Withdrawal Rate

Hi readers!

Welcome to another post of The Principles series, where I:

• introduce fundamental philosophical/economical concepts.
• show my vision/interpretation of them.
• help you understand the subject from other points of view linking other online resources.
• describe my own strategies and other thoughts on the same topic.

Today I’m going to talk about Withdrawal Rate: how to actually use your wealth when FIREd to cover for your expenses in a sustainable way. Enjoy.

Did I already tell you about Financial Independence? What? Only a dozen times so far?? Cool, time for one more! Here’s the the Wikipedia definition:

Financial independence is generally used to describe the state of having sufficient personal wealth to live, without having to work actively for basic necessities.

For financially independent people, their assets generate income that is greater than their expenses.

In a recent post I’ve explained my point of view with respect the first sentence of the above definition. Here I want to address the second (highlighted) sentence: how exactly your assets are supposed to generate income that’s greater than your expenses?

Well, the actual mechanic is different for each different asset category. Passive income generating assets for FI seekers are essentially clustered in two categories:

• Asset: Rental Properties – Income: rents.
• Asset: Stocks/Bonds/Funds – Income: appreciations, dividends.

There are other forms of semi-passive incomes, like royalties (you wrote a book and keep earning money from sales passively and forever), business activities (you buy a shop and you sit and wait for money to come), entrepreneurship (you launch a successful startup), sharing economy exploiting (you rent your extra rooms on airbnb, cook for strangers on bonappetour, babysit kids on bsit, drive people around with uber,…), blogging/writing/crafting (ads, promotions, consulting, copywriting, online sales…let’s be honest, it’s the only reason I started this bl).

The semi-passive incomes are amazing tools that provide safety margin to your strategy, but they’re not fully passive by definition. If you rely on some of these strategies to cover your expenses you’re not fully FI and you can’t “retire”. Depending on which portion of your expenses you want to cover with side gigs, you could slow down from your traditional job and switch to a form of semi-retirement. That’s what happened to Trent Hamm when he quitted his job. If quitting is too risky for a not yet FI family, you can switch to part-time or become a one-(traditional)income-family instead of two. Semi-retirement is a fuzzy concept and even though it may slow down the actual retirement it’s an amazing tool to use in case of work related stress, burnout or simply to taste what retirement could be. It’s a taste of freedom you can only allow yourself if your Financial Integrity is solid.

Let’s analyse the more common FI strategies: rentals and stocks/bonds/funds. One can argue that the rental properties strategy too is not fully passive (due to managing tenants or managing a property manager) and should be listed in the semi-something list. I don’t care much since it’s just a matter of definition. And it’s not my strategy at the moment!

Here I’m going to focus on my strategy, which at the moment is mainly buy&hold index funds, currently in the form of Exchange Traded Funds (ETF). I don’t know now how stable my choice is. I may be switching in the future if I find that in the target retirement country the laws and the market push for a different strategy or against my current one. But for now, in Switzerland (no capital gain tax), I’m investing in the stock market. You can find some details in my Net Worth post. More about my investments and how to invest in Switzerland in future posts.

When you hold stocks/bonds/funds (mutual/ETF) your assets generate wealth in 2 ways:

• appreciation – the positions you hold increase their value over time.
• dividends – the companies whose positions you hold distribute part of the revenues among their shareholders. If investing in securities that reinvest the dividends (like accumulating ETFs) or on stocks of companies that – by choice – don’t pay dividends (like Berkshire Hathaway, Google, Amazon, Pfizer, …) then you can consider just the appreciation component.

In both cases, your NW is expected to grow over time. The history of S&P 500 (an American index based on the 500 companies with biggest market capitalization) shows that given any 30 years window over the last 100 years (including the 1929 crisis) the index grew on average by no less than 7% per year (plus most of the companies in the index pay dividends). Of course, past performances are not a guarantee for future ones. There’s even a speculation trend among bloggers and analysts that the market is currently overpriced, that we are long overdue for a bear market. Anyway the truth is that no one knows the future so I’m planning my future sticking with the 7% yearly expected growth rule.

7% is the average expected return over a long period. It doesn’t mean you should expect 7% every year. For example, the value of the index in March 2000 was the same of March 2013… 13 years to recover losses! That’s why investing in stocks can only be effective on average as a long term strategy.

So let’s assume your NW is increasing both because of assets appreciation and dividends (that you may reinvest) and finally you’re FI and you want to live off of your wealth-generated income. How to do it?

What you usually do is uninvest part of your invested capital every year/month and use it for your expenses. The actual mechanic is different for each legislation. For example in US is common to apply the Roth IRA conversion ladder to avoid tax penalty for withdrawing on tax advantage accounts before some conditions are met. In Europe things probably change country by country but I think it’s generally simpler since investments are generally not available for pre-tax accounts like pension funds. For example in Switzerland I can’t invest my Pension Pillars 1 and 2, and I have very limited and expensive options for Pillar 3. So 100% of my stocks investments are from after tax accounts thus withdrawing should be painless I guess.

The amount you withdraw from your NW every year is called Withdrawal Rate. if your NW is 1 Million and you withdraw 10K per year, your WR is 1%. If you withdraw 1% and your NW grows by 7% per year you are probably going to be safe and not depleting your Nest Egg over the long run. If you withdraw 7% and your portfolio grows by 7% you’re simply keeping your NW constant (not exactly, since +7% and -7% is not zero!), which means you’re losing money over time thanks to inflation.

So, assuming I want to be able to constantly withdraw money from my investments, for the foreseeable future and never going to deplete my Nest Egg, what should be my WR? Here things get personal because it really is a personal issue. If you’re retiring at 30 or below you need your strategy to last 60+ years so you want to play safe, if you’re retiring at 60 years, you may withdraw more aggressively since there are less expected years left for you. The portfolio composition matters too: the more stock oriented your portfolio is the more aggressive your strategy can be.

Before moving on, let’s explain why WR matters: it defines, along with your expected yearly expenses, the amount of wealth (your Nest Egg) you have to accumulate to call yourself Financially Independent.

If you want to be safe and only withdraw 2% and you think you’ll need 30K per year than 30K have to be 2% of your Nest Egg, i.e. you need to reach 1.5 Millions. If you want to withdraw an aggressive 6%, you just need to reach 500K. Note that it doesn’t mean that being more aggressive makes things easier. In the first scenario the Nest Egg is probably going to grow over time even when withdrawing from it while in the second case the risk of a failure is extremely high.

I’t up to you to choose your safety level and define your own WR. History helps us though. History shows that if you had adopted a similar strategy in the past, starting at any point in the last century with a nest egg of X dollars and had withdrawn 2% of X each year (adjusting for inflation), your money would have survived till today. Not just survived, you’ll probably have way more than X (inflation adjusted). That shows that a 2% WR is way too safe, you can comfortably increase your WR.

What about 3%? 4%? 5%? Can I run some analysis over the historical data with other values for WR? Yes you can (and you should if you plan to be FI!). Apparently someone else did that for us and came up with interesting results. Three professors at Trinity College wrote a very influencing paper about sustainable WR. This is the so called Trinity study, and the results they found are simply stated as follows: based on a portfolio composed by 75% stocks and 25% bonds the maximum sustainable WR you could have had starting in year X (in the range 1925 – 1981) in order to not deplete your portfolio within the following 30 years has never been below 4%.

This is usually called the 4% rule and has been discussed on almost every personal finance blog (MMM, JlCollins, TheSimpleDollar). A withdraw Rate of 4% is usually referred to as the Safe Withdrawal Rate. Numbers have been ran over more than 100 years of recorded history, starting even before the great depression of 1929!

Again, past performances are not a guarantee of future returns, but 4% has been the Nest Egg depletion WR only in the worst case scenario in the last 100 years. It’s not unreasonable to stick with the SWR. JL Collins in his blog claims he’s going to withdraw “somewhere north of 5%“, others stick with the 4% or some variation of it, like Justin at RootOfGood that’s going to adopt a variable withdraw rate of 4% of Portfolio Value each year (in bull market they’re going to withdraw more, in bear market less). There are others who are going to play safe and withdraw below 4% to get more safety margin. Anyway, the strategy may be dynamic and playing safe at the beginning will more probably lead to an increase of your NW that in turn would allow for more freedom in the future.

Let’s play with math a little bit more. 4% Rule means that you need to reach a NW of ~25 times your yearly expenses or 300 times your monthly expenses. If you plan to live on 2K (whatever currency) per month and trust the SWR you need to have 600K NW. At our current spending rate of 60K CHF per year, if we want to stick with the SWR we’d need 1.5 Millions CHF, too much to retire before target age of 45.

[Anyway, the current 60K CHF expense rate per year is totally unstable. It’s going to either increase, in case we’re staying in Switzerland forever and have kids and move to a bigger house, or decrease, in case we’re moving to a cheaper country like Italy and go rural instead of big expensive cities]

Ready for the mind blow?

If you’re ok with 700 USD per month, and you stick with the SWR then you just need 210K USD.

Wow.

I could already be retired if I choose to live with so little. I could actually already be FI if I want to allow myself a monthly allowance equal to my current NW / 300, which with today’s numbers (August 2016) is ~1600 Euro per month. Which is more or less my salary when I was working at GameCompany!

You can see how spending less and saving money will manifoldly quicken your FI race: the less you spend the more you save and invest, the quicker your NW grows, the lesser you have to accumulate in order to be FI. Win win win!

Here’s the amazing math behind the SWR rule: any recurring monthly cost of X you want to add to your lifestyle costs 300X in term of NW. Do you want a gym membership of 50 Euro/month forever? Easy, accumulate 15K more and you have 50 per month forever!

The reverse is true: if your NW is greater (or equal) than zero, you can already be FI if you accept to live with NW/300 per month. Are you just starting and your NW is 50K USD? Well, if you can live with 166 USD per month (I doubt you can) you are FI! Is your NW zero? No problem, you can be FI if you can live with zero per month (an homeless is already FI).

Another way to put it into perspective is: what’s the difference between your desired monthly allowance and your current FI monthly allowance (your NW/300)? If you are not yet FI the former is bigger than the latter. When they meet you are FI! In my case my desired monthly allowance is not yet defined (somewhere between 2500 and 4000 Euro per month, but I’ll explore hypothesis with more details on a future blog post), while my current FI monthly allowance is 1600.

What’s the impact of a fixed cost somewhere in the future on your today’s Nest Egg? Simple, take the expected cost of that expense in today’s monetary value (no inflation counted) and let’s call it X. Take the years left between today and the expected expense year and let’s call the difference N. The cost of a future expense X in N years is Y = X/[(1.04)^N]. It’s discounting the value X by the SWR percent every year. If you invest Y today and it grows by 7% on average per year and inflation erodes 3%, there you are! after N years you’ve X inflation adjusted!

For example, let’s assume I want to take into account a future donation to my 2 hypothetical kids of 100K Euro in 20 years from now for their studies. 1.04^20 ~= 2.19 so Y = 45630 per kid so ~91K in total. 91K of today Euro will become 200K of today Euro in 20 years, i.e 352K Euro.

Same logic applies for expected windfalls like heredity. Note that this is purely hypothetical and it’s valid for very long time frames like 10 years or more. Market is too volatile in shorter time frames.

Time to showdown some of my numbers:

I want to play safe for several reasons:

• Trinity study is about US stocks and even though I can invest in US from wherever I want (and I’m investing in US too much already), I don’t want to be too USD dependent. Currency fluctuations can kill my nest egg even when the market runs.
• I have this feeling that markets are a little bit overpriced right now, so 7% expected over the long period may not hold for the future (I know, it’s a bias).
• I want an extra safety margin, at least at the beginning of my FI journey.

Given the above reasons, I’m planning a WR of 1/30 of NW each year: 3.33%. So in the above formulas, when you see a 25, consider it a 30. When you see a 300 consider it 360 for me. It’s not written into stones though, I hope to withdraw as less as possible in the early years of Early Retirement (ER) because I plan to have few other semi passive income streams – I don’t plan to retire to sit and watch TV all day, I’ve got plenty to do.

In next chapter we’re going to talk about the desired Spending Rate and consequently the needed Nest Egg to sustain the spending rate, given my chosen withdrawal rate.

The target Nest Egg to call yourself FIREd is sometimes called FU Money – or more politely Walk Away money. The money you need to say NO. The money you need to be FI.

What’s your target WR?