The July 2018 issue of the AAII Journal -- the monthly publication of the American Association of Individual Investors -- includes an intersting article about how to "increase your retirement resources". This plain English piece summarizes some of the findings from the authors' research paper "The Power of Working Longer".
According to the article, there are three primary factors that determine "the adequacy of retirement resources". Those are:
- When a person begins participating in an employer-sponsored saving plan,
- What percentage of their earnings they save in such a plan (i.e., their saving rate), and
- At what age they retire and begin taking Social Security benefits.
Until Elon Musk invents a time submarine, it's impossible for a worker to go back to their youth and begin saving for retirement earlier. Because of this, the authors focused their research on the relative power of saving more and working longer.
Last week, I wrote about the problem with retirement spending: How much should you spend during retirement? If you spend too much, you run the risk of depleting your savings. But if you spend too little, you're sacrificing the opportunity to make the most of your money, to "drink life to the lees".
One of the guiding principles in retirement planning is that there's a "safe withdrawal rate", a pace at which you can access your investments so that your nest egg will last for thirty years (or longer).
For simplicity's sake, a lot of folks talk about the "four-percent rule": Generally speaking, it's safe to withdraw 4% from your investment portfolio every year without risk of running out of money. (This "rule" manifests itself here at Get Rich Slowly when I say that you've reached Financial Independence once you've saved 25x your annual spending -- 33x your annual spending if you want to be cautious.)
Today, I want to take a closer look at the four-percent rule for safe withdrawals -- then explore why the theory behind it doesn't always mesh well with the reality of our daily lives.
The Four-Percent Rule Defined
Here's the top question and answer from that thread (with additional formatting for readability):
Is the 4% rule still relevant in today's economy? What safe withdrawal rate would you recommend for someone planning for longer than 30 years of retirement?
The "4% rule" is actually the "4.5% rule" -- I modified it some years ago on the basis of new research.
The 4.5% is the percentage you could "safely" withdraw from a tax-advantaged portfolio (like an IRA, Roth IRA, or 401(k)) the first year of retirement, with the expectation you would live for 30 years in retirement. After the first year, you "throw away" the 4.5% rule and just increase the dollar amount of your withdrawals each year by the prior year's inflation rate. Example: $100,000 in an IRA at retirement. First year withdrawal $4,500. Inflation first year is 10%, so second-year withdrawal would be $4,950.
Now, on to your specific question. I find that the state of the "economy" had little bearing on safe withdrawal rates. Two things count:
- If you encounter a major bear market early in retirement, and/or
- If you experience high inflation during retirement.
Both factors drive the safe withdrawal rate down.
My research is based on data about investments and inflation going back to 1926. I test the withdrawal rates for retirement dates beginning on the first day of each quarter, beginning with January 1, 1926. The average safe withdrawal rate for all those 200+ retirees is, believe it or not, 7%!
However, if you experience a major bear market early in retirement, as in 1937 or 2000, that drops to 5.25%. Add in heavy inflation, as occurred in the 1970's, and it takes you down to 4.5%. So far, I have not seen any indication that the 4.5% rule will be violated. Both the 2000 and 2007 retirees, who experienced big bear markets early in retirement, appear to be doing OK with 4.5%. However, if we were to encounter a decade or more of high inflation, that might change things.
In my opinion, inflation is the retiree's worst enemy. As your "time horizon" increases beyond 30 years, as you might expect, the safe withdrawal rate decreases. For example for 35 years, I calculated 4.3%; for 40 years, 4.2%; and for 45 years, 4.1%. I have a chart listing all these in a book I wrote in 2006...
If you plan to live forever, 4% should do it.
That's some helpful information, and it comes directly from a man who has been researching this subject for 25 years. Obviously, it's no guarantee that a four-percent withdrawal rate will hold up in the future, but it's enough for me to continue suggesting that you're financially independent once your savings reaches 25 times your annual spending.
But here's the catch -- and the reason I'm writing this article: From my experience, spending in early retirement is not a level thing. It fluctuates from year to year. Sometimes it fluctuates wildly.
I spend a lot of time talking with people who have retired early or are otherwise financially independent. From a purely anecdotal point of view, I'd say most of these folks are well-adjusted. They work to maintain balance in life, and especially with their personal finances.
That said, I've noticed that a lot of retirees -- early retired or otherwise -- struggle to know how much they should spend. I believe this dilemma exists for a couple of reasons:
- First is the life expectancy problem. You don't know how long you're going to live. If you did know the precise date of your death (or even the year of your death), retirement planning would be much easier. You'd be able to say, "Okay, I have ten years left and $300,000 in the bank. Based on that, I should be able to spend $30,000 per year." But you don't know when you're going to die, so a lot of retirement planning becomes guesswork.
- Second is the question of what your money is for? Do you want to leave a legacy for your children (or somebody else)? Do you want to maintain a chunk of change for possible end-of-life medical issues? Or do you want to use your wealth to live life to the fullest while you can? In my case, my ideal would be to die broke. If I could spend my very last penny on the last day of my life, that'd be perfect.
The general response to these two problems is to follow what has been dubbed the four-percent rule. Generally speaking, it’s safe to withdraw 4% from your portfolio every year without risk of running out of money. (There are a lot of caveats to this guideline. To learn more, follow that link to my Money Boss article -- or wait for that story to migrate to Get Rich Slowly in a few days!)
The AAII Journal -- the monthly magazine from the American Association of Individual Investors -- has published two articles in recent months about the problem of spending in retirement. Let's look at what they have to say.
My mother turned seventy a couple of weeks ago. This means a couple of things:
- First, she's reached the age at which she can receive maximum retirement benefits from Social Security.
- Second, it's time for her to start taking Required Minimum Distributions from her retirement accounts.
If you've been reading Get Rich Slowly for a while, you know that these two routine tasks are less than routine for my family. My mother has fought a long-time battle with mental illness. After a crisis in 2011, my brothers and I realized that she could not live alone. We found a highly-regarded local assisted living facility that specializes in patients with memory issues. (Mom has some sort of cognitive disability that includes memory loss, but which the doctors have been unable to diagnose.)
For the past seven years, Mom has lived at Happy Acres in a comfortable apartment with her cat (Bonnie) and her television. When I see her, I often ask if there's anything more she needs or wants. She assures me that this is all she needs to be happy.
At this point, Mom struggles with routine personal hygiene, so there's no way she can take care of tasks like signing up for Social Security or taking withdrawals from her retirement accounts. As her sons, that's now our job. (And we're happy to do it.)
You might think that this process would be easy -- but you'd be wrong. I suspect that in most cases, getting retirement benefits started is easy, but it's much less so in our situation.
Vanguard, the mutual fund company, recently published a free retirement planning guide for folks like me who aren't interested in hiring a professional financial advisor. Vanguard's Roadmap to Financial Security is a 32-page document intended to provide DIY investors with a framework for decision-making in retirement.
Here's an excerpt from the intro to this retirement planning guide:
All his life, Paul Terhorst wanted to be rich. Even in grade school, he looked forward to having a corporate job, to joining the world of big business. "I didn't just dream about money and power and expense account living -- I planned for it." He grew up and made it happen.
He got his MBA from Stanford. He became a certified public accountant and joined a large accounting firm. At age 30, he became a partner in the company. He had "a huge office, a leather chair, and a view of a polluted river". He'd achieved everything he'd always dreamed about.
But at age 33, while on a business trip to Europe, he overhead two guys talking about a friend who had retired early. Terhorst was intrigued. "I began toying with the notion that if I could come up with a way to live off what I already had, I'd never have to work again."
It took him two years to figure everything out. But in 1984, at age 35, Terhorst made the leap. He retired. (And he's been retired ever since.) In 1988 he published Cashing In on the American Dream to share his experience -- and the experience of others who made an early exit from worklife to pursue their passions.
"We need to find new opportunities for sharp, hardworking people who leave the corporate structure," he writes. "Up to now, those outlets have been second careers, the Peace Corps, turning a hobby into a business, and the like. Those outlets give you at least some money to live on. The route I describe in this book offers more freedom."
It Takes Less Money Than You Think
The first part of Cashing In on the American Dream is devoted to Terhorst's three-part formula for achieving early retirement:
- Do your arithmetic, by which he means crunch the numbers to see how low you can trim your expenses and how much you need to have saved in order to cover your costs.
- Do some soul-searching. Decide if early retirement is right for you. If so, what does it look like? How will you find meaning after work?
- Do what you want. Terhorst advocates a life of "responsible pleasure": Do what you love, but don't spend a lot of money to make it happen.
It takes less money than you think to retire early. "Millions could retire right now," Terhorst says. But many folks are bound by "golden handcuffs". Their high incomes fund lavish lifestyles, which means they remain voluntarily shackled to their jobs.
In 1984, Terhorst believed you needed a net worth of $400,000 to $500,000 -- which would be $972,000 to $1,216,000 today -- to retire early. With this level of wealth, he thinks you could live well on $50 per day. (According to official government inflation data, $50 in 1984 is equivalent to $121.62 in 2018. That means Terhorst advocates spending roughly $44,000 per year.) If you opt for what he calls "bare-bones retirement" -- what we might now call LeanFIRE -- you can retire much sooner.
Today's "money story" is a guest post from Bob Clyatt, author of the outstanding Work Less, Live More, which is one of my favorite books about financial independence and early retirement. [My review.] It's an update on what his life has been like since moving to sem-retirement fifteen years ago.
I had the good fortune to start a digital design firm in 1994. I sold it during the dot-com frenzy, leaving me with a bad case of burnout and full retirement accounts. It seemed like the right time to pull the plug, so in 2001 — at the age of 42 — I left full-time work.
I embarked on a self-funded post-career lifestyle that wasn't quite retirement (at least not in the traditional sense). I chose to do part-time, work-like activity in order to stay challenged and engaged while also closing budget gaps. Five years later, I wrote Work Less, Live More, which popularized the notion of semi-retirement.
So, I guess the big question is: Does semi-retirement work? What has it been like for me and my family? What lessons have I learned since embarking upon this path?
The Way to Semi-Retirement
The quick answer is: Yes, semi-retirement can and does work. The investing approach outlined in Work Less, Live More has sustained our spending since the day my wife and I quit work in early 2001. Our savings have allowed us to have part-time, low-paid (but intrinsically fun and meaningful jobs) at a time when the normal people in those jobs can’t actually make ends meet — and can't enjoy them as a result.
My wife works ten or twenty hours a week in a large specialty women’s clothing store. Her job allows her to stay connected to her interests in fashion while spending time with a younger generation of women: her co-workers and managers.
Meanwhile, I got to pursue my dream of becoming an artist. I went to art school, then built a sculpture studio. I now show and sell my work everywhere from Hong Kong to Paris, from trendy art fairs in Miami to galleries in Manhattan. [Check out Clyatt's contemporary sculpture at his website.]
I've certainly had fifteen-hour days and eight-hour weeks in semi-retirement, but mostly I putter around in the morning before going to my studio after lunch. I spend an active afternoon sculpting. At night, I'm parked on the couch just like the rest of the country.
Like all artists, I sigh that I don't have as many sales as I'd hoped after an art fair or gallery show. But then I pinch myself and remember that the art itself is getting better. I remind myself that creating the art is deeply meaningful and our financial needs are still covered by our savings.
I'm generally an even-keeled guy. I don't get worked up about much. I understand that different people have different perspectives, so I try to be respectful when others disagree with me. Having said that, there are indeed certain things that piss me off. Here are a couple that are centered around the idea of planning your retirement based on how much of your paycheck you should save.
Myth #1: You Need to Have 70% of Your Income
So how much are you supposed to be saving in order to finance 20 to 30 years post-work? The commonly accepted rule of thumb is that you'll want about 70% of your former annual income — at least — to continue living at or near the style to which you've been accustomed.
In 1988's Cashing In on the American Dream, Paul Terhorst wrote about retiring at age 35. Although his aim was to show readers the path to early retirement, he also sang the praises of temporary retirement -- retiring young with the idea that you might go back to work later in life.
As I mentioned a few days ago in my article on the five types of retirement there's another way to mix work with financial independence. In Work Less, Live More, Bob Clyatt makes the case for semi-retirement.
The Way to Semi-Retirement
In many ways, Work Less, Live More (published in 2005) reads like an updated (and more detailed) Cashing In on the American Dream. Even the author bios sound similar. Here's how Clyatt describes his background:
In 2001, after 20 years of sustained high-pressure work, the last seven spent battling in the Internet wars, my wife Wonda and I chucked it in, mothballed our suits, rented a small summer house in Italy, and began our new lives as early retirees.
But early retirement was no paradise for Clyatt and his wife. They were stressed, and their friends were stressed too. Did he really have enough money saved? What about the sluggish stock market? He began to question his assumptions: Had he made a terrible mistake?
Ultimately, he realized the worst-case scenario wasn't so bad. He probably did have enough to stashed away to sustain his early retirement, but even if he didn't the downside was that he might have to do a little work. This realization allowed him to embrace the idea of semi-retirement.
"Doing some amount of engaging work offers a comfortable transition between full work mode and full retirement mode," Clyatt writes. "With a modest income from part-time work, early semi-retirees may not have to face the dramatic downshifting in spending and lifestyle that so often confronts those who live only on savings or pensions."
Here's an extended explanation from the book:
Semi-retirement -- reclaiming a proper balance between life and work by leaving a full-time job -- offers a way out of the madness of overwork. By reducing spending and switching to a pared-back but more satisfying lifestyle, less money goes out the door.
Tapping into accumulated savings in a sensible way provides a steady annual income. Any shortfall can be filled with a modest amount of work, done in an entirely new state of mind: With less need to work for the largest paycheck possible, you can find low-stress work that you truly enjoy, on a schedule that gives you time to breathe.
Clyatt divides Work Less, Live More into eight chapters, each of which explores one of his rules for semi-retirement:
- Figure out why you want to do this.
- Live below your means.
- Put your investing on autopilot.
- Take 4% forever.
- Stop worrying about taxes.
- Do anything you want, but do something.
- Don't blow it.
- Make your life matter.
Let's take a closer look at the semi-retirement approach to creating work-life balance.