The animal spirits are running high.
Portfolios are growing faster than my waistline at Christmas (trust me when I say it’s a high bar to clear).
Unsurprisingly, people are feeling rich. Some of them are resigning from their jobs in search of a better gig.
Others are pulling the plug altogether, having figured out a way to turn their nest eggs into little perpetual motion machines.
Hell, even yours truly is entertaining a less lucrative, but far more enjoyable lifestyle.
Now, I don’t see myself leaving work altogether. Somewhat surprising for a personal finance blogger, early retirement actually terrifies me.
But at times, I do wonder – just how much income could our stock market portfolio reliably deliver in order to supplement my post-IB lifestyle?
Sure, there are plenty of retirement calculators out there. And yet, it’s kind of like skydiving with a parachute packed by someone else.
Probably safe, but I wouldn’t do it.
A notable exception is a wonderful series on safe withdrawal rates from Early Retirement Now. However, that’s more like an encyclopedia. Very helpful but will take weeks to work through.
What I want to do in today’s post is something far simpler: a headline stress test of the 4% rule by using historical S&P 500 return data.
To keep things nice and easy, we are going to use some round numbers:
- You retire with a pot of $1m
- You hope to draw an annual income of $40k from that pot
- You withdraw the money at the beginning of every year (a man’s got to eat)…
- …and you hope not to run out of money before you run out of life
Off we go.
The Naughty Nineties
In recent history, the worst possible move would have been to retire in the late 1990s, just before the dot-com bubble was about to pop.
So let’s have a look at the journey of a retiree who pulled the trigger on January 1, 2000. Would a $1m portfolio be enough to sustain that 4% withdrawal rate?
Well, as it turns out, yes it was:
It would have been shaky out there for a bit, with the portfolio dropping to $425k post-GFC. But thanks to a string of solid returns over the past decade, the portfolio would be up to $1.2m by November 2021.
If that looks all fine and dandy to you, it’s time to take a pause – because…
A-ha. Back in 2000, Britney Spears was still young, and that $40k sure went much further than today.
Assuming a 2.5% annual inflation rate, you actually need about $67k to afford the same lifestyle in 2021.
And once you factor that in, the numbers don’t look so good anymore:
As a matter of fact, they look quite depressing – because instead of $1.2m, you end up with just $323k.
At that rate, you are withdrawing about 20% of your portfolio each year. And regardless of how optimistic or pessimistic we can feel about the 4% rule, I think we can all agree that the 20% rule just doesn’t work.
Soup kitchen, here we come.
There is, of course, a way out here. Known by the sexy name of a “dynamic withdrawal strategy”, it involves reducing your income in years when the stock market performance isn’t so good.
In essence, it reduces the quantum of equities you are selling in a downturn while allowing for a “proper” level of spending once the market recovers.
Below, I have re-run the numbers assuming you can cut your spending by 20% in years when Mr. Market heads south.
Then, in years when the stock market is up, you reset your spending all the way up, including any “accrued” inflationary increases.
Here we go:
Unsurprisingly, the dynamic spending helps… but not nearly enough. Twenty-one years later, you end up with just $578k in your portfolio.
Not exactly on the breadline. Equally, the direction of travel is pretty clear here.
Nope, the 4% rule certainly didn’t work for the class of 2000. But were others equally unlucky?
Meeting The Flintstones
Let’s zoom out and test the 4% rule across the various generations.
The table below shows the ending value of a portfolio after a 20-year retirement depending on the retirement date.
For example, if you retired in January 1950, in twenty years’ time your portfolio would have been worth $9.2m. Correspondingly, the $67k you were withdrawing would imply a withdrawal rate of just 0.7%.
Here’s what the data looks like for the subsequent years:
Before you beat me to it, I do realize that 20 years is FAR too short for even a regular retirement, leave alone early retirement.
However, I wanted to capture that nasty period in the late 90s / early aughts to show just how much of an outlier it was. See the numbers highlighted in red above.
Interestingly enough, you DID NOT have to retire at the very peak of the dot-com bubble to put your portfolio at risk.
Doing so a few years prior was equally dangerous, notwithstanding a couple of subsequent bumper years in the stock market.
It wasn’t always that way, of course. As you can see, folks who retired in the late 70s / early 80s had an absolute home run, ending up with portfolios between $10m and $18m.
Free Advice, Worth Every Penny
I’ve always had a very simple approach to writing on this blog which is to avoid giving advice.
I look at the data and draw my own conclusions. You should do the same.
(You can also download the underlying spreadsheet here so that you can tweak the analysis as your heart desires)
With that in mind, here is where my head is after looking at the data above.
First of all, the 4% rule works – in the vast majority of cases. Sometimes, it works really well. In other situations, it simply does the trick.
But when it doesn’t, it feels kind of like playing Russian roulette with a 1,000 chamber gun.
Sure, the odds are in your favour – but it’s also your grey matter that ultimately ends up splattered all over the floor.
To avoid that unfortunate outcome, you need to build maximum flexibility into your budget. Arguably it’s much easier to do when you are budgeting for a six-figure annual withdrawal (aka FatFIRE) vs relying on a $20k annual budget.
Equally, someone on $20k a year can easily replace their entire income with a part-time job. Good luck doing that if you need $150k just to keep the lights on.
The other conclusion I am drawing here is about the advantages of a glide path of sorts. For example, if you feel you’ve hit your “number”, you can simply take a job that pays you just enough to cover the bills.
Then, you take a year or two to see what happens.
You no longer need to save for retirement. If markets perform well, you’ve increased your safety net. If they don’t, you’ve avoided a disaster. It’s a win-win.
The analysis also reinforces my conviction in having a big chunk of my portfolio in real estate.
Sure, it’s far from a passive investment. But its ability to throw off cash notwithstanding the market environment, while delivering 10%+ long-term returns, can do wonders to de-risking one’s retirement.
And the final, most obvious observation is to reduce your SWR.
Yes, a more conservative number (let’s say between 3% and 3.5%) means you’ll take longer to retire. But it will also ensure you only retire once.
As always, thank you for reading – and happy investing!
About Banker On Fire
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Banker On FIRE is an M&A (mergers and acquisitions) investment banker. I am passionate about capital markets, behavioural economics, financial independence, and living the best life possible.
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