The 4% SWR in Action
So much is written about the 4% SWR that I assume you know the basics. Let’s visualize the 4% SWR and see it in action. And at the end, discuss if we think it is still a good rule for present day use.
The 4% SWR Basics
You have $1 million dollars and 30 years left to spend it. A Three Fund Portfolio sounds good, and you select a 60/40 stock/bond asset allocation. You have $400,000 in a brokerage account, $400,000 in a 401k, and a Roth IRA worth $100,000.
As for asset location:
-Brokerage: $100,000 in US Stock, $200,000 International Stock, $200,000 US bonds
-401k: $200,000 in US Stock and $200,000 US Bonds
-Roth $100,000 in US Stock
Let’s take out 4% in the first year and adjust for inflation, and see how we do over time!
The 4% Rule with a Moderate Portfolio
Figure 1 (60/40 portfolio and the 4% SWR)
Figure 1 demonstrates the 4% SWR from a moderate 60/40 portfolio over time. You start taking $40,000 the first year, and increase that dollar amount by inflation each year. Since inflation is assumed to be 2% in this scenario, the second year you would take out $40,800, and so on.
Note that although you start at 4%, because your portfolio has investment returns, the withdrawal percentage only very slowly goes up over time. The maximum withdrawal rate is about 7.5% of your portfolio a year at year 30.
What if you changed your asset allocation to a much more aggressive 90/10 asset allocation?
The 4% SWR with an Aggressive Portfolio
Figure 2 (90/10 portfolio and the 4% SWR)
In figure 2, note how the withdrawal percentage actually decreases overtime as your 90/10 portfolio earns more than you take out each year. This is despite of inflation and the 2% increase in the dollar amount you withdrawal every year. In order for the withdrawal percentage to decrease, you must be making more in your portfolio than you are taking out.
How much does your portfolio grow each year? Well, to know that, you need a crystal ball.
Assumptions of Future Returns
Instead of a crystal ball, let’s assume that Vanguard’s recent assumptions hold true. They have released the following assumptions for 10 year returns: US equities 4-6%, US bonds 2.5-4.5%, International equities 7.5-9.5%.
To keep things simple, for this example we will use 5%, 3.5%, and 8.5% returns, respectively.
Comparison of the 90/10 and 60/40 Portfolios
Figure 3 (90/10 and 60/40 portfolio comparison)
Above we see the Monte Carlo success percentages and final balances of the 90/10 (left) and 60/40 (right) portfolios. Note the chance of success given the return assumptions from above is 90% for the more aggressive portfolio compared to 68% for the balanced portfolio. There is a lot more money left after 30 years as well (blue bars).
So why would you ever use a less aggressive portfolio? The answer to that question is Sequence of Return Risk.
Sequence of Return Risk and the 4% SWR
When you are drawing down on your portfolio, negative returns of the stock market cause you to reverse dollar cost average. This rapid initial depletion of your portfolio can cause long term failure after just a few negative years. Sequence of Return Risk (SORR) describes the failure of your portfolio determined by the returns before and after you start withdrawing from your portfolio.
How does SORR affect a 90/10 portfolio?
SORR and an Aggressive Portfolio
Figure 4 (90/10 portfolio with Sequence of Return Risk)
Figure 4 shows the same 90/10 portfolio we saw above, only we are using the actual returns from 2000-2010 instead of the assumed Vanguard returns. As you can see, the withdrawal percentage rapidly increases to unsustainable levels, and the portfolio runs out of money at age 84.
Let’s compare the drawdown of the 90/10 and the 60/40 portfolio using the actual returns from 2000-2010.
Above, we can see the 90/10 portfolio in dark green and the 60/40 portfolio in light green. With the more aggressive portfolio we see large losses during the negative years which are not made up for during the positive years. The aggressive portfolio runs out, whereas the moderate portfolio just makes in to the end of the plan.
So, in summary, you do well to be more aggressively invested unless you suffer from Sequence of Return Risk. That is the dilemma of the 4% Rule.
The 4% SWR Revisited
So, what is a retiree supposed to do? Now that we have low expected equity returns and bond yields… does a 4% SWR still work?
If you plan on a traditional retirement, the 4% Rule is safe if you take sequence of return risk into account in your asset allocation. Use a moderate portfolio 5 years before to 10 years after your retire. That is, Go Conservative to prevent Sequence of Return Risk! Before and after these times when you are most susceptible to SORR, you can take more risk with an aggressive portfolio. When your risk has passed, you may consider a bond tent or rising equity glidepath.
The 4% Rule is a hallmark of Financial Independence. This Rule calculates your FI number: 25x your annual expenses. There are many good and bad blogs about the 4% rule, but I will leave you with the following thoughts:
- US historical returns are considerably better than other countries’ returns
- 30 years is the general limit of the 4% rule
- The 4% Rule ignores social security and other income sources
- William Bengen’s original research used a 50/50 portfolio with 5 year treasury bonds
- The Trinity Study compared different withdrawal rates to different stock/bond portfolios.
- The Trinity Study used higher volatility corporate bonds rather than treasury bonds
- 4% is only used the first year to get the withdrawal dollar amount
- Subsequent years, the dollar amount is increased by the Consumer Price Index (CPI)
So, when it is your time to retire, will you use the 4% SWR? It’s probably a good place to start, but flexibility is the key.
Have a Withdrawal Plan in Retirement that is more flexible and honest.
You might be able to survive a decade of low fixed income yields and low expected equity returns by planning your 4% SWR to survive sequence of return risk, but, of course, you only get one chance to do this right.
Great post as always thanks so much. That’s a great exercise to run the actual projections. That said returns many be much less. How can bonds work? Even if rates decrease that means the income contribution goes to zero or near zero. It paints itself into a corner. US stock have not done well from today’s CAPE levels.
Flexibility is key as you point out.
Great topic. Agree completely. Have you also considered dynamic allocations and dynamic SWR’s in your portfolio based on existing CAPE levels each year to more closely monitor the current market conditions?
Big Erns calculations showed a 3.25% withdrawal should always work. Trinity study assumed zero funds left at 30 years.
If you want to leave assets for your heirs spend less than than 4%.
Great post as usual, David.
I still use 4% SWR as a rule of thumb to determine a target amount of savings at retirement for <45 year old clients. For those closer to retirement, start talking about more specific portfolio moves towards being conservative, but I usually couch it in terms of "what amount of money will you need within 5 years, 10years, etc.?". This often leads to a bond tent of around 40% at retirement. I think this article says my method is still valid.