If you’d like to use the 4 percent rule as your safe withdrawal rate but are terrified that it might leave you with nothing a few decades down the road, then I may have a great solution to offer you!
As I’ve been doing more and more research for my latest ebook (which will be all about optimizing “how much” you need to save for retirement), I’ve been getting really excited about some of the cool stuff I’m finding out.
For example, there was the post I did a little while back about how the updated Trinity Study showed that you could use a 7 percent safe withdrawal rate with a 91% chance of success if you don’t adjust your withdrawals for inflation.
The 1994 uber-classic 4 percent rule article from Bill Bengen also showed a 100% chance of success of your money lasting for 50 or more years if you used a safe withdrawal rate of 3.5% with inflation adjustment each year.
This got my creative juices flowing …
Why couldn’t we put the two concepts together and get the best of both worlds?
In this post, I’ve done just that. And I think you’ll be very surprised about how it appears to work out!
Doing More With Less
Before I get into the nitty-gritty details, I’d like to start off with the premise for this experiment.
Traditional retirement plans (such as the Bengen 4 percent rule) are usually designed to last for a minimum period of 30 years. If you’re like me and planning to reach financial freedom early on, this presents a problem. I need my money to last me 50 or 60 years; a lot longer than this.
An easy solution is to simply withdraw less money and lower your withdrawal rate. Like I mentioned above, Bengen’s article claimed that a rate of 3.5% worked every time for each 50 year rolling period. When I did my own study using FIRECalc, I found pretty much the same thing.
While that’s great to know, it does present you with a very significant problem: You need more money.
Half a Percent Makes a Big Difference
To illustrate this contrast, if I needed to create a passive income of $5,000 per month ($60,000 per year), then:
- Using a low safe withdrawal rate of 3.5%: $60,000 / 0.035 = $1,714,286
- Using the classic safe withdrawal rate of 4.0%: $60,000 / 0.04 = $1,500,000
That’s a difference of $214,286
That extra $214K is not so easy to come up with. Especially when your goal is to retire early, this means that you now have even less time to work with and leverage compounding returns to help you reach your goal.
Since we can’t very well find a magic investment that will yield a greater return than the S&P500, our only hope is to simply “save more money”.
Unfortunately, that’s easier said than done. I’m sure lots of people would like to experience financial freedom but forgot to start aggressively saving in their early 20’s.
As always, I ask the question: Can we do more with less?
A Possible Safe Withdrawal Rate Loophole?
Since we know that the Trinity Study supports a safe withdrawal rate as high as 7% without inflation adjustments and Bengen’s data supports a safe withdrawal rate of 3.5% with inflation adjustment, is there a way that we can compromise in the middle somewhere?
In other words, can I start my early retirement with a higher safe withdrawal rate if I’m willing to adjust less for inflation as time goes on?
If I’m able to do this, then I’d be able to start off with a higher withdrawal rate (which would require me to save less money in the beginning) and still have the safety and security of my money lasting beyond the standard 30 year threshold.
I had a few ideas about how I could test this theory.
Manipulating the 4 Percent Rule
I started this experiment by downloading historical investment return data from NYU and setting up two main columns in Excel: One for a “standard” 4-percent, inflation-adjusted method and the other for what we’ll call a “hybrid” method.
Similar to Bengen’s classic approach, I looked back at 30 years of returns for a 50/50 split stocks and bonds portfolio with rebalancing each year.
Using the Standard method as a baseline, I started with a 4% withdrawal and then increased the withdrawals by 3% for inflation each year. Example: $40,000 the first year, $41,200 the second, $42,436 the next, and so on …
For the Hybrid method, I increased the withdrawal rate to 4.5% and decreased the inflation adjustment rate until the two graphs lined up.
At around a rate of 1.5% for inflation, the graphs were almost a perfect match with 2.2% or less variance!
My Finding: I was able to increase my withdrawal rate by 0.5% if I am willing to accept 1.5% less each year for inflation adjusted withdrawals.
Alright! We’re off to a good start.
Going for Safety!
So far so good for someone wishing to duplicate the standard 4-percent rule profile. But my heart was really set on duplicating the safer, longer lasting 3.5% safe withdrawal rate profile. Again, I know that if I can do this, then my money is virtually guaranteed to last for at least 50 years.
I then tried the same experiment again using a 3.5% safe withdrawal rate for the Standard and 4.0% for the Hybrid. Again, if I was able to reduce my inflation adjustment rate by 1.5%, then the two graphs line up almost perfectly with 2.3% or less variance.
My finding is the same as the last one!
Could I be on to something here?
The Problem With Lower Infaltion Adjustments … And a Solution
Before we go changing history with this new, revolutionary approach to the safe withdrawal rate, let me be the first to point out the obvious problem here:
Eventually you’ll reduce your purchasing power to an unacceptable level.
In my simulation, at first, the lower inflation adjustments are barely noticeable. But given the way that compounding returns work, that difference between the two rates gets wider and wider with time. By the end of 30 years (in the second experiment), the amount that the retiree gets to enjoy using the Hybrid method is 26% less than what a retiree using the Standard method receives: $62,523 vs $84,954.
If only there was some way to start getting additional money as we get older …
… Oh, wait. There is. It’s called Social Security.
Social Security’s Got Your Back
Despite what you may think, Social Security is not going away (completely) any time soon. Though they do report that after 2034 you will only receive 79 cents per every dollar of entitlement, that’s still several thousand dollars per year that you’re entitled to.
(Social Security can’t go away because if it did, there would be total social uproar. You and everyone else has been paying into it your entire working career. Of course, that’s to fund current retirees. Your Social Security will be paid by younger people who are working and paying in just as you are now. This is why Social Security is often regarded as one of the greatest legal Ponzi Scheme’s ever created.)
So then, let’s pay out the timeline. If you retire early at age 45 and start withdrawing Social Security by age 62, then you only had to live with the lower inflation adjustments for 17 years total. That’s really not that bad, especially when you consider the difference between Standard and Hybrid retirement income at that point is only 10%: $50,759 vs $56,165.
That’s really not that bad considering how much less you had to save to get there!
If you’re willing to compromise how much you’d like to adjust your retirement income for inflation, then mathematically it is possible for you to manipulate the 4 percent rule and enjoy a higher withdrawal rate while simulating the safety and security of a lower safe withdrawal rate profile.
For the two experiments I conducted, we found that you could increase your safe withdrawal by +0.5% if you’re willing to decrease your inflation adjustment by -1.5%.
I suppose you can have the best of both worlds!
This is yet again another tool that I will be considering as I update my financial freedom plan each year!
On a technical note: In the future, I would like to continue to develop this study by testing this theory against other rolling periods (for example: 1984-2014, 1983-2013, and so on). I’d also like to see the influence of other stocks / bonds ratios and how it holds up for periods longer than 30 years.
Readers – What do you think? Do you believe this could be the compromise between taking a higher safe withdrawal rate but maintaining a higher degree of safety? What are some other ways we could creatively compromise the 4 percent rule to do more with less?
Featured image courtesy of Flickr | Frankeleon