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.
Interested in safe withdrawal rates and want to dive into the detail? You can check out the entire series here:
- Part 1: Introduction to Safe Withdrawal Rates
- Part 2: Building and Validating a Data Set
- Part 3: Initial Findings (Domestic Equities and Bonds)
- Part 4: Portfolio Optimisation (International and Domestic Equities and Bonds)
- Part 5: Extending Retirement Length
- Part 6: Targeting a Larger Final Portfolio Balance
- Part 7: Sequence of Returns Risk and Safe Withdrawal Rates
- Part 8: Summary (So Far)
What is a safe withdrawal rate?
As we near retirement, we should have accumulated a healthy portfolio that we can live off. Unless you’re a pure dividend investor, this usually requires selling part of the portfolio to cover your living expenses.
But there’s a precarious balance between withdrawing enough money to really enjoy your retirement and withdrawing so much that your portfolio runs out of money (followed soon after by an undignified return to work).
The safe withdrawal rate tries to find the equilibrium between these two things. It is the proportion of your portfolio that you can safely withdraw without running out of money during retirement.
For example, a withdrawal rate of 4% means that you can withdraw 4% of your initial portfolio balance throughout retirement (adjusting for inflation). We call it a safe withdraw rate if our historical simulations suggest that we won’t run out of money during retirement. This is effectively the 4% Rule.
The chart below shows the safe withdrawal rate for a portfolio made up of 50% Aussie equities and 50% international equities over time.
The safe withdrawal rate isn’t just important because it helps us remain solvent during retirement, it also determines how much we need to save during the accumulation phase. So if you play through the maths, a safe withdrawal rate of 4% implies that you need 25x annual expenses to retire. If we drop this to 3.5%, then we need to save closer to 28.5x annual expenses to retire.
And once we’ve hit your annual expense savings number, we can consider ourselves financially independent.
What determines safe withdrawal rate?
There are two factors that determine safe withdrawal rate: average returns over retirement and the sequence of those returns (i.e. whether good returns occur at the beginning or end of retirement).
We conducted a couple of regressions to determine whether average returns or sequence of returns had a bigger influence on safe withdrawal rate. After running the numbers, we found that sequence of returns was the biggest determinant of safe withdrawal rates (by far!). The regression model also suggested that returns in the early years should be the biggest concern of recent retirees.
The risk that retirees experience poor returns at the wrong time is known as sequence of returns risk. Sequence of returns risk is highest immediately before and after retirement because this is when the portfolio balance is at its highest.
Good returns during this period gives the retiree a bit of extra cushion to survive poor returns later. Poor returns during this period can decimate a portfolio to the point of no return.
By this logic, in the worst case scenario we can be hit by sequence of returns risk twice. Poor returns just before retirement and then again just after retirement.
However, it’s more likely that we ride a bull market before retirement, which helps us eventually hit our retirement number. At some point after that, the market corrects and we experience a period of poor returns at the beginning of retirement. Well, at least we’re only stung once!
Optimal portfolio allocation
We can’t really control sequence of returns risk (stock market crashes don’t ask for permission!) but we can try to manage it through portfolio allocation.
So we dove into Modern Portfolio Theory to determine the optimal asset allocation for Aussie retirees. In particular, we looked at the best weighting of Aussie equities, international equities, Aussie bonds and international bonds for retirees. That is, the weighting that had the lowest chance of us running out of money during retirement.
After running the analysis, we uncovered that the optimal asset allocation follows a surprisingly elegant pattern. The equity component of our portfolio should be split 50/50 between Aussie and international equities. We don’t need bonds at all, but if we want some bonds to smooth the volatility, we should simply buy international bonds. There’s no need of Aussie bonds at all.
We found that the allocation above successfully minimised risk (i.e. volatility) whilst maximising return. And by minimising volatility, it reduced the effect of sequence of return risk, thus making this asset allocation the least likely to run out of money in retirement.
Note the ‘international’ component actually refers to U.S. equities. U.S. companies make up a large proportion of international indices. Plus U.S. markets also had the most robust data to test.
Adjusting retirement parameters
The analysis that we conducted to determine the optimal portfolio allocation assumed a relatively short retirement length (30 years) and defined portfolio ‘success’ as having more than $0 at the end of retirement.
But we then realised that those criteria aren’t necessarily applicable to early retirees. Not only do most of us financial independence enthusiasts plan on being retired for much more than 30 years, but we might also want to bequest money to our family.
We found that two things were needed for a portfolio to survive a long (60 year) retirement length: a high equity allocation and equities that were diversified across Aussie and international markets. In fact, compared to a 50/50 split of Aussie and international equities, a 100% Aussie equities portfolio was 10x more likely to fail!
And we found a similar thing for a higher final portfolio value. If we want to end retirement with the same amount of money as we started with, we also need both a high equity allocation and equities that were diversified across Aussie and international markets. In this case, a high equity weighting helps a portfolio lagging at 30 years ‘catch up’ and reach the initial balance again by 60 years.
Designing the perfect safe withdrawal rate table
The exact relationship between portfolio allocation, retirement length, final portfolio balance, and safe withdrawal rate is complex and difficult to get our heads around.
Normally we’d build a big table that shows the likelihood of a portfolio not running out of money during retirement for each combination of factors (safe withdrawal rate, equity allocation, retirement length, target portfolio balance). But that would be way too big and confusing to be useful.
But then we thought more practically. We’re all just trying to figure out what what safe withdrawal rate reflects our risk appetite and circumstances. In other words, we want to answer the question: how much can I take our of my retirement portfolio and still feel comfortable with any risk?
So in the tables below, we’ve approach things slightly differently.
Firstly, we defined two risk tolerances. We consider high risk to be somebody who is comfortable with a 5% chance of their portfolio running out of money during retirement. And we consider low risk to be somebody who is comfortable with a 1% chance of their portfolio running out of money.
Then we figured out the exact safe withdrawal rate that would result in a retirement portfolio running out of money 5% of the time and 1% of the time. And we did this for each combination of equity weighting, retirement length, and final portfolio balance.
It’s worth noting that equity weighting takes into account the optimal asset allocation described earlier. For example, an equity weighting of 80% implies 40% Aussie equities, 40% international equities, and 20% international bonds.
Determining your safe withdrawal rate
The high risk tolerance table is below. If you consider yourself to be comfortable with a high risk portfolio (i.e. you’re fine with a 5% chance of running out of money during retirement), then find the cell that corresponds to your personal portfolio equity weighting, retirement length, and final balance target. This is the maximum safe withdrawal rate that is acceptable for you.
You can see that with a high risk tolerance, in most cases you can withdrawal well above 4.0% of your retirement portfolio every year. Of course, you might run out of money. But let’s not think about that too much!
Now if you consider yourself to be low risk (i.e. you’re only fine with a 1% chance of running out of money during retirement), then use the table below and find the cell that applies to you. This is the maximum safe withdrawal rate that is acceptable for you.
You can see that, when risk tolerance is reduced, safe withdrawal rates quickly revert below 4.0%. And when you’re an early retiree that targets a high final portfolio balance to leave for their family, you really do need to adjust down your withdrawal rate to be safe.
If you’re interested in looking at any other likelihood of success (e.g. you’re curious to know safe withdrawal rates with a 2.5% likelihood of failure) then leave a comment below. I’m happy to run the analysis and add to this article.
The purpose of this post was to summarise all our work on Aussie safe withdrawal rates to date. Hopefully we’ve been able to stitch all our analyses together into a useful tool to figure out the appropriate safe withdrawal rate.
If you have any questions or requests for safe withdrawal rate analysis, just drop a comment below and let’s discuss it. This is a very fruitful area of analysis and one that’s extremely important to early retirees.
All the best in your journey to early retirement!