Live Poor. Die Rich. The 4% SWR Rule.
A widely circulated nugget of conventional wisdom is that in order to make a retirement portfolio last 30 years, retirees should withdraw no more than 4% of their portfolio in the first year, and then withdraw the same amount, with inflation adjustments, each succeeding year.
In 2008, Nobel price recipient Prof. William F. Sharpe co-authored an article entitled “The 4% Rule – At What Price?” which observes that “[t]he 4% rule is the advice most often given to retirees for managing spending and investing.” The authors remarked that they were “struck by the universal popularity of the 4% rule – retail brokerage firms, mutual fund companies, retirement groups, investor groups, financial websites, and the popular financial press all recommend it,” and observed this platitude “is the most endorsed, publicized, and parroted piece of advice that a retiree is likely to hear.”
Many studies, including the famous Trinity study, support the 4% rule. The volatility and associated risks of being significantly invested in stocks are, in fact, so great that retirees determined to maintain a constant level of inflation-adjusted spending must minimize the initial percentage they take from their portfolio to ensure that their assets last their lifetimes.
Although significant data supports the 4% rule, an almost universally missed consequence of the rule (with a few notable exceptions, such as Sharpe’s article above) is that retirees are directed to withdraw less from a portfolio invested in the stock market than they could sustainably withdraw, with inflation adjustments, from a portfolio that was fully invested in relatively risk-free assets, like treasury inflation-protected securities (“TIPS”).
In mid-October 2008, Treasury Inflation Protected Securities (TIPS) boasted real yields of approximately 3%. A laddered, 100%-TIPS, tax-deferred portfolio yielding 3% real would sustain a 5% safe withdrawal rate over a 30-year period.
Yes, that's right. A 100%-TIPS tax-deferred portfolio yielding 3% real would not only be less volatile than a diversified, part-stock portfolio, but also safely sustain a much more generous level – 25% more generous, in fact – of retirement expenditures than a diversified portfolio to which the 4%-SWR rule was applied.
True, as of mid-October 2008, TIPS yields were well above their historical averages. But even a TIPS portfolio that yielded only 1.3% real would sustain a 4%, inflation-adjusted, safe withdrawal rate over a 30-year period. That is, it would safely sustain just as generous a level of retirement expenditures as a risky portfolio, to which the 4%-SWR rule was applied, but with a lot less heartburn.
Yet the conventional wisdom – invest aggressively and spend defensively – persists. Financial advisors advise their elderly clients to invest a significant portion of their savings in stocks in order to pursue their greater expected returns, but – because of the risks – to live more frugally than they might if they chose a safer, less-volatile, 100%-TIPS alternative. Unfortunately, few retirees are even informed about this safer alternative.
(See this case study illustrating the effect of an even more conservative, 3% safe withdrawal rate).
The conventional wisdom is better tailored to helping retirees die rich than live rich. Except for retirees who wish to maximize what they leave behind to heirs, this approach to retirement investing and spending makes little sense. Yet this contradiction is seldom, if ever, recognized by advisors offering the advice, or retirees receiving it, because few even know how to compute (and fewer still even bother to compute) a sustainable inflation-adjusted withdrawal amount from an all-TIPS portfolio or other suitable proxy for an approximately risk-free portfolio.
TIP$TER was designed with this purpose in mind. Prospective and future retirees should compare the risks and rewards of an aggressive but diversified part-equity-based investment approach with a much safer alternative – a 100%-TIPS (tax-advantaged) portfolio – and then decide whether the potential rewards are worth the risks.