SWR and inflation - newbie question

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jon1981
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SWR and inflation - newbie question

Post by jon1981 » Fri Jan 12, 2018 12:27 pm

Hi everyone,

I am planning early retirement and have read many posts/article about SWR (I'll be using 4% for my purpose). What I seem unable to figure out is how to account for inflation.

My basic understanding is that upon retiring, SWR theory states that one will withdraw 4% (more or less depending on source) of the portfolio value at start of retirement. This part makes sense to me but moving forward, if one were to withdraw always the same amount (4% of portfolio's starting value), inflation would quickly impact one's purchasing power.

How is inflation accounted for when actually withdrawing money, should I increase the 4% yearly to account for inflation?

Thank you!

marcopolo
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Re: SWR and inflation - newbie question

Post by marcopolo » Fri Jan 12, 2018 3:00 pm

jon1981 wrote:
Fri Jan 12, 2018 12:27 pm
Hi everyone,

I am planning early retirement and have read many posts/article about SWR (I'll be using 4% for my purpose). What I seem unable to figure out is how to account for inflation.

My basic understanding is that upon retiring, SWR theory states that one will withdraw 4% (more or less depending on source) of the portfolio value at start of retirement. This part makes sense to me but moving forward, if one were to withdraw always the same amount (4% of portfolio's starting value), inflation would quickly impact one's purchasing power.

How is inflation accounted for when actually withdrawing money, should I increase the 4% yearly to account for inflation?

Thank you!
The SWR studies assume you start withdrawal at 4% of first years balance, and then increase the dollar amount withdrawn each year by the CPI.
So, inflation is baked into the SWR studies.
Once in a while you get shown the light, in the strangest of places if you look at it right.

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iceport
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Re: SWR and inflation - newbie question

Post by iceport » Fri Jan 12, 2018 3:35 pm

jon1981 wrote:
Fri Jan 12, 2018 12:27 pm

How is inflation accounted for when actually withdrawing money, should I increase the 4% yearly to account for inflation?

Thank you!
Yes, that's what the analysis was based upon.

Inflation data is available from the U.S. Bureau of Labor Statistics, as explained here: Inflation and retirement spending/Inflation data
The average annual inflation values... can be retrieved at CPI-U 12-Month Percent Change (select "include annual averages" and "Go", then page down to the table).
There are other formatting options available (link in the upper right), and other inflation indexes available (use "top picks").

So in calendar year 2017, for example, inflation rose at an average annual rate of 2.1%. (That's true for both the CPI-U and CPI-W indexes.)

If you retired at the beginning of 2017 and established your withdrawal amount based upon 4% of your portfolio value, for 2018 you would increase your withdrawal amount by 2.1%.
"Discipline matters more than allocation.” ─William Bernstein

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nisiprius
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Re: SWR and inflation - newbie question

Post by nisiprius » Fri Jan 12, 2018 3:55 pm

The answer is yes, withdrawals are assumed to be inflation-adjusted, and the (reasonable) hope is that investment portfolios will grow enough faster than inflation to sustain them.

As traditionally framed, e.g. in the 1998 Trinity study, several different regimes were studied but the one that's normally discussed is "inflation-adjusted, thirty years."

In this regime, at retirement you calculated a number of dollars equal to X% of the portfolio value. You then maintain purchasing power exactly level by increasing that number of dollars every year according to inflation. You do not pay attention to what is happening to the value of the portfolio, you just withdraw the inflation-adjusted dollar sum. The studies then asked how often, historically, such a regime would have lasted the full thirty years without running out. More specifically, over the period for which reliable data is available--often taken to start in 1926, thus 1926-1995 for the Trinity study, for all of the overlapping thirty-year periods, in what percentage of them did the portfolio last thirty years. A final arbitrary step is someone's judgement on what failure rate is considered safe enough. In the Trinity study, at a 4% (initial year) withdrawal rate and inflation-adjusted withdrawals, it would have lasted 30 years 95% of the time for 100% stocks or 50/50 stocks bonds, and 98% of the time for 75/25.

Three points are worth noting.

1) It was never suggested that anybody literally do this. It was done mostly to explore the issue of what was safe.

2) At the time, the emphasis was not so much on 4% being safe, but on the then-surprising idea that 7% or 8% was not safe. It had been widely assumed that it would be. The fact that the Trinity study considered withdrawal rates as high as 12% speaks volumes.

3) The authors of the Trinity study wrote:
The word planning is emphasized because of the great uncertainties in the stock and bond markets. Mid-course corrections likely will be required, with the actual dollar amounts withdrawn adjusted downward or upward relative to the plan. The investor needs to keep in mind that selection of a withdrawal rate is not a matter of contract but rather a matter of planning.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

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iceport
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Re: SWR and inflation - newbie question

Post by iceport » Fri Jan 12, 2018 4:38 pm

nisiprius wrote:
Fri Jan 12, 2018 3:55 pm
1) It was never suggested that anybody literally do this. It was done mostly to explore the issue of what was safe.
I suppose it's debatable just how literally the original authors intended the study's findings to be used. However, in my experience here on this forum and reading various books and articles on sustainable withdrawal strategies, it is explicitly suggested that retirees plan to do just that, literally. Yes, an important caveat is as you highlight in Note 3. But absent obvious cause to consider course adjustments, one could reasonably "plan" on following the assumed 4% of initial balance plus inflation.

There are a multitude of reasons why that would be impractical for individual retirees with real-world complications — and that could well include most retirees. But in the simplest of circumstances, it is a reasonable approach to determining a maximum sustainable withdrawal rate, as is suggested all the time. And for all the scrutiny it's received over the years, the spending model has still held up surprisingly well. Many of the alternatives offer various improvements (trade-offs, really), but they don't seem to invalidate the original intent of the 4% rule.

The wiki article cautions:
The authors of the paper, however, did not mean for their scenarios to be applied rigidly or uncritically.
My main point here is that you can set out using the 4% rule literally without necessarily following it rigidly or uncritically.
"Discipline matters more than allocation.” ─William Bernstein

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