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Optimal Finance Daily - Financial Independence and Money Advice
3300: [Part 1] The Four Backstops to the Four Percent Rule by Sean Mullaney on Early Retiree Planning
00:10:16
Sean Mullaney highlights why the Four Percent Rule may not be as rigid as many fear
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This is optimal Finance Daily the Four Backstops to the 4 Percent Rule Part One by Sean Mullaney of fitaxguy.com Introduction Worried about an early retirement based on the 4% rule? Might the 4% rule work? Because of natural backstops, most early retirees enjoy the 4% rule. The 4% rule is a rule of thumb developed by the FI community. For example, J.L. collins writes extensively about the 4% rule in Chapter 29 of his classic book, the Simple Path to Wealth. Boiled down, the rule of thumb states that an investor can retire when he or she or a couple has 25 times their annual expenses invested in financial assets, equities, and bonds. They would then spend down 4% of their wealth annually in retirement. The first year's withdrawal forms a baseline and is increased annually for inflation. The IDEA behind the 4% rule is that the retiree would have a very strong chance of funding retirement expenses and never running out of money in retirement as a result, some refer to 4% as a safe withdrawal rate. Here's how it could Maury is 50. He has a million dollars saved in financial assets. He can spend $40,000 in the first year of retirement. If inflation is 3% at the end of his first year of retirement, he increases his withdrawal by 3%, or $1,200, to $41,200 for the second year of retirement. The 4% rule has a nice elegance to it. Most investors aim for a greater than 4% return. In theory, with a 5% return every year, the 4% rule would never fail a retiree. If you spend approximately 4% annually and you earn approximately 5% annually, you have, in theory, created a perpetual money making machine and guaranteed success in retirement. The theory is great, but in practice we know that investors are subject to ups and downs, gains and losses. What happens if there's a large dip in equity and or bond prices during the first year or two of retirement? What if there are several down years in a row during retirement? As a result of these risks and stock market highs in late 2021, some are worried that the 4% rule is too generous for many retirees. This post adds a wrinkle to the discussion the four backstops to the 4% rule for early Retirees what if worries about the adequacy of the 4% rule for early retirees can be addressed by factors outside of the 4% rule safe withdrawal rate. And what if those factors quite naturally occur for early retirees? Here I discuss what I believe to be the four natural backstops to the 4% rule. Number one spending. A 4% spending rate in retirement is not preordained. From the on, high spending in retirement can be adjusted. Those adjustments can take on two flavors. The first flavor are defensive spending reductions. As Michael Kitches observed on an episode of the Bigger Pockets Money podcast, retirees will not blindly spend 4% annually, but without making adjustments in down stock markets. See that the stock market is down 10% this month. Okay, take a domestic vacation for six days instead of an international vacation for nine days. Buy a used car instead of a new car. Scale down and or delay the kitchen remodel. There are levers early retirees can pull that can help compensate for declines in financial assets while not too radically altering quality of life. The second flavor is from a financial perspective, even better. As early retirees age, there will be natural reductions in spending. How many 80 year olds decide to take a 12 hour flight to the tropics for the first time? There's a natural reduction in energy and interest in certain kinds of spending. As one ages, it's likely that many retirees will experience very natural declines in expenses as they age. Number two, Social Security. For the early retiree under 62 years old, the 4% rule must disregard Social Security. Why? Because Social Security does not pay until age 62, and many in the financial independence community delay Social Security payments beyond age 62, perhaps all the way to age 70 to increase the annual payment. Here is an example of how that works. Melinda is 55. She's accumulated 1.5 million in financial assets and can live on $60,000 per year. If she retires at age 55 and lives off $60,000 a year increased annually for inflation, the only financial resources she has are her financial assets, what I refer to as her 4% assets. She cannot live off of Social Security payments until age 62 and may choose to defer receiving Social Security up to age 70. If Melinda defers Social Security until age 70 and receives $2,500 per month at age 70 from Social Security, her 4% assets now don't need to generate the full 4% once she turns 70, since Social Security will pay her $30,000 a year at age 70. In theory, under the 4% rule, Melinda's Social Security is play money. Melinda funds her lifestyle with withdrawals from her financial assets, and now she's getting additional Social Security payments. But if her portfolio is struggling to produce the amount Melinda needs to live off of, Social Security payments provide a backstop and can help make up the difference. You might think. But wait a minute. Didn't Melinda significantly lower her Social Security benefits by retiring early by conventional standards? Hear the answer on tomorrow's episode. You just listened to part one of the post titled the four backstops to the 4% rule by Sean Mullaney of fitaxguy.com Imagine you're a business owner who has to rely on a dozen different software programs to run your company, none of which are connected, and each one is more expensive and more complicated than the last. It can be pretty stressful. Now imagine Odoo. 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Figuring out a good drawdown strategy is something discussed often in the fire community. While I DIY my financial planning and investing now I'm in the accumulation phase and things are pretty simple at the moment. I definitely see myself consulting a flat fee advisor to help me with a drawdown strategy when the time comes. However, I've heard from many friends who are currently drawing down on their portfolios that in the face of an uncertain future, you're better off relying on general rules of thumb rather than trying to suss out and predict every last detail. And that's what the 4% rule is. It's a guideline. The downside is that the model assumes that you have no other income and will never have any other income for the rest of your life, which for most people isn't true. Social Security is going to kick in at some point, if nothing else, as Shawn mentions here. Also, early retirees oftentimes go on to create businesses or find other hobbies that end up earning them some money that they didn't anticipate when they were retiring. It also assumes that you'll never decrease your spending for any reason. It doesn't consider when Medicare kicks in and reduces your health care costs, and assumes that your personal rate of inflation will match the overall rate of inflation, which for the frugal among us is laughable. Rather than plan your withdrawals for the rest of your life based on the 4% rule, it makes more sense to have flexibility and refine your retirement plan annually. Some tools that I've heard great things about for modeling include Portfolio Visualizer and New Retirement. That should do it for today. Have a happy rest of your day and I'll see you tomorrow. Where we'll finish up this post and where your optimal life awaits.