The majority of Americans use debt to fund their lifestyles, but we all know that it’s not sustainable. The average American owes more than $140,000 in debt. If you take out a loan to pay for a new car, a home, or even tuition, you’re borrowing against the future, and you’re borrowing against the future of your kids. **If you’re like most Americans and have invested your money in the stock market, then you’re probably familiar with the term “401(k).”
As mentioned in the title, this is about a 4% withdrawal from your portfolio of all your investments. This 4% is a safety/insurance amount that you are allowed to withdraw from your portfolio every year. This plan is for people that don’t have a lot of risk (such as an emergency fund), but still want some sort of savings.
As you probably know, the stock market is volatile. And sometimes, that volatility can make you want to pull your money out of the market. But is it safe? Can you really withdraw 4% of your portfolio and it will not hurt you?. Read more about does the 4% rule preserve capital and let us know what you think.(Disclosure: some of the links below may be affiliate links). A common misconception about the Trinity study is that people think they are taking 4% out of their current portfolio. If the portfolio is worth $1,000,000 this year, they can withdraw 4% of that amount, or $40,000. In reality, however, the withdrawals are based on the original portfolio at retirement. If you start with $800,000, you can withdraw $32,000. Then adjust your payments each year for inflation. The first year it is the same, but the following years the two methods are very different. But what happens if you withdraw based on the current portfolio instead of the original portfolio? We’ll see about that!
Withdrawal from the current portfolio
I assume you are familiar with the Trinity study and know how to retire based on your portfolio. Otherwise, you should read the previous article and come back here. The basic idea of the Trinity study is that you can maintain your lifestyle over time (30 years in the original study) if you withdraw X% (where X is the withdrawal rate) of your original portfolio each year. The tax-free amount is determined once and only then adjusted for inflation. This means you need to know in advance how much you will spend during retirement. Many people think they can take X% of their current portfolio instead of the original portfolio. So if the portfolio is 1,000,000 in the first year, they can withdraw 40,000. And if the portfolio is worth 1,100,000 in the second year, they can withdraw 44,000. That’s not the problem with the Trinity study or the 4% rule, but I think it’s important to see what happens when we run simulations when we take money out based on the current portfolio.
I will run simulations based on the Trinity study with different uptake rates. The only thing I’m going to do differently is that the payment amounts will be based on the current portfolio, not the original portfolio. To do this, I use data on the US equity markets from 1871 to 2020. I will use different portfolios of stocks and government bonds. In all my simulations I assume a TER of 0.1% per year. I use my own tools to run these simulations. If you are interested in the instrument and the data, you can check out my article Updated Trinity Study. The result of the simulation is the success rate. Success is defined as no money until the end of the simulation. A simulation that ends with a result of 1 CHF is considered successful. And the success rate is the percentage of successful simulations in a set of simulations.
Retired since 30 years
Let’s start our modeling directly with a retirement within 30 years. This is a reasonable time frame for some retirees. So these are the results if you base your conclusions on the current portfolio rather than the original portfolio: Withdrawal based on the current portfolio – 30 years – 1871 – 2020 As you can see, all portfolios have a 50/50 chance of success! Even with a withdrawal rate of 6%! This is much better than using the standard trinity study rule! Does this mean we just found a great way to support our lifestyle by withdrawing more money with a greater chance of success? No! If you think about it: As long as you take a percentage out of your current portfolio, it will never reach zero. For example, with a 4% withdrawal rate, even $100 can last almost forever. In the first year, you can withdraw $4, then $3.84, then $3.68, and so on. At some point you may hit bottom because you can’t share a penny. The biggest problem with this simulation is that it assumes we can live on any amount of money, even a nickel. If you could live on a penny a year, you wouldn’t have to rely on Trinity studies to retire. We must therefore indicate the minimum amount that we have to live on. This will be the bare minimum to survive. It may be less than what you currently plan to spend on your retirement, but it must be reasonable (because you have to stick to it).
Retirement after 30 years of minimum service
Let’s repeat our simulation by entering a minimum into the system. But we still have to choose the minimum. It is useful to use a percentage of the original portfolio as a minimum for modeling. So if you use 4% and your portfolio is 1,000,000 Swiss francs, the minimum you can spend in a given year is 40,000 Swiss francs. So let’s look at the results with withdrawals from the current portfolio and a minimum interest rate of 4%: Withdrawal based on current portfolio (min: 4%) – 30 years – 1871 – 2020 This time, there’s a little variety. But the return is still excellent, much better than with the 4% withdrawal rule. So can you withdraw 6% of your portfolio each year with at least 4% of your original portfolio? Well, not exactly. Another important element is missing: inflation!
This method requires a minimum, but then inflation must be taken into account. Thirty years later, this minimum is hardly relevant. We only adjust the minimum amount for inflation, not the amounts that can be paid out, based on the payout rate and cash value. So let’s look at the results of adjusting the monthly minimum amount for inflation, using data from the U.S. Consumer Price Index (CPI): Withdrawal based on current portfolio (min: 4%) – inflation – 30 years – 1871 – 2020 Withdrawal based on current portfolio (min: 4%) – inflation – 30 years – 1871 – 2020 We see that the results are already much more interesting. And we also find that portfolios with less than 40% equities do not perform well. So let’s start by removing those portfolios: Withdrawal based on current portfolio (min: 4%) – inflation – 30 years – 1871 – 2020 Withdrawal based on current portfolio (min: 4%) – inflation – 30 years – 1871 – 2020 Now we can already see the different portfolios better. We can notice several things in this table. First, there is a flat line between 3% and 4%. That makes sense because we shoot at least 4% a year. So we can’t be better than 4%. We will see later what happens when the 3% minimum value is taken into account. The second interesting fact is that the loss of success rate after 4% is not particularly large. Of course, the success rate is still lower, but that makes sense because we are taking more money out of the portfolio every year, especially in the early years. But it also shows that you can shoot well above the minimum and not take too many risks. For example, we can withdraw 6% of our 100% equity portfolio each year and have a 93.4% chance of success with a minimum withdrawal rate of 4%. This is still a few percentage points below the 4% net absorption rate. But it’s not significantly worse. This shows that we can usually absorb more than people think without depleting the wallet. This may demonstrate the value of a flexible range of withdrawal rates. For example, a 100% stock portfolio with an aggressive withdrawal rate of 5% and a minimum withdrawal rate of 4% would still have a 95.9% chance of success. Let’s see what happens if we put in at least 3% of the original portfolio and adjust it monthly for inflation: Withdrawal based on current portfolio (min: 3%) – inflation – 30 years – 1871 – 2020 Withdrawal based on current portfolio (min: 3%) – inflation – 30 years – 1871 – 2020 With the exception of the portfolios that consist of 100% bonds, all portfolios perform very well in this situation. This makes sense as we have lowered the minimum payment to just under 3%. A 3% withdrawal rate is very conservative and has a very high probability of success. This shows that the most important parameter is now the minimum, and not the take-up rate. To see for yourself, let’s look at the results with a minimum of 5% of the original portfolio: Withdrawal based on current portfolio (min: 5%) – inflation – 30 years – 1871 – 2020 Withdrawal based on current portfolio (min: 5%) – inflation – 30 years – 1871 – 2020 We see that the 5% minimum intake is too aggressive. Even if the portfolio were fully invested in stocks, the probability of success would not exceed 80%.
Retirement after 40 years of service
Let’s continue with a retirement at age 40. Using the same parameters, these are the results over 40 years: Withdrawal based on current portfolio (min_ 4%) – inflation – 40 years – 1871 – 2020 We have found that the method still works very well after 40 years. For comparison, we compare it to the standard output rule from the Trinity study with the same parameters: Withdrawal based on initial portfolio – inflation – 40 years – 1871 – 2020 If we compare the two graphs, we can see several things. First: For low recording rates, the standard recording rule is much better. This is quite normal as we use a minimum of 4%. A withdrawal rate of 3% of the current portfolio makes no sense if the minimum rate is 4% of the original portfolio. The second point is that the success rates at higher retrieval rates are better with this new method than with the standard Trinity Study method. Why? This is because we can take a large percentage (withdrawal percentage) of the current portfolio in the first few years of the simulation. But once that number hits the small bar, we’re back to 4% of the original portfolio. So we’re back to the 4% rule! If withdrawal rates are high, we will withdraw less than the standard retirement method once the minimum is reached.
Are we spending more?
So, are we really shooting more than with the standard withdrawal rule? We have seen that with higher withdrawal rates we end up withdrawing only 4%, but it would be interesting to see if we actually withdraw more money with this method. So I noted down what the average intake was for each model year. In this average I have only taken into account successful simulations. The simulation started at $1,000. Here are the results for the average amount withdrawn per year using the new withdrawal method and a minimum withdrawal rate of 4% (based on the original portfolio) and 40 years: Withdrawal based on current portfolio (min: 4%) – inflation – 40 years – 1871 – 2020 And here is the same information, but for the standard recording method: Withdrawal based on initial portfolio – inflation – 40 years – 1871 – 2020 From these two graphs we can deduce several things. First, we take more money out of theportfolio. In some cases, they receive on average 50% more. This is the purpose of this method of withdrawal. But the withdrawal rate itself doesn’t make much difference. The most important thing is the minimum. With the standard withdrawal method, the money we withdraw per year depends entirely on the withdrawal rate. So we can say that we can withdraw more money without it having a big impact on the success rate. However, this depends entirely on the minimum used. And that means we have very different years. We will probably have years where we can spend twice as much as the next year. This can be a problem for people who are not flexible in their spending.
Finally, there’s something else we need to pay attention to. Many people only look at the success rates of individual parameter sets. However, we must also consider the worst-case duration of each set of parameters. Sometimes it is better to retire with a lower success rate but a significantly higher worst-case duration. The worst time is when the simulation can fail. Let’s test the worst-case duration with this new method for 40 years of retirement: Withdrawal based on current portfolio (min: 4%) – inflation – 40 years – 1871 – 2020 And let’s compare with the standard extraction method: Withdrawal based on initial portfolio – inflation – 40 years – 1871 – 2020 We can see that the two graphs are very different. The main difference is that the current portfolio withdrawal strategy depends almost entirely on the minimum you choose, while the standard retirement method depends entirely on the withdrawal rate. So with this method, you shift the problem from choosing the withdrawal rate to choosing a minimum and sticking to it.
The dangers of flexibility
This method can work, but only if you can stick to your chosen minimum. Many people find that they can be very flexible with their spending. They may shorten their vacations, eat out less or stop going to the movies. And in some cases, it really is. But in most cases people overestimate their ability to be flexible. The main reason is that if you get into the habit of spending more for a few years, it will be difficult to reduce that level of spending in the future. The more good years you have, the harder it will be to spend less. And flexibility is not always easy to find. If you’re moving to a bigger house, you won’t be able to move if a bad month occurs and you don’t have enough money to pay the interest on your mortgage. This is an extreme example, but not impossible. People can probably live with the difference between 4.5% and 4% in terms of payment rates because there is little flexibility. But most people will not be able to change their habits from 5% to 4%, let alone 6% to 4%. So if you plan to have a lot of flexibility in retirement, I would advise you to be careful!
Since many people think they should take withdrawals based on the current portfolio rather than the original portfolio, as was the case with the Trinity results, I modeled what would happen if we took withdrawals based on the current portfolio. I think it is possible to retire with this method. However, you must set a minimum amount that you must withdraw. This is determined by the minimum amount of money you need to survive. If the years are successful, you can withdraw more, up to your withdrawal percentage. But when the years come, you only get a small amount out of it to survive. The advantage of this method is its flexibility. You can withdraw more money and enjoy a higher standard of living in good times, and return to a lower standard of living in bad times. And it won’t do much to reduce your chances of success. The big problem with this method is the choice of the minimum. This is even more complicated than choosing a withdrawal rate, and you still need to choose a withdrawal rate. And on top of that, you have to keep it to a minimum. If you manage to withdraw more money in consecutive years, it is unlikely that you will recover. And in this case, you’re going to have a problem. Because this method is only as good as the minimum you choose. If you choose a conservative minimum and a slightly higher withdrawal rate, say 3.5% and 4%, I think this method makes sense. But it doesn’t make sense to go for something like 4% and 5%, especially in the long run. If you have any suggestions for similar simulations, please let me know! And if you want to read more simulations like this, I recommend my simulations on low-yield bonds. What do you think of these results? How do you prepare for retirement? Get our best strategies and tips delivered straight to your inbox. Get free advice on your finances to help you become financially independent!You find yourself asking one of two questions: Am I out of money? Or should I cash out to get more money? Most people make the mistake of judging their financial health by looking at their portfolio. The problem with this approach is that we can go through our lives without ever seeing a portfolio.. Read more about what is the 4% rule and let us know what you think.
Frequently Asked Questions
Is 4% a safe withdrawal rate?
Sometimes you need to take the plunge into the unknown – and sometimes it’s the right move. But what about 4%? Is that an appropriate withdrawal rate? What is a “safe” withdrawal rate? Efficient Frontier (EF) Theory says that any withdrawal rate that is higher than the annualized risk-free rate will produce a loss of principal. The 4% rule is a chart that plots a safe withdrawal rate versus expected future returns. The rule implies that to withdraw 4% of your portfolio, you need to expect to see an annualized return of at least 4% over the next 36 years.
How much you can safely withdraw yearly from your portfolio?
Most people don’t have too much invested in the stock market. For most people, it’s not a good idea to start withdrawing from their portfolio, because you may not understand how much you can afford. Long-term investing 101 says that the best thing you can do for your portfolio is to leave it alone for as long as possible, taking advantage of the benefits of compounding interest and low fees. “Don’t touch it” seems like a great advice, but that’s not always possible.
Is 4% rule still valid?
Short answer: Yes. Related: I recently read a CNBC article that discussed how the 4% rule of thumb is still applicable, because financial advisors are measuring the historical average and not the actual future performance of the portfolio. So, it is still valid, but only if the current portfolio is less than 4% larger than what it was prior. You may have heard that the 4% rule, which states that you should withdraw 4% of your portfolio annually to ensure that your retirement account is adequately insured, has been modified in recent years. The big question is: What’s changed? Is the rule still valid?
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