Sunday Morning Coffee

A more accurate title to this post would be "4% of what?" as that was the nature of a discussion in the comments of this article at Seeking Alpha. There were varying opinions on how to determine where the 4% should come from; should it be net of various investment expenses paid or not.

Some said with absolute certainty that fees count toward the 4% and there was equal conviction that they shouldn't. There was also some discussion about adjusting the withdrawals up for inflation.

The easy one first. Fees means what you pay for someone to manage your money. This can be a management fee to someone like me, the OER for any funds that you might use, or both. The fees only count if you, the end user think they should count. What I mean is that this is an individual decision to be made by the end user.

That being said I frame all of this differently than the conversation had in the above linked post. The idea of 4% is based on the probability of a nest egg lasting based on various withdrawal rates with the optimal number generally being 4% (I think actually it is 4.2%). Above 4% and the probabilities of success go down quickly. 

In past posts I've used the phrase whatever you got, 4% (more like 1% per quarter). On the last day of the quarter, if the portfolio is $616,000 then a $6160 withdrawal, to last for the next three months, would comply with the 4% withdrawal rate. If three months later the amount is $621,000 then the withdrawal should be no more than $6210. This focuses on the bottom line of the portfolio where growth in the portfolio is a combination of price appreciation and dividends. 

You may conclude that this makes the income stream somewhat unpredictable but in most instances the variance would be a few hundred dollars which seems far less problematic than being 83 years old and very fit with only $48,000 left.


A different way to go about this that seems popular is to just take the dividends. All I'll say there is learn about both (or any other methods) and choose what makes the most sense for you. 


The idea of boosting the withdrawal for inflation such that if this year you start out at 4% and the following year you take 4.1% because some measure of inflation went up 2.5% has never made sense to me. I've never heard of anyone actually calculating their withdrawal rate to come up with a 4.0243% safe number. Additionally to the extent that the general tendency of equity prices is to go up over time, then the price appreciation is how the portfolio builds in inflation. 

If the portfolio was worth $616,000 year ago and then this year it is worth $684,000 then there is potentially an 11% raise in the withdrawal rate if that raise is actually needed--all the better if it is not.


The above may or may not seem logical to you, it does to me, but it isn't the reality of too many of our clients, if any. My more practical observation is that the client is educated about safe withdrawal rates and probabilities, the client then comes up with some number they need per month that may or may not tie in with 4%, we'll ask about places to cut back if the number seems high, they will say yes or no to cutting back and then that number will stay the same for a while until/unless some sort of significant life event occurs.


A $3900 monthly withdrawal rate might be a high number for a year or two but often the portfolio can grow into that number being "safe" or safer. Of course there is not guarantee of this. One common type of problem I've seen that really hurts this model is the person who regularly has $10,000 (or more) one-offs. For anyone new a one-off is some unbudgetable expense like a vet bill or new tires or a home repair issue. These are the more common one-offs. Some folks have uncommon ones. I don't know what they are but some folks have more uncommon (meaning more expensive) one-offs than other people and this creates a greater risk to the sustainability of portfolio.  


Of course there are also people who simply spend too much anyway you cut it.


As hopefully alluded to there are a lot of variables to how this plays out for everyone. The basic idea of 4-5% is perhaps best thought of as a starting point or a building block for how much needs to be accumulated and then how much can be taken out. A 5% withdrawal rate would work the vast majority of the time but the probabilities of success go down some. Trying to make 4-5% work while understanding that 8-9% is much much riskier is the bigger picture point of understanding. A $1 million nest egg makes for a modest retirement not a wealthy one. 

From there it is hopefully common sense that the more that is spent the greater the chance of running out of money. After these big picture issues are digested is when your specific details start to fit into the puzzle. By details I mean things like how you manage your portfolio, whether you have a part time secondary career, whether you move, how you mange debt and every other thing you can think of. 


The picture is a friend's (inherited) Harley Davidson from the mid 1950's (I think that is when it is from) that his father bought brand new.