In his often quoted article from 1994, William Bengen concludes that a 4% safe withdrawal rate is generally safe. 4% is a nice rule of thumb, and provides an easy way to roughly calculate the amount of money needed for financial freedom. The 4% rule is a topic for much debate in the ‘FIRE’ community. The underlying reasoning and portfolio construction tips of mr. Bengen are much less discussed. They provide some very interesting insights.
In the 2 concepts to calculate your financial freedom age the savings rate and safe withdrawal rate are introduced. I define these two concepts as follows:
savings rate = the % of your income that you don’t spend
save withdrawal rate = the % of your savings that you can safely spend
Let’s have a closer look at Safe Withdrawal.
Markets go up and down
The 1994 article starts with the following fictitious scenario:
- It’s 2004, markets have been kind and provided a much better return than savings accounts
- It’s 2006, markets have turned sour and stock markets plummeted 35%
- It’s 2009, markets have recovered nicely and portfolio’s have gained almost all their lost value. However inflation is 8% eroding purchasing power of retirees.
Add only a few years to the fictitious scenario, and it perfectly describes the financial crisis which started in 2008. Only the high inflation rate is something we have not seen. Although just used as a introduction to his article, it shows these scenarios actually take place. The point of William Bengen was that merely looking at averages is not enough, you have to look at what is actually happening year to year and what effect that has on your portfolio.
The financial freedom goals
In the experience from mr. Bengen as a financial planner most of his clients have two main goals for retirement (or financial freedom):
- Making it through retirement without exhausting your funds: your money should outlive you instead of the other way around
- Accumulating wealth for their heirs: not spending it all during your retirement years
Safe withdrawal rate and inflation
A safe withdrawal rate of 4% actually means using 4% of your built up capital in the first year of retirement. Every subsequent year, the amount of money you withdraw from your capital is based on the first years 4%, corrected for inflation. So you do not take out 4% every year. the actual percentage will fluctuate with the returns on your capital and inflation rates.
Bengen includes a warning not to increase your withdrawal specifically in the beginning years of retirement when the markets were good and your capital grew well. Stick to the inflation corrected withdrawal of 4% in the first year of retirement. You will need the excess return when markets go down. From his analysis, it shows that deflationary scenario’s, like the great depression in the thirties had less impact on portfolio’s than an inflationary scenario, such as what happened in the 1973 / 1974.
It is not a deflationary period that is to be truly feared, but an inflationary period that wreaks havoc on purchasing power as well as portfolio values.
Stock or bonds?
When you reach financial freedom, you must have the right amount of capital, based on your expected cost of living. What is the effect of the composition of the portfolio? Bengen studied this as well, looking at scenario’s with a 0, 25, 50, 75 and 100% stock allocation (the rest are bonds). He made calculations for 1,2,3,4,5,6,7 and 8% of withdrawal rates.
One conclusion of these calculations is:
holding too few stocks does more harm than holding too many stocks. Too few stocks in the portfolio shortens the portfolio life
Mr. Bengen then concludes:
An asset allocation as high as 75 percent in stocks during retirement seems to fly in the face of conventional wisdom at least the wisdom I have heard. But the charts do not lie, they tell their story very plainly
The power of stocks lies in their recovery power after a stock market downturn. This is much stronger than for bonds. Additionally, more stock in a portfolio, will also increase the chances of your capital growing, and leaving money for the next generation.
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