Question about the Safe Withdraw Rate rule

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Phenom01
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Question about the Safe Withdraw Rate rule

Post by Phenom01 » Wed Oct 09, 2019 9:02 pm

When calculating the amount of money needed for early retirement, do you need to account for inflation? Let say if my current annual expenses are $40k. $40k x 25 = $1M. Does that mean I would need $1M at retirement to maintain a $40k/year lifestyle? Or do I need to adjust that $1M for inflation?

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Re: Question about the Safe Withdraw Rate rule

Post by antiqueman » Wed Oct 09, 2019 9:05 pm

You should adjust for inflation.

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Re: Question about the Safe Withdraw Rate rule

Post by Phenom01 » Wed Oct 09, 2019 9:13 pm

so $40K + (1.03) ^ 25 = $83,751? Assuming I want to retire in 25 years, I would need $80,751 x 25 = $2,093,777.93?

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Re: Question about the Safe Withdraw Rate rule

Post by RickBoglehead » Wed Oct 09, 2019 9:27 pm

Phenom01 wrote:
Wed Oct 09, 2019 9:13 pm
so $40K + (1.03) ^ 25 = $83,751? Assuming I want to retire in 25 years, I would need $80,751 x 25 = $2,093,777.93?
Yes.
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Phineas J. Whoopee
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Re: Question about the Safe Withdraw Rate rule

Post by Phineas J. Whoopee » Wed Oct 09, 2019 9:32 pm

It isn't so much a rule as an empirical observation about the past. The test was how much one could withdraw from their portfolio, using an initial percentage (which worked out to be 4%), subsequently adjusted for inflation each year - that is, not 4% of portfolio, but 4% of initial portfolio value then each year, in dollar amount, adjusted for inflation - which did not, in a mixed stock / bond portfolio, entirely deplete the value to zero prior to thirty years.

It is not a way to preserve a portfolio beyond thirty years, just an observation about the most disadvantageous thirty-year studied period from the past that would not have gone to zero prior to that point. In many other studied periods a lot would have been left over.

So, yes, it is adjusted for inflation, but only based on the dollar amount of the first year's withdrawal.

At the time people were bandying about that it would be safe to take out seven percent. It wasn't so much four percent is perfect, as it was that seven percent is highly hazardous.

Does that help?

PJW

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MP123
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Re: Question about the Safe Withdraw Rate rule

Post by MP123 » Wed Oct 09, 2019 9:46 pm

The 4% "rule" from the Trinity study, Bergen, Pfau, et al assumes that you will adjust the initial 4% amount for inflation each year.

So in your example you would need $1M to support $40k adjusted for inflation according to this rule. In other words future inflation is already factored in once you start the withdrawals. But will you be living on $40k in 25 years when you retire?

This is more of a rule of thumb than a law of nature of course.

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Re: Question about the Safe Withdraw Rate rule

Post by Peter Foley » Wed Oct 09, 2019 10:01 pm

I've always understood it the way that MP123 describes it.

Some studies based on the original Trinity study have used that same premise. For example you can take out slight more if you eliminate the inflationary increase in withdrawals in down market years. (Guyton - I believe.)

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Re: Question about the Safe Withdraw Rate rule

Post by Northern Flicker » Wed Oct 09, 2019 10:08 pm

MP123 wrote:
Wed Oct 09, 2019 9:46 pm
The 4% "rule" from the Trinity study, Bergen, Pfau, et al assumes that you will adjust the initial 4% amount for inflation each year.

So in your example you would need $1M to support $40k adjusted for inflation according to this rule. In other words future inflation is already factored in once you start the withdrawals. But will you be living on $40k in 25 years when you retire?
The research does not assume one would. First, the way the 4% rule works is that you withdraw 4% the first year. In subsequent years, you increase the withdrawal of the previous year by applying the inflation rate. If year one required $40K and there were a 2% inflation rate for that year, then the next year’s withdrawal would be $40,800.
This is more of a rule of thumb than a law of nature of course.
Correct. It is more a planning heuristic than a procedure to be implemented rigidly, although it might be used directly if there are discretionary expenses like travel included in the budget that can be cut when other expenses turn out to be higher.

The research assumes retirement at age 65. Someone targeting early retirement would want to plan using a smaller percentage like 3%, 3.3%, etc.
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Re: Question about the Safe Withdraw Rate rule

Post by goodenyou » Wed Oct 09, 2019 10:12 pm

What you have illustrated is that inflation is likely to have the most deleterious effect on your sustainable withdrawal rates. As Bengen states in his paper Determining Withdrawal Rates Using Historical Data, "it is not a deflationary period like the Depression that is truly to be feared, but rather an inflationary period that wreaks havoc on purchasing power as well as portfolio values."
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Re: Question about the Safe Withdraw Rate rule

Post by Phenom01 » Wed Oct 09, 2019 10:28 pm

MP123 wrote:
Wed Oct 09, 2019 9:46 pm
The 4% "rule" from the Trinity study, Bergen, Pfau, et al assumes that you will adjust the initial 4% amount for inflation each year.

So in your example you would need $1M to support $40k adjusted for inflation according to this rule. In other words future inflation is already factored in once you start the withdrawals. But will you be living on $40k in 25 years when you retire?

This is more of a rule of thumb than a law of nature of course.
Wait so i would need $1M and not the ~$2M?

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Re: Question about the Safe Withdraw Rate rule

Post by Phineas J. Whoopee » Wed Oct 09, 2019 10:31 pm

Phenom01 wrote:
Wed Oct 09, 2019 10:28 pm
MP123 wrote:
Wed Oct 09, 2019 9:46 pm
The 4% "rule" from the Trinity study, Bergen, Pfau, et al assumes that you will adjust the initial 4% amount for inflation each year.

So in your example you would need $1M to support $40k adjusted for inflation according to this rule. In other words future inflation is already factored in once you start the withdrawals. But will you be living on $40k in 25 years when you retire?

This is more of a rule of thumb than a law of nature of course.
Wait so i would need $1M and not the ~$2M?
You would need, naively, one million for forty thousand a year. Should your withdrawal needs be higher in a quarter century you would need a correspondingly higher amount to begin distributions from. Should you plan a period longer than thirty years you would need still more.

Four percent is a rough planning tool with respect to the total amount one needs at the beginning, assuming a thirty year period, and relies on the future being similar to the past. It is not a withdrawal plan.

PJW
Last edited by Phineas J. Whoopee on Wed Oct 09, 2019 10:33 pm, edited 1 time in total.

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Re: Question about the Safe Withdraw Rate rule

Post by goodenyou » Wed Oct 09, 2019 10:33 pm

Phenom01 wrote:
Wed Oct 09, 2019 10:28 pm
MP123 wrote:
Wed Oct 09, 2019 9:46 pm
The 4% "rule" from the Trinity study, Bergen, Pfau, et al assumes that you will adjust the initial 4% amount for inflation each year.

So in your example you would need $1M to support $40k adjusted for inflation according to this rule. In other words future inflation is already factored in once you start the withdrawals. But will you be living on $40k in 25 years when you retire?

This is more of a rule of thumb than a law of nature of course.
Wait so i would need $1M and not the ~$2M?
$40K of equivalent purchasing power in 25 years with an inflation rate of 3% over the 25 years would require the ~$2M. It would be ~$80k per year in 2045 dollars. You could choose to spend $40k in 25 years after 25 years of 3% inflation, but you may not like your purchasing power and lifestyle choices at that time. It would be the equivalent of living on ~$19k per year today.
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Re: Question about the Safe Withdraw Rate rule

Post by Admiral » Thu Oct 10, 2019 6:09 am

Phenom01 wrote:
Wed Oct 09, 2019 9:02 pm
When calculating the amount of money needed for early retirement, do you need to account for inflation? Let say if my current annual expenses are $40k. $40k x 25 = $1M. Does that mean I would need $1M at retirement to maintain a $40k/year lifestyle? Or do I need to adjust that $1M for inflation?
You'd need:
a) more, to account for taxes, since 40k is net expenses not gross income
b) less, since you will presumably have SS, assuming you earn wage income

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Re: Question about the Safe Withdraw Rate rule

Post by rkhusky » Thu Oct 10, 2019 6:25 am

And, the study used a reasonable stock/bond portfolio. If you keep the $1M in CD's, you will likely want to save up more.

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Re: Question about the Safe Withdraw Rate rule

Post by MikeG62 » Thu Oct 10, 2019 6:39 am

Phenom01 wrote:
Wed Oct 09, 2019 9:13 pm
so $40K + (1.03) ^ 25 = $83,751? Assuming I want to retire in 25 years, I would need $80,751 x 25 = $2,093,777.93?
Let me take a shot at it.

If your current spending is $40,000 per year and you expect to retire in 25 years, then you need to adjust your current annual spend for inflation to determine the amount you will be drawing when your retirement begins. It is not likely that will also be $40,000. Whether it will be $83,000 is hard to say - your personal inflation rate may be lower or higher than 3.0%. Also, your spending may well change. There are things you are spending money on now (included in the $40,000) which you won't be spending money on in retirement (could be a mortgage or commuting expenses for example) and things you will spend money on in retirement that you are not spending money on now or aren't spending as much on (i.e., that are not included in the $40,000, such as health care, income taxes and travel and entertainment).

If you are truly 25 years from retirement I would just keep saving. Too many things that will change over the next 25 years to make an accurate prediction now.

As others have said, the idea behind the 4% rule of thumb is that based upon US history one could spend 4.0% of their initial portfolio balance in their 1st year of retirement and then adjust that spend every year going forward for inflation and have their portfolio last for 30 years.
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Re: Question about the Safe Withdraw Rate rule

Post by Stinky » Thu Oct 10, 2019 6:57 am

MikeG62 wrote:
Thu Oct 10, 2019 6:39 am

If your current spending is $40,000 per year and you expect to retire in 25 years, then you need to adjust your current annual spend for inflation to determine the amount you will be drawing when your retirement begins. It is not likely that will also be $40,000. Whether it will be $83,000 is hard to say - your personal inflation rate may be lower or higher than 3.0%. Also, your spending may well change. There are things you are spending money on now (included in the $40,000) which you won't be spending money on in retirement (could be a mortgage or commuting expenses for example) and things you will spend money on in retirement that you are not spending money on now or aren't spending as much on (i.e., that are not included in the $40,000, such as health care, income taxes and travel and entertainment).

If you are truly 25 years from retirement I would just keep saving. Too many things that will change over the next 25 years to make an accurate prediction now.

I like MikeG’s way of looking at this.

I especially like his comment about the difficulty of looking 25 years on the future. I’m in the early stages of retirement. There’s no way that I could have known in 1994 how things would look for me in 2019. I’m just thankful that I was saving in 1994 and continued right up to retirement.
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Re: Question about the Safe Withdraw Rate rule

Post by MP123 » Thu Oct 10, 2019 10:43 am

Northern Flicker wrote:
Wed Oct 09, 2019 10:08 pm
MP123 wrote:
Wed Oct 09, 2019 9:46 pm
The 4% "rule" from the Trinity study, Bergen, Pfau, et al assumes that you will adjust the initial 4% amount for inflation each year.

So in your example you would need $1M to support $40k adjusted for inflation according to this rule. In other words future inflation is already factored in once you start the withdrawals. But will you be living on $40k in 25 years when you retire?
The research does not assume one would. First, the way the 4% rule works is that you withdraw 4% the first year. In subsequent years, you increase the withdrawal of the previous year by applying the inflation rate. If year one required $40K and there were a 2% inflation rate for that year, then the next year’s withdrawal would be $40,800.
I think we're saying the same thing and I agree with your explanation of the inflation adjustment. My point was that one doesn't need to adjust the starting amount of the portfolio to account for inflation but rather each year's withdrawals are adjusted. And these withdrawals are based on 4% of the starting portfolio value, not 4% of the portfolio value at the time of the withdrawal so one must keep that in mind.

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Re: Question about the Safe Withdraw Rate rule

Post by RickBoglehead » Thu Oct 10, 2019 10:51 am

So, in summary:

- If you believe that your spending today of $40,000 a year is adequate.
- And you think that 3% inflation for the next 25 years is a good predictor.
- And you think that withdrawing 4% a year will work for you.

Then, you need to amass just over $2 million in the next 25 years to carry out your plan.
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Re: Question about the Safe Withdraw Rate rule

Post by dbr » Thu Oct 10, 2019 11:19 am

There might be some confusion between the issues of increasing the dollars withdrawn by inflation as one goes along in retirement and the question of what the beginning portfolio value needs to be in the future for a retirement that begins in the future.

The general answer is that inflation needs to be taken into account and is with any normal retirement planning model. One would have to look at the specific model to see how the data is handled. A difference is whether or not numbers in the model are real dollars or nominal dollars, etc.

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Re: Question about the Safe Withdraw Rate rule

Post by Tal- » Thu Oct 10, 2019 11:28 am

MikeG62 wrote:
Thu Oct 10, 2019 6:39 am
Phenom01 wrote:
Wed Oct 09, 2019 9:13 pm
so $40K + (1.03) ^ 25 = $83,751? Assuming I want to retire in 25 years, I would need $80,751 x 25 = $2,093,777.93?
Let me take a shot at it.

If your current spending is $40,000 per year and you expect to retire in 25 years, then you need to adjust your current annual spend for inflation to determine the amount you will be drawing when your retirement begins. It is not likely that will also be $40,000. Whether it will be $83,000 is hard to say - your personal inflation rate may be lower or higher than 3.0%. Also, your spending may well change. There are things you are spending money on now (included in the $40,000) which you won't be spending money on in retirement (could be a mortgage or commuting expenses for example) and things you will spend money on in retirement that you are not spending money on now or aren't spending as much on (i.e., that are not included in the $40,000, such as health care, income taxes and travel and entertainment).

If you are truly 25 years from retirement I would just keep saving. Too many things that will change over the next 25 years to make an accurate prediction now.

As others have said, the idea behind the 4% rule of thumb is that based upon US history one could spend 4.0% of their initial portfolio balance in their 1st year of retirement and then adjust that spend every year going forward for inflation and have their portfolio last for 30 years.
Posts like this are why these forum need a like button. This is a great summary of the 4% guideline.

With that said, the validity of the 4% rule (really, the 4% guideline) is a topic of debate, and gets pretty complicated. Personally, we are planning to use a withdrawal rate closer to 3% - though we also plan to leave the workforce early and live a very long time.
Debt is to personal finance as a knife is to cooking.

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Re: Question about the Safe Withdraw Rate rule

Post by FactualFran » Thu Oct 10, 2019 4:23 pm

Phenom01 wrote:
Wed Oct 09, 2019 9:02 pm
When calculating the amount of money needed for early retirement, do you need to account for inflation? Let say if my current annual expenses are $40k. $40k x 25 = $1M. Does that mean I would need $1M at retirement to maintain a $40k/year lifestyle? Or do I need to adjust that $1M for inflation?
If you retire now, then you would want $1M now. If you retire in the future, then according to the 4% rule of thumb you would want 25 times your annual living expenses in retirement starting at that time.

If as a result of retiring early you are likely to be making withdrawals for more than 30 years, then you will likely want an investment balance at the start of retirement that is more than 25 times the annual living expenses in retirement starting at that time.

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