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!
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)
How did we calculate SWRs?
We chose to use the analytical approach to safe withdrawal rate calculations that have been used by Suarez et al., Morningstar and Big ERN. This means that we select the final portfolio value that we are targeting and calculate the exact safe withdrawal rate required to achieve it.
We start by calculating the cumulative return of one dollar invested over our total retirement length (C_T). This tells us how much it would ‘cost’ us to withdraw that money and miss out on any compound interest. And then we calculate the total return of the retirement portfolio if we never took any money out (C_1).
Now we can calculate the final value (FV) of a retirement portfolio by taking the total value of the portfolio if we didn’t withdraw any money and then subtracting the opportunity cost of those withdrawals.
From there we can calculate the withdrawal rate (WR), which is the difference between the total value of the portfolio if we withdrew money and the total value of the portfolio if we didn’t withdraw money, divided by cumulative returns.
How did we make it more applicable to Australians?
We adjusted the calculations in two ways to make the results more applicable for Australians.
Firstly, we sourced Australian equity and bond returns from 1871 to 2018. This allows us to calculate safe withdrawal rates for Australians who invest in Australia (e.g. the ASX200). And when we combine this data with our U.S. data, we can calculate safe withdrawal rates for Australians that invest in a mix of Aussie and U.S. markets. Let’s be honest, most of us do!
Secondly, we adjusted the expense ratio to reflect the reality of Australian portfolios. It’s sad but true to say that it costs us more to invest our money than in the U.S. Aussies in the FIRE community are pretty savvy when it comes to minimising fees, so we have assumed that the fees that most Australian’s pay on their portfolios is broadly in line with common ETFs.
With this in mind, we have included the following fees in our calculations:
- Australian equities: 0.14% (fees charged by Vanguard VAS)
- Australian bonds: 0.20% (fees charged by Vanguard VAF)
- U.S. equities: 0.18% (fees charged by Vanguard VGS)
- U.S. bonds: 0.20% (fees charged by Vanguard VIF)
Using the approach outlined above, we calculated over 700,000 safe withdrawal rates. Each withdrawal rate is unique combination of equity/bond split, target balance at end of retirement, retirement horizon, domestic/international split, and month (from February 1871 to July 2018). In this article will will use a subset of the 700,000 safe withdrawal rate data set, and focus on a 30 year retirement horizon only.
Safe withdrawal rates over time
We start by calculating the safe withdrawal rate over time for a 100% equities portfolio and a 100% bonds portfolio for a 30 year retirement length. In the charts below we compare the output for the U.S. and for Australia.
The average safe withdrawal rate for both portfolios is broadly the same between the U.S. and Australia. However, U.S. safe withdrawal rates drop below 4% slightly more frequently than Australian safe withdrawal rates for both 100% equities and 100% bonds portfolios. It remains to be seen what this means for portfolio success rates.
We find that there is low correlation between U.S. and Australian safe withdrawal rates for a 100% equities portfolio (r² = 0.07), yet there is a high correlation between the countries in a 100% bonds portfolio (r² = 0.76). This isn’t surprising, as it is well known that Australian bond yields are typically affected by changes in U.S. bond yields.
Portfolio success rates
To understand what safe withdrawal rates mean in practical terms, we convert them into success rates. It works like this: if a withdrawal rate of 4.00% has a success rate of 95%, this means that we would have run out of money in only 88 of 1770 monthly starting points.
We started by calculating success rates for a U.S. portfolio of different equity and bond allocations. The purpose of this calculation is to ensure that we replicate Big ERN’s findings with our calculations and to use as a point of reference to compare Australian success rates later.
The table above shows acceptable (95%+) success rates for withdrawal rates of 4.00% or lower when portfolios contain at least 50% equities. This is effectively the main result of the Trinity Study. However, success rates drop off sharply for withdrawal rates above 4.00% or for portfolios with less than 50% equities.
These results are broadly in line with Big ERN’s. On the one hand, we’ve used higher portfolio fees in our calculations, which would result in slightly lower success rates. On the other hand, Big ERN has forecast equity and bonds returns beyond 2018 with zero volatility, which would result in slightly higher success rates. Overall, the difference between Big ERN’s and our success rates is between 0-1%, which feels reasonable.
Now for the good stuff. Overall, we see very similar results for Australian safe withdrawal rates. However, there are a few things to keep in mind:
- A withdrawal rate of 4.00% results in acceptable success rates for Australian portfolios with at least 75% equities. However, if the portfolio has only 50% equities, the withdrawal rate must be reduced to 3.75% to maintain an acceptable success rate.
- Adding some bonds into the portfolio (75% Australian equities, 25% Australian bonds) results in a higher success rate than a 100% equities portfolio. This is most likely due to diversification effects.
- For those who are happy to take significant risk, Australia tends to have higher success rates than the U.S. for withdrawal rates above 4.00%. Of course, this is not recommended as it introduces a very real risk that you run out of money before the end of retirement.
The chart above illustrates the relationship between safe withdrawal rates and success rates for various equity/bond allocations over a 30 year retirement length. As you can see, success rates fall to unacceptably low level very quickly for portfolios with 50% equities or less. To maintain an acceptable success rate you need to either reduce your safe withdrawal rate or increase your equity allocation.
This isn’t the whole story… yet
Wait! Don’t race out and rejoice that a 4.00% withdrawal rate is acceptable for Australian retirement portfolios with at least 75% equities. Remember we are talking about a 30 year retirement length, which is probably not long enough for somebody whose goal is to retire early.
In the next article we will look at the effect of longer retirement lengths on safe withdrawal rates. Our hypothesis is that longer retirement lengths require lower safe withdrawal rates or a higher equity allocation to maintain acceptable success rates.
Update: Part 4 is focused on portfolio optimisation across domestic and international equities and bonds!
As always, if you have any questions, comments or feedback, please email me. I’d love to hear your thoughts.