Most people who embark on the path to F.I.R.E (financial independence, retire early) determine the amount on money they will need for life through principals of The Trinity Study. But does this really work? I wanted to study the impact of downturns, how long it takes to recover from one and if you stick to the 4% rule, does it work?
First what is the Trinity study and what did it conclude
Three professors from Trinity University studied the safe withdrawal rates and introduced the 4% Rule. In a nutshell, the study concludes that a person has sufficient savings in assets if 4% of his/her assets are sufficient to cover a year’s expenses.[3][4] What this amounts to is, if you have 25 Xs your annual expense needs and you invest this in the stock market, it is safe to withdraw 4% from it every year. Even if the market fluctuates, over the long run, it tends to grow. The reason this works is because inflation is usually 2-3% but your assets in the historical average S&P 500 return is 10%.
So why did I question it?
When I wrote the post on whether to invest or pay off your mortgage, I had seen that the S&P 500 Index hit a high of 471 in 1928, then the depression hit and the market did not get back to that high till December 1959, a whopping 31 years later! Similarly the S&P 500 Index hit a new high of 786 in 1968, then went through a depression and only reached 786 back in 1993, 25 years later! This told me a couple of things:
- You need to have enough money to tide you over downturns. Once the downturn starts, it often takes 2-3 years to bottom out but the climb back to its high may take several more. You need guts of steel not to sell during that period when you’re goal is to preserve capital.
- Minimize your withdrawal during that period.
- Ideally you have enough money to invest during that time as stocks are on sale. You could catch returns like 57% in 1933, 29% in 2003, etc…
Let’s put the study to test using real returns from the past 2 downturns
I wanted to model what our portfolio would look like if we had our current starting portfolio balance but had to go through both the 2001 and the 2008 downturn again. My SO who had previously worked in Finance, is a maverick model builder. He built a retirement model with simple inputs starting portfolio value, inflation and expected returns from the market. We used the past years actual market returns from 2001-2019 and applied those returns to the coming years, 2020-2039 and then assumed a 6% return from 2040 – 2069 by which time I will be 92 and hopefully pop it! Based on this average return over the 49 year period would be 6.44%. We assumed an inflation rate of 3%.
When the withdrawal rate was 4%, we ran out of money in 23 years.
When it was 3%, the portfolio lasts 43 years.
But the magic withdrawal rate for us was 2.8%. This rate ensured we would still have a couple of 100,000 dollars when I expect to die at 92.
This result is also due to the fact that we assumed a 6% return for the last 29 years of the model. But by then, I will be 62 in the final leg of my life, looking to preserve capital. I expect I will shift more of my portfolio to bonds so an average return of 6% feels right.
Net, net the 4% rule works if you expect to be 100% invested in the stock funds but if you want to preserve capital and take a less aggressive stand, you may need a lower withdrawal rate. Many people address this differently, they move to lower cost living areas and so withdraw less. Or they work during downturns so they have staying power and can continue to invest.
References
“Retirement Spending: Choosing a Sustainable Withdrawal Rate,” by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz (all professors at Trinity University in Texas)