Many of us in the financial independence community like to consider ourselves non-conformists. While the masses are deep in consumer debt and locking themselves into years of work, the rest of us are being smarter with our money and setting ourselves up for a long life of leisure.
But at the same time, we all praise the 4% Rule like it’s gospel without questioning whether it applies to early retirees, particularly us way over here in Australia.
Over the last few months we’ve been deep in safe withdrawal rate analysis to test whether the 4% Rule actually works for us Aussies — or whether it’s not quite as ‘safe’ as we think.
This article stitches all that analysis together and introduces a simple tool for us to determine the exact safe withdrawal rate that applies to our individual circumstances and risk tolerance.
Over the last couple of months we’ve spoken a lot about how varying portfolio factors, such as asset allocation and retirement length, affects safe withdrawal rate. And now we have a clearer view of how much we can withdraw from our portfolio without running our of money during retirement.
But we haven’t actually spoken about what market conditions determine safe withdrawal rates. Why are some periods associated with low safe withdrawal rates and others not?
So in this article we deep dive into the mathematics behind safe withdrawal rates to figure out what you want to stock market to be doing while you’re saving money and while you’re withdrawing money in retirement.
After a short Christmas and New Year’s break, we’re back into safe withdrawal rates!
All the work that we have conducted so far has defined a successful retirement portfolio as a portfolio that has does not run out of money during retirement. So we calculated the safe withdrawal rate that would completely deplete the portfolio at the last day of retirement.
But, practically speaking, this would be a scary ride for many retirees. There would be a number of close calls in which the portfolio balance fell very close to zero but did not technically fail. In these cases, it’s not hard to imagine that a retiree would do something drastic, like an undignified return to work in their 70s or 80s.
Should that portfolio be considered safe? It may not have run out of money but it wasn’t a comfortable ride into retirement. A cushion would be nice.
Moreover, I’d guess that many retirees don’t want to end retirement with very little money. Surely most people want to bequest something to their family or favourite charity.
It seems that we could make a fair argument that most people want some balance left in their portfolio at the end of retirement. So in this article we examine the effect of the target final portfolio balance on safe withdrawal rates.
In part 3 of our Safe Withdrawal Rate Series we set out to determine the optimal mix of Australian equities and Australian bonds that would allow us to withdraw the most from our retirement portfolios without running out of money.
We found that we could safely withdraw 4.00% of our retirement balance per year (adjusted for inflation) as long as the portfolios had at least 75% Australian equities.
We also noticed that portfolios with 75% equities and 25% bonds actually performed better than a 100% equities portfolio. This was our first indication that diversification can be beneficial, even if we diversify into a lower return asset.
Then in part 4 of the series, we extended our analysis to determine whether international exposure would be better for Australian retirees. We found that we can safely withdraw more when Aussie retirement portfolios were made up of Australian equities, U.S. equities and U.S. bonds. We don’t even need to buy Australian bonds!
One conscious limitation of all that previous analysis is that we assumed a 30 year retirement length. However, in reality many early retirees may be retired for 40, 50 or even 60 years. So in this article we will examine the effect of longer retirement lengths on safe withdrawal rates.
In Part 3 of our Safe Withdrawal Rate series we determined the best mix of Australian equities and bonds to maximise the chance of a retirement portfolio lasting 30 years. We discovered that a mix of 75% Australian equities and 25% Australian bond was optimal.
But in reality, most of us Aussies invest in a mix of Australian and U.S. markets (and possibly some ‘whole of world’ markets).
So in this article, we are going to extend our previous analysis to look at an internationally diversified portfolio. We are going to determine how we should allocate our retirement portfolio across Australian equities, Australian bonds, U.S. equities and U.S. bonds.
If you’ve spent any time in the financial independence community, then no doubt you’ve come across the 4% rule. The rule states that you can withdraw 4% of your retirement portfolio (adjusted for inflation) without running out of money. As such, 4% is known as the safe withdrawal rate.
If you play through the mathematics, the implication of the 4% rule is that you need 25x your annual expenses to retire. So many would-be early retirees structure their entire retirement plan around that 25x expenses number.
More recent studies have questioned the robustness of the 4% rule for U.S. markets. Amongst other things, they have found that 4% very quickly turns into 3.5% or below when you change equity/bond portfolio mix, retirement length and other factors.
But all of this work was done for Americans using U.S. markets data. The question for us Aussies is: Does any of this apply to us? If so, which parts?
In this article we begin to clarify some of the important — but still unanswered — questions about the 4% rule for Australians. We test whether the basic 4% rule applies to Australians and whether it needs to be adjusted for different portfolio mixes.
In future articles in this series we will elaborate on these findings and test follow-on questions, such as ‘what is the effect of retirement length of safe withdrawal rates?’, ‘can we improve safe withdrawal rates by mixing Australian and international investments?’, and more!
Ever heard of the phrase “garbage in, garbage out”? It’s the idea that no matter how good the analysis is, if the data is wrong then the results will be wrong too.
The challenge with safe withdrawal rates is that you need historical data to run the calculations. And historical data, particularly early data from the late 1800s and early 1900s, is notoriously difficult to find. So before I dive into the deep, dark chasm that is safe withdrawal rate calculation, I’m going to spend some time ensuring that I’m using solid data.
Apologies in advance. This is going to be a dull article for those of you who aren’t interested in validating data sources. But it’s a necessary evil.
The fundamental question that people have about early retirement is: how much do I need to save to retire?
For those who understand the mathematics behind early retirement, the main thing that determines how big our retirement portfolio must be is the safe withdrawal rate.
Essentially, safe withdrawal rate is the amount of money you can withdraw from your portfolio when you are retired without running out of money.
I stumbled upon an amazing 28 part series on Early Retirement Now that calculates safe withdrawal rates for U.S. markets. It calculates safe withdrawal rates for different retirement lengths, asset allocation, and more!
However, there are major differences between U.S. and Australian markets that mean each would likely have different safe withdrawal rates.
It’s not fair that our U.S. friends have such great data on their required retirement portfolio and we don’t. So in the next few posts, I plan to replicate some of the analysis on Early Retirement Now — with Australian data, for Australians.