The question of how much money can be safely withdrawn from a portfolio has been around for as long as portfolios have been around. Various academic analysis over the years have attempted to address this question, and the most reference is the Trinity Study, published in 1998. This study lead to the widely quoted rule of thumb that a 4% withdrawal rate will cause your money to last for at least 30 years. You put 20% to 80% of your money into stocks, the rest into bonds, and increase the amount you withdraw each year by the rate of inflation.
Ok, so far, so good. Looks like our friends in academia have solved our problem for us. We follow the advice above and we have a worry-free retirement, right?
Wrong.
There are a number of very serious issues with the 4% withdrawal rate. For one thing, it’s only designed to make your money last 30 years. That’s fine if you retire at 65, but not so fine if you retire at 45. In addition, many of the conditions that existed when the 4% rule was created no longer apply.
Issue #1 – ridiculously low bond yields
The Trinity study was done at a time when bond yields were significantly higher than they are today. In 1998 the yield on a 10 year Treasury bond was 5.54%. In July of 2016 the rate was 1.46%. That 4% difference essentially wipes out the entire 4% safe withdrawal! From 1973 to 1993 the 10 year Treasury rate never dipped below 6%. That’s a 20 year run with very high returns. Now bonds are yielding a mere 26.4% of what they were returning when the study was done.
Of course, since we are adjusting our withdrawals for inflation we only really care about real returns (bond interest rate minus inflation). If we look at real returns for TIPS (Treasury Inflation Protected Security) we get the following returns:
| Date | Value |
| 29-Jul-16 | -0.03% |
| 1-Jan-16 | 0.67% |
| 1-Jan-15 | 0.27% |
| 1-Jan-14 | 0.63% |
| 1-Jan-13 | -0.61% |
| 1-Jan-12 | -0.11% |
| 1-Jan-11 | 1.06% |
| 1-Jan-10 | 1.37% |
| 1-Jan-09 | 1.91% |
| 1-Jan-08 | 1.47% |
| 1-Jan-07 | 2.44% |
| 1-Jan-06 | 2.01% |
| 1-Jan-05 | 1.72% |
| 1-Jan-04 | 1.89% |
| 1-Jan-03 | 2.29% |
(This shows the inflation adjusted return for TIPS on January 1st of each year from 2003 to 2016, plus the rate as of July 16, 2016)
TIPS work by providing a return that’s adjusted for inflation. If inflation goes up then your return goes up. If inflation does down then your return goes down. Buying a 10 year TIPS today means locking in a -.03% real return per year for 10 years, regardless of what inflation does.
Given that the 4% rule was based on rolling 30 year periods from 1929, the study used the higher real returns for bonds from that time period. Yields today are lower than in the past. Lower yields today result in less income. Less income requires lower withdrawal rates to ensure your money lasts for a minimum of 30 years.
Issue #2 – ridiculously high stock valuations
As I mentioned in a previous post, the S&P is clearly overvalued today. The CAPE (Cyclically Adjusted PE, which is calculated using today’s price and an average of the last 10 years of earnings) puts today’s market at 60% overvalued. If the market reverts to the mean over the next 10 years and we have 5% growth in profits we’ll be looking at -0.73%/year returns after inflation. If we have a portfolio that’s split 50/50 between stocks and bonds we’d be looking at total return of:
Total return = 50% bond returns + 50% stock returns = (.5)(-.03%) + (.5)(-.73%) = -.38%/year
So, based on current stock and bond valuations, we can expect -.38% returns per year for the next 10 for a portfolio of 50% bonds and 50% stocks. As you can imagine, pulling out 4% of your original portfolio value per year after LOSING .38% per year from your investments is not a formula for long-term financial security. If you started with a $1,000,000 portfolio, then after 10 years you’d be down to $569,414 in inflation adjusted dollars.
At that point your $40,000 yearly withdrawal is 7% of your remaining portfolio. There’s no way you can expect to average 7%/year after taxes from a combined bond/stock portfolio. Even a very optimistic 5% combined return after inflation has you going broke at year 36, and again, this is a VERY optimistic scenario.
So where does that leave us?
Well, somebody already did an analysis on the success rate of various scenarios using the same time methodology used in the Trinity Study:
This shows the success rate for various combinations of stock allocation, withdrawal rates, and time periods. Note that for any stock allocation of 50% or higher a 3% withdrawal rate was successful 100% of the time through 40 years.
When I run the numbers in the scenario I presented above (-.38%/year return for 10 years, then 5%/year after that) using a 3% withdrawal rate we end up with $973,553.49 in today’s dollars even after 45 years. If appears that a 3% withdrawal rate can reasonably be expected to last forever.
Conclusion
Given the current environment of high stock valuations and low bond yields, a 4% withdrawal rate can no longer be considered safe. The longer the planned retirement, the lower the safe withdrawal yield. For early retirees looking at long (40+ years of retirement), a 3% withdrawal rate is safe in today’s environment of low bond yields and high stock prices.