Note: We’ve been having a few technical SNAFUs in the past few days, which included emailing an unfinished draft of this article at the weekend. Apologies! Heads would roll if they weren’t our heads…
The 4% rule does not work as advertised. Where does that leave folk with dreams of retiring one day? What’s a better number for UK and global investors who need a SWR that survives contact with reality?
The big benefit of the 4% rule is that it’s inspired some brilliant research. You can use this research to find your baseline SWR and calculate a reasonable retirement target figure. If you’re retired or near retirement, that baseline SWR offers you a simple formula for drawing down your nest egg at a prudent rate.
So a realistic SWR is worth having. We just need to know where to look for it.
The World portfolio SWR baseline
Wade Pfau is a 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.
Note I say ‘theoretically’. In the real world the SWR shrinks before the headwinds we’ll discuss below.
We’ll use the Developed World portfolio SWR from here on in. 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.
Failure means our 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 lots of money on the table in the majority of scenarios.
- People can avoid running out of money by cutting back their withdrawals when they see their portfolio drying up.
- The 10% failure rate is reduced by the cheery chances of you dying before your nest egg dwindles. (Jump to our article on investor maths and scroll down to the Probability: Will you need all that money? calculation for more.)
Okay, so a 3.93% SWR it is. How much do we need to retire on then?
1 / 3.93 x 100 = 25.45 times our annual retirement income need.
For instance, if you needed £25,000 income in retirement:
25.45 x £25,000 = £636,250
Editor: You clutz! It’s the 3.93% rule then? In short, the 4% rule does work, you total time-waster?
No!
Much like Monty Python’s Black Knight, our SWR is about to get chopped down to size.
Or maybe eaten is a more appropriate analogy…
SWR layer cake
Your personal SWR depends on ingredients such as:
- Investment fees
- Taxes
- 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 (the father of the 4% rule) proposed the withdrawal plan layer cake.
The layer cake customises your SWR by adding bonuses and penalties for various factors that may influence your retirement outcome. The concept was expanded by Michael Kitces, the renowned financial planner and retirement researcher. It’s Kitces framework we’ll use to hone our baseline SWR.
Be aware that the layer cake is a confection standing 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 instance, Early Retirement Now (ERN) has shown that higher equity allocations have historically enabled higher SWRs over long retirement lengths.
Note: Double beware: the layer cake is baked 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 it is more sophisticated than the naive 4% rule.
Let’s bake our SWR cake.
Deduct fees
Our SWR is nibbled away by investment fees. Fund fees, platform fees, advisor fees – in short any percentage slice of your returns that you don’t account for in your annual income requirement.
Happily, your portfolio’s percentage fees aren’t just chipped straight off your SWR. There’s good evidence that the loss isn’t that bad.1
Multiply your total expenses by 50% instead.
For example:
0.5% (my total fees) x 0.5 = 0.25% SWR deduction.
The Accumulator’s layer cake SWR:
3.93% – 0.25% fees = 3.68%
Retirement length
This one is a biggie. So far we’ve assumed that we’re willing to cark it within 30 years of retiring. But what if you’re not feeling so co-operative?
The quicker you clear off, the higher your SWR can be. Plan on hanging around? You incur a SWR penalty for loitering.
Blogger ERN uses US data to show that SWRs gradually decline as retirement stretches from 40 to 60 years. The SWR tends to level out at some point along the curve, especially if your SWR is conservative.
I haven’t found publicly available global historical data for retirements over 30 years, so let’s apply Kitces’ time horizon modifier:
- +1% SWR for a 20-year time horizon.
- +0.5% SWR for a 25-year time horizon.
- -0.5% SWR for 40 years or more.
Intriguingly, Kitces’ modifier tallies with the results published by Morningstar in a research paper: Safe Withdrawal Rates for Retirees in the United Kingdom.
Morningstar employs a proprietary formula to estimate future SWRs for UK retirees, assuming a diversified portfolio tilted towards UK securities.
The Morningstar results suggest:
- +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 10%)
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:
SWR 3.68% – 0.5% retirement length = 3.18%
Taxes. Uh-oh
You can’t avoid death and taxes they say (though watch me try!) and both must 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.
The simplest thing to do is to estimate the annual, gross, pre-tax income you will need.
For example, say you need £25,000 to live on. You believe it will all come from taxable sources, such as your SIPP and State Pension, but remember that everyone has a personal tax-free income allowance:
£25,000 – £12,500 tax-free personal allowance = £12,500 (the portion taxed at 20%)
£12,500 / 0.8 = £15,625 (the gross income you need to meet your after-tax income target)
£12,500 + £15,625 = £28,125 (the total gross income you need to live on £25,000 a year)
£28,125 / 3.18% SWR = £884,433 (target wealth required to retire and pay your taxes)
If instead you intended to draw down £12,500 of your £25,000 from ISAs then you wouldn’t have any more tax to pay on this sum.
That would make your target…
£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 a 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.
With that said, Kitces has also shown the baseline normally produces a large legacy in most 30-year historical scenarios. You only check out with less than your starting capital in 10% of cases (again, US data).
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%. Increase 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 of 2008/9, bond yields have collapsed and equity prices soared. Many commentators suggest 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 for US portfolios with 50% bond allocations.
Worse still, ERN has shown that high US equity valuations bring down the SWR over long time horizons. Toppy valuations increase your chance of running into an adverse sequence of returns – the risk that near and early retirees are especially vulnerable to.
The good news is the rest of the world does not look as expensive as the US today by the light of the CAPE ratio – a widely used measure of stock market value.
- 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.
That suggests high equity valuations are less worrisome to globally diversified investors than to home-biased American investors hoping their stellar run continues.
The World SWR already incorporates losses far beyond the worst suffered in the US. The World dataset includes the hyperinflation and physical destruction of two World Wars that laid waste to the Japanese, German, Italian, Austrian and French markets among others.
This should all (hopefully) 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 an average valuation environment
- +1 SWR for a 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%
At last! 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 x 100 = 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 can put you on a sounder footing than naively following the 4% rule.
The important thing is to be conservative with your assumptions, understand how SWRs work and have a back-up plan.
Take it steady,
The Accumulator
- From the link: “The explanation for this is that, under the SWR framework, income withdrawal is adjusted for inflation, which means the income goes up over time and as the account balance is depleted over time, the impact of %-based fee is reduced.” [↩]
