implied by the past.

I am not willing to bet my retirement financial security on such a dangerous assumption as passive backcasting. There are better alternatives.

Hope that helps,

Todd

The last sentence in Brian’s post way up at the top is how I shaped my ER plan: “I am thinking it more about developing a monthly income from dividends and interest that exceeds monthly expenses.”

I reinvest any surplus dividends and cap gain distributions to provide me with a slight inflation guard in the future.

@Alex.

Other Alternatives:

1) Buy cheap real estate in a growing area, fix it up a bit, and sell at a higher price, or rent it out monthy and keep increasing the rent as you get a good credit/renown on your apartments and as demand increases in the area.
(works with unmanned parking garages too, and vending machines)

2) Start a bussiness from nothing. God made Man from dust, because he saw the potential of love in man. Find passion in your ideas and create them from dust. Before you know it that dust will love you back, but give it faith in it’s freewill, try not to limit it with to much control but set down your beliefs and laws. Don’t go destroying your dust with fire by selling it to the devil! You will be impacting thousands to billions of lives. (imagine if Apple or Google sold out short)

3) Create scientific marvels that help humanity, make sure to be on the governments/UN’s good side, and try not to piss off other scientists, as they might take your invention and create some horrific executional chair scene out of it. (happened with Edison Vs. Tesla 1904)

4) Religion is tax free, as the Vatican is well aware of.

5) Groups of people create cities and nations. Use teamwork with friends to make ideas into realities. Network.

6) That 5 paragraph essay you wrote in high school, could have been published on ehow.com and have made you over a thousand $ by now. Write and share your knowledge/skills to better tommorrow and give you a gift from the present.