The 4% rule does not work as advertised, so where does that leave folk with dreams of retiring one day? If a 4% Sustainable Withdrawal Rate (SWR) is unsafe then what’s a better number to use?

First up, the 4% rule has inspired some excellent research. You can use that research to find a baseline SWR that will help you calculate a reasonable retirement target figure. If you’re retired or near retirement, that SWR also offers you a simple formula for drawing down your nest egg at a prudent rate.

What we want is a SWR that survives contact with reality, so let’s dig into the evidence.

The World portfolio SWR baseline

Wade Pfau is the leading researcher on international withdrawal rates. He used historical returns from 1900 – 2015 to calculate a SWR of:

  • 3.45% for a Developed World portfolio (50:50 world equities / world bonds)
    3.36% for a UK portfolio (50:50 UK equities / UK bonds)

This theoretically means that you could withdraw an inflation adjusted 3.45% from your Developed World portfolio annually – without running out of money – throughout a 30 year retirement, no matter when you retired from 1900 to 1986. I say theoretically because in the real world the SWR shrinks before the headwinds we discuss below.

We’ll use the Developed World portfolio SWR from here on in because it best tallies with the diversified Total World portfolio we think makes most sense for UK investors.

Failure rate bonus

It’s not often we’re rewarded for failure but our SWR goes up to 3.93% if we’re prepared to accept a 10% failure rate, according to Pfau. This means the money would have run out before our 30 years was up in 10% of all historical scenarios. I think this is an acceptable failure rate because:

  • A conservative SWR strategy leaves plenty of money on the table in the majority of scenarios.
    People avoid running out of money by cutting their withdrawals when they see their portfolio burning up.
    The 10% failure rate is reduced by the probability you die before your nest egg dwindles. Scroll down to the Probability: Will you need all that money? section for more.

OK, so a 3.93% SWR it is. How much do we need to retire on then? 1 / 3.93 x 100 = 25.45 times by our annual retirement income need.

So it’s the 3.93% rule? In other words, the 4% rule basically does work, you total time-waster?

No! Like Monty Python’s Black Knight our SWR is about to get chopped down to size. Or maybe eaten is the more appropriate analogy…

SWR layer cake

Your personal SWR depends on ingredients such as:

  • Investment fees
    Length of retirement
    Asset allocation
    Sequence of returns
    And more

These factors vary by person and help explain why the 4% rule is one size that fits no-one. To narrow the uncertainty William Bengen (father of the 4% rule) proposed the withdrawal plan layer cake.

The layer cake customises our SWR by adding bonuses and penalties for various factors that may influence our retirement outcome. The concept was expanded by Michael Kitces – the renowned financial planner and retirement researcher – and it’s Kitces framework we’ll use to hone our baseline SWR.

Beware that the layer cake is a confection that stands on a pedestal of assumptions. As Kitces says:

Although the “layer cake” approach of safe withdrawal rates does allow for planners to adapt a safe withdrawal rate to a client’s specific circumstances, there are several important caveats to be aware of. The first and most significant is that many of the factors discussed here were evaluated in separate research studies, and it is not necessarily clear whether they are precisely additive.

Ongoing SWR research certainly implies that your specific cake mix will raise or lower the profile of individual ingredients. For example, Early Retirement Now (ERN) shows that higher equity allocations have historically enabled higher SWRs over long retirement lengths.

Double beware: the layer cake is made with US data. The assumptions may not hold to the same degree using international datasets.

TL;DR – the layer cake approach is art as much as science, but is more sophisticated than the naive 4% rule.

OK, let’s bake our SWR cake.

Deduct fees

Our SWR is nibbled away by investment fees. Fund fees, platform fees, advisor fees – any percentage slice of your returns that you can’t account for in your annual income requirement.

Happily, if your portfolio’s percentage fees amount to 0.5% then you don’t just chip that off your SWR. There’s good evidence that the loss isn’t that bad.

Multiply your total expenses by 50% instead. For example: 0.5 (fees) x 0.5 = 0.25% SWR deduction.

The Accumulator’s layer cake:
SWR 3.93% – 0.25% fees = 3.68%

Retirement length

This is a biggie. So far we’re assuming that we’re willing to cark it within 30 years of retiring. But what if you’re not feeling so co-operative? The mechanism is simple: the quicker you clear off the higher your SWR. Plan on hanging around? You incur an SWR penalty for loitering.

ERN uses US data to show that SWRs gradually decline as retirement stretches from 40 – 60 years, tending to level out at some point along the curve, especially if your SWR is conservative.

The Ultimate Guide to Safe Withdrawal Rates – Part 1: Introduction

I haven’t found publically available data for retirements over 30 years using global historical data, so let’s apply Kitces’ time horizon modifier:

+1% SWR for 20 year time horizon
-0.5% SWR for 40+ years

Intriguingly, Kitces’ modifier tallies with results published by Morningstar in their research paper, Safe Withdrawal Rates for Retirees in the United Kingdom.

They use a proprietary formula to estimate SWRs for UK retirees using a diversified portfolio tilted towards UK securities. The Morningstar results offer:

+1% to 1.3% SWR for retirement lengths ranging from 20 to 25 years (depending on equities allocation and failure rate).
-0.4% to -0.6% SWR for retirement lengths ranging from 35 to 40 years (depending on equities allocation and failure rate of 90%).

I’d like a long and happy retirement, please. I’ll take the -0.5% hit on 40 years plus.

The Accumulator’s layer cake:
SWR 3.68% – 0.5% retirement length = 3.18%

Taxes – uh-oh

You can’t avoid death and taxes they say (but watch me try!) and both these subjects loom large in our SWR calculations.

The baseline SWR does predict your death but not your tax rate because that’s a lot of work. Time for a shortcut.

The simplest thing to do is work out the gross income you need. For example, you need £25,000 to live on and you estimate it will all come from taxable sources e.g. your SIPP and State Pension.

£25,000 – £12,500 tax-free personal allowance = £12,500 (taxed at 20%)
£12,500 / 0.8 = £15,625 (the gross income you need)
£12,500 + £15,625 = £28,125 (the total gross income you need to live on £25K a year)

£28,125 / 3.18% SWR = £884,433 target wealth required to retire and pay your taxes.

If you intended to draw down £12,500 of your £25,000 from ISAs then you wouldn’t have any more tax to pay. In which case you’d need to accumulate £12,500 / 3.18% = £393,081 in your ISAs and the same again in your SIPP.

Think tax rates will be different in the far future? You’re right. Feel free to input whatever tax schedule you prophesise.

The Accumulator’s layer cake:
SWR 3.18% with taxes accounted for by gross income estimate.

Leave legacy

Want to leave something for the kids? Then you’ll need to lower your SWR. The baseline case assumes you’re prepared to spend your last penny. Kitces has shown that the baseline will leave a large legacy in most 30-year scenarios, and only less than your starting capital in 10% of cases (US data alert).
If you want to improve your chances of leaving 100% of your nominal capital then Bengen and Kitces suggest cutting your SWR by 0.2%. Raise the penalty for more glorious legacies.

I don’t have kids, so…

The Accumulator’s layer cake:
SWR 3.18% – 0% legacy = 3.18%

Market valuations

Since the Global Financial Crisis in 2008, bond yields have collapsed and equity prices soared. Many credible commentators predict we now live in a low growth world with weaker expected returns relative to historical norms.

Wade Pfau warns that lower bond yields diminish the chances of the 4% rule working in the US for portfolios with 50% bond allocations.

ERN shows that high US equity valuations bring down the SWR over long time horizons.

The Ultimate Guide to Safe Withdrawal Rates – Part 3: Equity Valuation

However, the rest of the world is not as expensive as the US. Equity valuations are commonly measured using the CAPE ratio.

The US CAPE ratio is over 30 versus its historical average of 16 – pricey!

World CAPE is 23 versus an average of 20. A little high but not too rich.

UK CAPE is 16 – right around average.

But the world doesn’t look pricey overall, not like the US. According to Star Capital paper: PREDICTING STOCK MARKET RETURNS USING THE SHILLER CAPE, p.8 ] (this includes emerging markets) p.9 for averages – The World is in 75th percentile (i.e. pricey)
A CAPE of 15-20 could qualify as average. Below 13 looks like it would be low.

[Amazing table on subsequent 10-15 yr returns p.10]

That suggests high equity valuations are less worrisome to globally diversified investors than to home-biased American investors expecting their stellar run to continue.

Moreover, the World SWR already incorporates losses far beyond the worst the US suffered. The World’s dataset includes the hyperinflation and physical destruction of two World Wars that ravaged the Japanese, German, Italian, Austrian and French markets. That should mean the World SWR can cope with a wider range of nightmare scenarios than a US SWR buoyed by the bounty of the American Century.

Kitces valuation recommendation is:

+0.5% SWR for average valuation environment
+1 SWR for low valuation environment

Kitces also says:
Consider reducing the safe withdrawal rate in extreme combinations of high valuation and low interest rate environments.

Certainly Developed World bond yields are low but equity markets don’t seem overcooked on aggregate. I’m going to play it cautiously and round down my SWR to 3% due to the low interest bond situation.

The Accumulator’s layer cake:
SWR 3.18% – 0.18% valuations = 3%

My world portfolio SWR

I’ve battered my personal SWR with every negative factor going and ended up with an SWR of 3%. My desired income in retirement is £25,000, so my retirement target at 3% SWR is:

1 / 3 x100 = 33.3333 x £25,000 = £833,333

But the story doesn’t end there. We can add another set of tiers to our layer cake to make our SWR rise again. Like blowtorching an edible Paul Hollywood on Bake Off, these moves require upgrading your skills so we’ll get into that in next week’s post.

If you want to keep things simple and just apply your SWR at a constant inflation-adjusted rate to produce a predictable retirement income then the steps above are surely better than naively relying on the 4% rule. The important thing is to be conservative with your assumptions, understand how SWRs work and have a back-up plan.

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