Vanguard recently put out an article stating that those planning to retire early are putting themselves in a dangerous situation by applying the 4% rule, with an expected success for a 50 year retirement at only 36%. For people just tuning in FIRE stands for Financial Independence Retire Early and the 4% rule is an observation that you can withdrawal 4% of your portfolio from a mix of 75% stocks and 25% bonds and never run out of money. Vanguard uses extraordinarily conservative assumptions in this article that will likely cause people to be likewise overconservative with their retirement decisions.
Where The 4% Rule Came From:
The 4% rule came from the Trinity study which looked at all the 30 year periods from 1921 to 1991 and reported exactly how several different asset mixes would have worked out with different withdrawal rates for a mock 30 year retirement. In 100% of the cases with a 75% stock 25% bond split the portfolio ended with at least $1, therefore success.
The study also showed 90%+ success rates for 5%, 6%, and 7% withdrawal rates and the median account using a 4% withdrawal ended with 10 times more money than the account started with. These 30 year periods also included by the way, those that started in 1927 and 1928. I’ve detailed the Trinity Study in depth more here as well as the 4% rule.
Vanguard assumes that future returns will be substantially less than historic returns. In the assumptions they used, they put forth a real return that is LESS than 4% per year. If the real return is at least 4%, then the money would last forever. If it is under 4% of course it will eventually run out. Vanguard published their 10 year outlook stating that they project stocks to return 4.02% and bonds to return 1.31%, with inflation of 1.58%. This means a 75% stock and 25% bond portfolio would have a real return of only 1.76% per year on average over the next decade.
Is Vanguard Right?
IF the long term outlook for a total stock market and total bond market fund is under 4%, and truly only 1.76%, then indexing itself, which Vanguard pioneered, is, and should be, dead. It would no longer make sense to put money in risk assets if the return is so low. The idea of investing in paper assets, particularly indexed paper assets that forces you to buy the entire stock market, or a large segment of it, would no longer be practical. Individuals would need to invest more heavily in individual stocks, physical real estate, paying off 30 year mortgages that are at 2.5%, and direct business assets.
A 3% withdrawal rate (which would also deplete over time with Vanguards assumptions) would require someone to amass 33 times their yearly expenses in assets. A 2.5% withdrawal rate would require 40 times annual expenses.
Does A 10 Year Outlook Matter?
A 10 year outlook also doesn’t mean that much with a 50+ year time horizon. I actually recommend to most FIRE enthusiasts and everyone else, to NOT withdraw from paper accounts for living expenses during the first decade of retirement / FI. For a couple who earns $100,000 a year and saves $50,000 in tax advantaged accounts with a mortgage of $800 a month and income taxes of $10,000 a year, once they stop saving for retirement and have paid off their house, they only need about $30,000 of income per year. The idea of pumping tons of money into retirement accounts for 20 years, then immediately flipping the switch and withdrawing seems odd to me.
Rather than working a combined 80 hours a week (40 per person) to make $100,000 a year, they could scale back roughly 75% and earn $25,000 working 20 hours a week (10 hours per person). The rest of their income could come from a rental house or 2. By leaving their paper asset retirement accounts alone for a decade they should grow into too big to fail territory. IF the retirement accounts return close to the historical average they would double during the decade. If they performed as dismally as Vanguard predicts, they would at least increase slightly and we would be 10 years further in the future. Is working 10 hours a week really retirement? Well no, but it’s a heck of a lot closer to retirement than full time work is!
Does Failure Increase With Time Horizon?
Vanguard’s article goes on to state that with an increased length of time risk of failure grows. The truth of how compounding interest works actually goes against this, and this reverts back to the original point. IF you believe your long term returns will be under 4%, then you have a major scarcity mindset and if your returns are this low, then yes, the risk of failure grows; however, if your returns are actually closer to the historic average of around 8% real returns, then as investment horizon increases, so does the likelihood of success. Each year your account should be growing by an equal amount of your withdrawal, and you are far more likely to end a 50 year period with 20X as much money as you started with than to hit $0.
Where I Agree:
Vanguard recommends a dynamic withdrawal strategy. Rather than withdrawing 4% of the initial balance PLUS inflation per year blindly, tailor withdrawals to performance. If you would be scheduled to withdraw $40,000 + 1.5% inflation, so $40,600, but the market fell 10%, in the year, withdrawal closer to $30,000 and cut spending or supplement with earned income. Being willing to withdrawal less money in down market years will greatly increase the longevity of your income.
A numerical option would be to withdrawal 4% of the current balance, spread out over the year, so 0.33% per month. If your portfolio is $1 million is January, you withdrawal $3,330. If it drops to $800,000 in February, you only withdrawal $2,640.
Delaying withdrawals in bad months is also a great dynamic option. For example, in March of 2020 the overall market fell close to 50%. Selling any assets and taking withdrawals during this time would have been undesirable. Anyone who had the ability to wait 6 months to take a withdrawal faired much better.
Actions To Take:
- Don’t put too much stock in short term projections: 10 years is short term and its about as equally likely that broad based US stocks will return 12% as it is that they will return 4%. Unemployment is low, people are buying things, businesses are making things, and there is a ton of innovation occurring throughout the US and World economy. Even if there is a substantial economic downturn this decade, it will be countered by a bull market down the road.
- Increase your savings rate: This will solve most problems. I think investing more is always better than investing less. You have complete control over your savings rate, but don’t have control over what return the stock market as a whole will get. As Dory from “Finding Nemo” would say, “Just keep swimming!”
- Have an investing plan outside of paper assets: Own real estate and start at least 1 part time business. I have done very well with low cost rental real estate in the 3 years I have been investing. Currently our rental portfolio of 6 properties brings in enough cash income to cover over half of our total expenses. We are also selling books online through Amazon FBA. Having Amazon fulfill all the orders greatly simplifies things and we can work when we want to and the money still roles in. Our 10 year old is starting a vending machine business and the ROI and hours required is looking very appealing. I will be writing some articles on this shortly.
- Plan for some active work in retirement. This is a good idea for all retirees, but especially for the FI crowd retiring in their 30s and 40s. Planning for some type of active income goes a long way. Working 5 to 10 hours per week can keep you from touching retirement accounts and will also give some purpose to your day. I work as a contractor for nuclear plant outages and typically work 72 hours a week for jobs that last anywhere from 3 weeks to 8 weeks. Working a total of 7 weeks for the year would average out to about 10 hours a week, even though I would get 45 weeks off of work.
What do you think of Vanguard’s 10 year projection? Do you think real returns will be less than 25% of the historical data?