When using swr do you consume prinicpal or just income?

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bitterroot
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When using swr do you consume prinicpal or just income?

Post by bitterroot » Sat Jun 27, 2009 10:26 pm

An issue I dont understand totally is the question of when you establish a SWR is that normally considered what your minimum return you will receive on your investment during your retirement. For example, I have assumned that if you use 4% SWR that meant that you anticipate earning
4% on your nest egg but you didnt touch principal. But then I realized that probably wasnt correct becuase there is no guarantee you will receive 4%, or 3% etc as a SWR, so there must be an invasion of principal to obtain a SAFE withdrawl rate. But we know that if you invest in TIPS you will get the coupon for life of the individual bond, so obviously in that case you dont just use prinicipal to fund SWR. Can some pls . explain this issue---in simple terms.


Thank you.

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Tall Grass
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Post by Tall Grass » Sat Jun 27, 2009 10:39 pm

My take would be that any erosion of principal would not be a safe withdrawal rate regardless of the percentage used; or said another way, "safe" is NEVER taking out more than the portfolio produces.

Many of us, me included, take into account that on occasion there will be principal erosion, but not enough that we will run out of money during our lifetime...
"A wise man should have money in his head, but not in his heart." - Jonathan Swift

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Post by livesoft » Sat Jun 27, 2009 10:51 pm

You may find this Vanguard whitepaper helpful:
https://institutional.vanguard.com/iip/ ... talRet.pdf

It appears that you will do better if you spend some principal instead of just using the income from your portfolio for expenses.

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Post by joe8d » Sat Jun 27, 2009 10:56 pm

My take would be that any erosion of principal would not be a safe withdrawal rate regardless of the percentage used; or said another way, "safe" is NEVER taking out more than the portfolio produces.
I agree with Tall Grass.I'm probably unusual in that, having been retired over 5 years,I have not taken anything from my portfolio and have actually added to it.
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Rodc
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Post by Rodc » Sun Jun 28, 2009 8:52 am

Every study I have ever seen assumes you will eat into principal if needed. In fact that would seem essential to the definition. After all if you are just going to spend income generated, there is nothing left to think about.

And that is one of the flaws in the whole concept. They assume you not only will eat into principal but you will continue to do so without adjusting your spending while you watch your portfolio drop away towards nothing.

How realistic is that?

SWR studies are fine for quick back of the envelop calculations to say set a target savings rate when you are young, but should not be used as a real strategy in retirement, IMHO.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Post by Triple digit golfer » Sun Jun 28, 2009 9:06 am

I would plan to eat into the principal. Why would I want to save all that money and then never cut into any of it?

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Re: When using swr do you consume prinicpal or just income?

Post by bob90245 » Sun Jun 28, 2009 9:19 am

bitterroot wrote:An issue I dont understand totally is the question of when you establish a SWR is that normally considered what your minimum return you will receive on your investment during your retirement. For example, I have assumned that if you use 4% SWR that meant that you anticipate earning 4% on your nest egg but you didnt touch principal.
The normal definition of SWR is to completely consume principal over a 30-year withdrawal period. An examination of the historical data has shown that the required real rate of return has been variable to support a 4% SWR.

Image
Source: http://bobsfiles.home.att.net/ReturnsVsSWRs.html#30Year

From the chart, we see that the real return necessary to support a 4% SWR ranged from as low as 3.8% to as high as 5.7%. There was even a lower real rate of return of 3.2% which supported a SWR of 7.2%.

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Post by TheEternalVortex » Sun Jun 28, 2009 10:05 am

Using an annuity you can get something like 6% annually (of course you lose half your principal). So you could for example buy an annuity with 2/3 of your money, which will by itself give you a 4% SWR. Then you don't even have to touch the rest and can use it for "extras".

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Post by dbr » Sun Jun 28, 2009 10:21 am

Tall Grass wrote:My take would be that any erosion of principal would not be a safe withdrawal rate regardless of the percentage used; or said another way, "safe" is NEVER taking out more than the portfolio produces.

Many of us, me included, take into account that on occasion there will be principal erosion, but not enough that we will run out of money during our lifetime...
In principle this approach to portfolio protection should require ADDING to the principal annually to maintain pace with inflation. The real value of the portfolio must be maintained. Setting aside quibbles about validity of CPI-U, holding 100% TIPS and spending the real yield would be an example of this.

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Post by dbr » Sun Jun 28, 2009 10:37 am

SWR studies are a contemplation of how a relatively fixed cash flow need might be funded from assets that have variable return, variable both in magnitude and in sequence of variability. "Safe" refers to consideration of the worst possible case in which assets are seen to never decline below some minimum amount within some maximum time frame. The study can let the minimum principle amount be no less than the starting value, and the study time frame can be extended to 40-50-60 years or whatever. I recommend looking at http://www.firecalc.com/ and consider the various options for spending rules that can be exercised there.

A major complication in all such studies is the problem that when spending is dropped to a "safe" level, almost all the outcomes leave the investor dying with a huge unspent estate.

An obvious and often recommended alternative to this problem is to fund retirement by purchase of a single premium immediate annuity. The purpose of this is to accomplish the critical goals of smooth funding and longevity guarantee. Using the principle of pooled risk such a guarantee is possible at payout rates much higher than the SWR's obtainable from a portfolio. The cost of an insurance approach is that the investor gives up the principal. Retirement funding has the properties of all those well known jokes where you can have any two of three choices, but never all three. One of the ironies of objecting to the abandonment of principle requirement is that just precisely the one tool that has always done exactly that, the defined benefit pension, is a tool the disappearance of which is roundly lamented these days. A final note is that a problem that does need to be addressed in the annuity approach is inflation protection, but in a previous post I noted same issue with maintaining portfolio value. Note that most 4% SWR studies are representing an inflation increased 4%.

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Post by nisiprius » Sun Jun 28, 2009 11:55 am

What dbr said! Also: "Safe withdrawal rates" refer to a situation in which are trying to draw a steady supply of spending money from a portfolio that includes stocks and other assets with fluctuating values.

If the portfolio does well, you nevertheless hold your withdrawals down to the safe rate, and the portfolio grows. You may not even be consuming all of the income. In fact the portfolio had better grow during good times, because at other times when it doesn't do well, the assumption is that you still keep withdrawing at the same steady rate, consuming capital and shrinking the portfolio.

I don't think it really applies to someone who has a conservative portfolio that produces a fairly steady and predictable income, and can hold their spending down to the income it produces.

Where it comes in is for the investor who has heard the siren song of equities and is confident that equities will return their historic 7% real, but just doesn't know when. This investor believes that a high-equities portfolio will return big windfalls at irregular intervals, and that sometime during retirement he's bound to catch enough of these windfalls to enable him to live much better than had he chosen a conservative portfolio.

SWR tries to answer the question "how many of these equity chickens can prudently be counted--in fact, eaten--before they hatch?"

To come up with an answer, writers ran backtests or simulations against various systematic withdrawal plans. The "Trinity" study decided, apparently arbitrarily, to assume a thirty-year retirement period, and measure "safety" according to the chances of running out of money within thirty years.

Implicitly, then, it is assumed not only that you may spend capital, it's fairly likely that you will. Implicitly, these studies are groping for the highest "safe" value. Thus they deliberately make a tradeoff, accepting a high chance of having to spend down capital in order to achieve a higher withdrawal rate. It's OK to run down, as long as you don't actually run out.

The Trinity study makes references to "course corrections," and I infer that the authors didn't mean it to be taken as a plan to be executed, just a rule of thumb reassuring clients that if they keep to a prudent 4% they don't need to switch to dog food immediately when 2008 happens, but can safely keep up their spending for several years even though it is drawing down their portfolio.

The scary thing to me, though, is the instability of any situation in which you are making steady withdrawals from a declining portfolio, because constant or inflation-increased withdrawals represent a larger and larger percentage of the portfolio's value. There is the possibility of rapid collapse.

It's like home mortgage payments in reverse. With a mortgage, you pay down your principal agonizingly slowly at first, then at a rapidly accelerating rate. The bank's calculations are quite precise. They expect to be getting payment from you for thirty years. But if you pay even a small amount extra, it has a dramatic effect, and you may get your mortgage paid off in just 25 or 20 years. That's good when you're paying off a mortgage. In reverse, a steady withdrawal that's just a little bit too high may mean the portfolio that was supposed to last 30 years may run out in 25 or 20, which is not so good.
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Post by tibbitts » Sun Jun 28, 2009 12:18 pm

I'm really surprised there is even a discussion over this. I have always believed that SWR implied exhausting principal in a predetermined number of years. I expect 99% of the population that can't imagine accumulating enough (particularly in this post-pension era) to not draw down principal recognizes that definition.

That doesn't mean it's not an unpleasant or uncomfortable feeling to watch your balance dwindle down toward zero, but lots of things in life are unpleasant - but unavoidable for almost everyone.

Paul

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Post by sport » Sun Jun 28, 2009 1:53 pm

tibbitts wrote:That doesn't mean it's not an unpleasant or uncomfortable feeling to watch your balance dwindle down toward zero, but lots of things in life are unpleasant - but unavoidable for almost everyone.
I'm always surprised that there is so little mention of the other main method of withdrawal, the constant percentage method. This method eliminates all of the questions and concerns about running out of money. Of course, withdrawals will vary, perhaps a lot. However, many employed people live on variable incomes their entire career (such as commissioned sales people). So, what is so terrible about doing the same during retirement? IMO, being concerned about a variable income is much less of a problem than being concerned about running out of money at an advanced age.

Jeff

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Post by Rodc » Sun Jun 28, 2009 1:56 pm

jsl11 wrote:
tibbitts wrote:That doesn't mean it's not an unpleasant or uncomfortable feeling to watch your balance dwindle down toward zero, but lots of things in life are unpleasant - but unavoidable for almost everyone.
I'm always surprised that there is so little mention of the other main method of withdrawal, the constant percentage method. This method eliminates all of the questions and concerns about running out of money. Of course, withdrawals will vary, perhaps a lot. However, many employed people live on variable incomes their entire career (such as commissioned sales people). So, what is so terrible about doing the same during retirement? IMO, being concerned about a variable income is much less of a problem than being concerned about running out of money at an advanced age.

Jeff
Agreed.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Post by Triple digit golfer » Sun Jun 28, 2009 2:03 pm

tibbitts wrote:I'm really surprised there is even a discussion over this. I have always believed that SWR implied exhausting principal in a predetermined number of years. I expect 99% of the population that can't imagine accumulating enough (particularly in this post-pension era) to not draw down principal recognizes that definition.
Agreed. Most advice here is great, but some gets far-fetched. The fact of the matter is most people can't afford to save enough to only draw on income.

I hear some advice here and I just have to laugh.

"Just save more."
"Save at least 20% of your income."
"Pay yourself first."

Oh, it's that easy, huh? Just do it, huh? Yeah, forget the mortgage/rent or car payments. Don't bother eating. Clothes? Who needs 'em?! Electric or gas bill? Nah. Pay yourself first and if nothing is left over, screw the utilities!

Most things aren't as easy as they're made out to be by some.

And like I said...most advice here is great. Some of it is not realistic.

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Post by SquawkIdent » Sun Jun 28, 2009 2:05 pm

jsl11 wrote:
tibbitts wrote:That doesn't mean it's not an unpleasant or uncomfortable feeling to watch your balance dwindle down toward zero, but lots of things in life are unpleasant - but unavoidable for almost everyone.
I'm always surprised that there is so little mention of the other main method of withdrawal, the constant percentage method. This method eliminates all of the questions and concerns about running out of money. Of course, withdrawals will vary, perhaps a lot. However, many employed people live on variable incomes their entire career (such as commissioned sales people). So, what is so terrible about doing the same during retirement? IMO, being concerned about a variable income is much less of a problem than being concerned about running out of money at an advanced age.

Jeff
Also agree. Keep your retirement expenses in check (ie no mortgage, etc.). And if you can mix this withdrawal method with a pension (preferrably COLAd) that meets your basic living expenses you would be in Schaffer city IMHO. I am surprised there isn't more talk about this withdrawal method. I don't care what the Trinity table tells me, I would be hard pressed to keep taking more money out of a portfolio as the market implodes (like last year). :shock:

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Post by Opponent Process » Sun Jun 28, 2009 2:17 pm

passing away with a large, untouched portfolio is just not the way for me. and you never really reach zero; there's always some social security floor.
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Post by Tall Grass » Sun Jun 28, 2009 3:11 pm

joe8d wrote:
My take would be that any erosion of principal would not be a safe withdrawal rate regardless of the percentage used; or said another way, "safe" is NEVER taking out more than the portfolio produces.
I agree with Tall Grass. I'm probably unusual in that, having been retired over 5 years,I have not taken anything from my portfolio and have actually added to it.
Ditto...I am nine years into retirement, and although I have factored in some erosion of principal to occur before my life ends, it hasn't happened yet.

I call this "safe", at least as far as I'm concerned, even if I die with only 25% of my portfolio monies left.
"A wise man should have money in his head, but not in his heart." - Jonathan Swift

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Post by DRiP Guy » Sun Jun 28, 2009 3:33 pm

Tall Grass wrote:My take would be that any erosion of principal would not be a safe withdrawal rate regardless of the percentage used
While I respect your right to do (and espouse) whatever works for you, the 'perpetually funded portfolio' left intact at death is certainly NOT a staple in most retirement planning scenarios, and the SWR studies I am familiar with rely on being able to deplete the majority of the nest egg during the decumulation phase.

EDITED TO ADD: (Sorry. gotta learn to read the thread completely before replying -- this was already well covered and better by prior posters)

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Floating money

Post by Cody » Sun Jun 28, 2009 4:14 pm

One can set the rate of W at 4% and draw that every year for thirty years. Got it.

Or withdraw at a floating % based on the market? What then is the rate of withdrawal in a good year - 4%? Then do you reduce it to say 2% in a bad year? And so on. Or is it done differently.

Does this mean nothing in a "bad year?" Or just less? How much less?

Just trying to get a handle on how you set the number (%) from year to year as markets change up or down.

Cody

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Re: Floating money

Post by nisiprius » Sun Jun 28, 2009 4:24 pm

Cody wrote:One can set the rate of W at 4% and draw that every year for thirty years. Got it.

Or withdraw at a floating % based on the market? What then is the rate of withdrawal in a good year - 4%? Then do you reduce it to say 2% in a bad year? And so on. Or is it done differently.

Does this mean nothing in a "bad year?" Or just less? How much less?

Just trying to get a handle on how you set the number (%) from year to year as markets change up or down.

Cody
Well, there are lots of different schemes and plans, and one of the very best places to have a look at them is at Bob94205's wonderful website.

There's no right answer, because it all depends on the specific behavior of the market. People invent various systems and do simulations on them.

One of the systems suggested in the original Trinity study is: first year, withdraw 4% of value of the portfolio. Subsequent years, just keep increasing that dollar amount to adjust for the cost of living. You just do that no matter what, regardless of the value of the portfolio. They found that for a certain range of portfolio compositions, that would usually last thirty years.

Perhaps this is the place to point out that Vanguard's Managed Payout funds are another example of the genre, although their stated goal is maintain the real value of the portfolio, not to draw it down. They steer a course somewhere in between the traditional method implied by the Trinity study (no adjustments based on portfolio performance) a constant percentage (oops, it's 2009, cut your spending by half compared to 2008). Their payout is based on a formula that's based on a moving average of... something... over the last three years.
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Re: Floating money

Post by sport » Sun Jun 28, 2009 4:40 pm

Cody wrote:One can set the rate of W at 4% and draw that every year for thirty years. Got it.

Or withdraw at a floating % based on the market? What then is the rate of withdrawal in a good year - 4%? Then do you reduce it to say 2% in a bad year? And so on. Or is it done differently.

Does this mean nothing in a "bad year?" Or just less? How much less?

Just trying to get a handle on how you set the number (%) from year to year as markets change up or down.

Cody
Cody,

What I was referring to was just withdraw a safe percentage each year. Vanguard says you can withdraw up to 5% this way. Each year you calculate the value of your portfolio and withdraw your percentage (say 5%). If the markets were good to you, your portfolio increased and 5% of the increased amount is what you can take out. If the markets were mean, and your portfolio went down, you can still take 5%, but it is 5% of a smaller portfolio. With this method there is no adjustment for inflation. If the markets incease with time (the usual past result) your withdrawals also increase proportionately. In simple terms, when you have more, you can take more. When you have less, take less. Keep in mind, with this method it is mathematically impossible to run out of money. However, if you take too much, your future withdrawals will be smaller (dollar amount), perhaps a lot smaller. Thus, the 5% maximum percentage.

Best wishes,
Jeff

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Post by tibbitts » Sun Jun 28, 2009 4:41 pm

jsl11 wrote:
tibbitts wrote:That doesn't mean it's not an unpleasant or uncomfortable feeling to watch your balance dwindle down toward zero, but lots of things in life are unpleasant - but unavoidable for almost everyone.
I'm always surprised that there is so little mention of the other main method of withdrawal, the constant percentage method. This method eliminates all of the questions and concerns about running out of money. Of course, withdrawals will vary, perhaps a lot. However, many employed people live on variable incomes their entire career (such as commissioned sales people). So, what is so terrible about doing the same during retirement? IMO, being concerned about a variable income is much less of a problem than being concerned about running out of money at an advanced age.

Jeff
I'm a person who has had a variable income for many years, but the difference is that when they're relatively young, a lot of people feel like if the income becomes too variable on the downside, they can go get a real job, particularly if they have up-to-date skills. Older people don't always feel that way; they don't have that fallback position. And usually, in retirement it might be a matter of $30k in a good year and $15k in a not-so-good year, not $90k vs. $45k or something. Most people are basically using most of their fixed SWR for essentials, so there really isn't a lot of room for deviation.

Paul

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Post by Rodc » Sun Jun 28, 2009 5:55 pm

tibbitts wrote:
jsl11 wrote:
tibbitts wrote:That doesn't mean it's not an unpleasant or uncomfortable feeling to watch your balance dwindle down toward zero, but lots of things in life are unpleasant - but unavoidable for almost everyone.
I'm always surprised that there is so little mention of the other main method of withdrawal, the constant percentage method. This method eliminates all of the questions and concerns about running out of money. Of course, withdrawals will vary, perhaps a lot. However, many employed people live on variable incomes their entire career (such as commissioned sales people). So, what is so terrible about doing the same during retirement? IMO, being concerned about a variable income is much less of a problem than being concerned about running out of money at an advanced age.

Jeff
I'm a person who has had a variable income for many years, but the difference is that when they're relatively young, a lot of people feel like if the income becomes too variable on the downside, they can go get a real job, particularly if they have up-to-date skills. Older people don't always feel that way; they don't have that fallback position. And usually, in retirement it might be a matter of $30k in a good year and $15k in a not-so-good year, not $90k vs. $45k or something. Most people are basically using most of their fixed SWR for essentials, so there really isn't a lot of room for deviation.

Paul
Your income would only fall that much in a year if your portfolio dropped that much in a year, like if last year you were retired and had a 100% stock portfolio.

If last year you had a 40% stock portfolio, 30% TIPS and 30% TBM you might have dropped 15%-20% or something, and so your income in the constant percentage scheme would have dropped 15% - 20%, not really so bad, especially if you are not living on the edge.

If you are living on the edge you should probably be thinking of buying at least some income via an annuity. If you had half your income covered by SS and an annuity, with the same portfolio last year you would have taken a 7% - 10% hit in income.

All in all, seems like a better way to go to me.
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Re: Floating money

Post by nisiprius » Sun Jun 28, 2009 6:02 pm

jsl11 wrote:What I was referring to was just withdraw a safe percentage each year. Vanguard says you can withdraw up to 5% this way... with this method it is mathematically impossible to run out of money. However, if you take too much, your future withdrawals will be smaller (dollar amount), perhaps a lot smaller. Thus, the 5% maximum percentage.
Simple observations:

1) With regard to the constant-percentage method. You can put $1 million under the mattress and withdraw 40% of it every year and it is still "mathematically impossible" that you will run out of money. You'll withdraw $400,000 the first year. In year 5, you'll have to make do with $129,600, still pretty good. In year 8, $27,993, and a lot of people have to get by with less. Of course, in year 15, you'll need to make $783.64 last for a whole year which is starting to pinch, and in year 30 your annual withdrawal will be thirty cents.

Point being, if you withdraw at too high a rate you'll get into serious trouble eventually even with the constant-percentage method. If you're conservatively invested, it will happen slowly and gradually and you can probably see it coming and ease back into a lower percentage. If you're aggressively invested, maybe not.

Also, a combination of constant percentage withdrawals and an aggressive portfolio implies that if something like 2008 happens, you must make a sudden sharp cutback in spending, so there's something of a feast-or-famine dynamic.

2) With regard to constant-COLAed-withdrawals. Think in real (inflation-adjusted) dollars. It is easy to see that an investment that merely keeps pace with inflation, with no real return at all, will allow an annual withdrawal of 3.33% for exactly 30 years.
Last edited by nisiprius on Sun Jun 28, 2009 6:06 pm, edited 1 time in total.
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Post by dbr » Sun Jun 28, 2009 6:04 pm

jsl11 wrote:
tibbitts wrote:That doesn't mean it's not an unpleasant or uncomfortable feeling to watch your balance dwindle down toward zero, but lots of things in life are unpleasant - but unavoidable for almost everyone.
I'm always surprised that there is so little mention of the other main method of withdrawal, the constant percentage method. This method eliminates all of the questions and concerns about running out of money. Of course, withdrawals will vary, perhaps a lot. However, many employed people live on variable incomes their entire career (such as commissioned sales people). So, what is so terrible about doing the same during retirement? IMO, being concerned about a variable income is much less of a problem than being concerned about running out of money at an advanced age.

Jeff
It may indeed be a bit surprising (actually there is not little mention of it), but with all the water under the bridge since the original Trinity study and Bengen's work, these things have been studied almost to death and variations written up by authors of every stripe. Bullet number 3 in the Firecalc spending models is the constant percentage option together with a variant of it as proposed by Bob Clyatt. There are other retirement models that can examine similarlor more flexible situations.

As a little background one should be aware that the original context of the Trinity study was that of recognizing that retirement funding analysis that recommended withdrawal rates like 8%-10% based on consistent high equity returns was flawed by not considering the variability and sequence of returns. The 4% + inflation SWR concept was a splash of cold, clear reality at the time. It seems that today 4% has migrated to the status of rashly and zealously impetuous rather than conservative. Now that is odd.

What is more to the point in modernizing the Trinity results is taking cognizance of TIPS as one of the investment options. Also any modern tool recognizes the interplay between annuitized, COLA'd and not COLA'd, income streams and portfolios.

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Re: Floating money

Post by sport » Sun Jun 28, 2009 9:18 pm

nisiprius wrote:
jsl11 wrote:What I was referring to was just withdraw a safe percentage each year. Vanguard says you can withdraw up to 5% this way... with this method it is mathematically impossible to run out of money. However, if you take too much, your future withdrawals will be smaller (dollar amount), perhaps a lot smaller. Thus, the 5% maximum percentage.
Simple observations:

1) With regard to the constant-percentage method. You can put $1 million under the mattress and withdraw 40% of it every year and it is still "mathematically impossible" that you will run out of money. You'll withdraw $400,000 the first year. In year 5, you'll have to make do with $129,600, still pretty good. In year 8, $27,993, and a lot of people have to get by with less. Of course, in year 15, you'll need to make $783.64 last for a whole year which is starting to pinch, and in year 30 your annual withdrawal will be thirty cents.

Point being, if you withdraw at too high a rate you'll get into serious trouble eventually even with the constant-percentage method. If you're conservatively invested, it will happen slowly and gradually and you can probably see it coming and ease back into a lower percentage. If you're aggressively invested, maybe not.
Sure, that's why I mentioned the 5% maximum.

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