An Artificial Risk
One of the more commonly cited retirement financial risks cited is the notorious sequence of returns risk. This is a phenomenon where poor returns occurring early in retirement contribute to running out of money sooner than if they occur later, even if overall returns during retirement are the same.
Take two investors, both of whom average, say, 6% overall returns over thirty years. This might be via a path where most years average 9%, but a couple of years of negative returns bring down the average. Both investors begin by withdrawing 4% of their nest egg in the first year of retirement and adjust the withdrawals by “inflation” (eg as determined by the CPI) thereafter. This is the popular “4% Rule” widely cited by advisors as a safe drawdown strategy.
Why does the order in which the same overall returns occur matter? The large withdrawals early in retirement force sales at low prices and deplete capital faster than they would if they occurred late in retirement.
But is it the markets or the investor that produces this asymmetry? Neither. It’s the fault of the withdrawal plan.
It’s the result of lack of feedback, a withdrawal strategy that looks at the market value of the portfolio just once – at the very beginning – and then never looks again. In short, it is a flaw in the withdrawal strategy, not the investor or the markets, that produces the risk. If poor returns occur soon after starting, it may just mean you took that just one look near a market peak.
What if, instead of taking one snapshot of the portfolio value and basing decades of subsequent behavior on it, we checked in every year? Instead of adjusting the withdrawal with a government statistic we just withdrew 4% of whatever the portfolio value is at that time?
Remarkably, sequence of returns risk vanishes. A large drawdown in the markets has the same effect regardless of when it occurs, courtesy of the basic mathematics principle known as the commutative law. The order in which returns occur don’t matter.
What’s more, the risk of running out of money vanishes along with it.
The amount of the withdrawals may decline, however, if the chosen percentage is higher than the rate of return. For an appropriately allocated portfolio, 3% is more likely to keep withdrawals apace with inflation. To produce a stream of income that keeps pace with inflation, and never runs out, forget the 4% rule. Withdraw 3% of the portfolio value each year.
The man who created the 4% rule for retirement savings now wants you to spend more — says it’s a ‘shame’ when retirees can’t enjoy their money
A bit about the origin of the deeply flawed but ubiquitous “4% Rule”. Here it’s “updated” to be even more flawed.
The problem is playing games with historical statistics which cannot predict the future, neither of how long you will live or how your investments will perform. It’s literally gambling with your life savings.
The better solution is in the above post. You can create a secure income that never runs out. Whatever’s left goes to your heirs. For income that you want to maximize without having a bunch left over when you expire, that’s what annuity income is for … Social Security, pensions, superannuations, and commercial annuity products. Trying to bend an investment portfolio to that purpose virtually assures a bad fit. It’s all about using the tool best suited for each purpose. The art of retirement income planning is apportioning resources to each of these fundamentally different models.
I recommend establishing sufficient annuity income – Social Security, pensions – to at least meet your basic costs of living. If what’s already available isn’t enough, buy an annuity. Use your portfolio income – your 3% withdrawals – for the finer things in life and for your legacy.
Don’t use a hammer to drive a screw.
I just retired at age 61 and left my $145,000 salary — how much can I pull from my nest egg every year without the fear of running out of money?
“A 3% withdrawal rate on a $3.6 million portfolio yields $108,000 annually and carries a 95%+ success rate over 30 years.”
That’s better … the rate has been reduced to 3%. But not stated here is the apparent assumption that you’re still using the snapshot method of determining withdrawal rates and adjusting for “inflation” thereafter. Because if you take 3% of the portfolio balance every year, the success rate is 100%.
And it’s not merely thirty years, but never.
Sequence of returns and Safe Withdrawal Rates are two key topics discussed within the FIRE (Financial Independence Retire Early) Community. For those retiring in their 40s and 50s, the need to sustain their lifestyles until the pension pot and social security become accessible makes these topics even more important. In my readings, there was no mention of the commutative law, and its impact on the overall returns profile and portfolio values.
In the case of FIRE aspirants, perhaps the need to have a stable income to replace their salary earnings drives their interestin a fixed amount withdrawal strategy. Someone retiring later, with access to pension and social security, is better placed to manage the withdrawal rate at their discretion as you’ve described here.
The mention of the commutative law was an oblique reference to why the sequence of returns doesn’t matter if you base withdrawals on portfolio balances each year. The portfolio balance is a straight product series. For instance, if you withdraw x% annually when you have a sequence of annual returns a, b, c, your balance after three years is (1-x)a*(1-x)b*(1-x)c. The balance is abc*(1-x)^3 … regardless of in which order a, b, c occur. Sequence of returns risk is an artifact of using a rule that ignores b, c, etc.
(Note for clarity’s sake a, say, 6% return here is expressed as 1.06. You don’t see this elsewhere because it’s Financology original material. If something is conventional wisdom, there’s little point in repeating it here;-)
The quest for a stable income isn’t met if you run out of money, which is a possibility if you follow the popular snapshot guidance. Having FIRED myself many years ago, I’m intimately familiar with the issues it involves, but the “4% Rule” my post addresses is used as standard retirement advice (the source cited in the first comment is just one of legions of examples; note the references to a thirty year retirement). Yet some advisors now advocate just what I do here, that is, applying a percentage to the portfolio value each year. Even those who don’t advocate some form of flexibility or departures from the rule, effectively an admission the rule is flawed. Of course it is. It manufactures risks that don’t otherwise exist.
They’re not trivial. As noted in the link in the second comment above, surveys are said to reveal that people fear running out of money before death more than they fear death itself.
The principles are further explained in the first comment above. You can divide the types of retirement income into two general categories; portfolio income and annuity income. Portfolio income is inherently variable but can be made to last indefinitely; there are funds left over. Annuity income is more constant and expires when you do. The flawed rule arises from trying to make the first look like the second.
There are multiple ways to cope with these flaws. One is to stubbornly stick with the flawed rule and write treatises on the sequence of returns risk it creates; hope people will adapt and not worry too much about the 5% or so that you’ve modeled to run out of money. I think the better solution is to apportion retirement resources to each of these two different types and let each do what it does best.
Thanks by the way for raising the specific case of retirement before conventional annuity programs like pensions or superannuation or Social Security become available. Commercial annuities are an option at almost any age if lifetime income is the objective. The same principles apply. But what if your focus is on just trying to fill the gap years? That’s a different question and calls for a different answer. It’s not necessarily complicated though … multiply your income target by the number of years you want it, and that’s how much you need. Allow more depending on the risk in your asset mix. Whatever portfolio assets you have left after that are the lifetime retirement assets my post addresses. For many early retirees, the more complicated issues are likely to be non-investment-related, like medical insurance coverage, and highly dependent on where you live.
You’re welcome. Several very good points to further dig into, in particular the amounts of passive capital with limited to no shareholder say in how corporations are run. It’s one of the unintended consequences of the growth in passive investing.
Yet more articles that treat the 4% Rule as a universal standard … this is why I have to write this stuff!
https://www.msn.com/en-us/money/other/the-real-net-worth-experts-say-you-need-to-retire-comfortably-in-2026/ar-AA201pMw?ocid=finance-verthp-feeds&cvid=6ab60fc4056048a28fcfcbfc92c0d40c&ei=25
https://www.msn.com/en-us/money/other/is-600-000-enough-to-retire-what-the-numbers-actually-say/ar-AA1Tj5Hi?ocid=finance-verthp-feeds&cvid=6ab60fc4056048a28fcfcbfc92c0d40c&ei=29
https://www.msn.com/en-us/money/other/got-2m-saved-you-should-probably-retire-immediately-don-t-sacrifice-it-all-for-nothing/ar-AA2cLpRk?ocid=finance-verthp-feeds&cvid=6ab60fc4056048a28fcfcbfc92c0d40c&ei=44
Can You Retire Early in Your 40s or 50s?
“Another guideline is the 4% rule, which says you can withdraws 4% of your retirement portfolio in your first year of retirement and adjust for inflation each year thereafter…
… But the rule, based on 1990s market data, assumes a 30-year retirement. In 2025, experts now recommend a more cautious approach, around 3.7%, or even lower, especially if you’ll be retired for more than 30 years…”
Retirees’ safest move raises the risk of hitting $0
Ridiculous and ridiculouser … here the 4% Rule is so sacrosanct it dictates the contents of your portfolio. Tail wags dog. And what exactly is this “study” based on? Past returns. Yes, the very same past returns that do not guarantee future results.
Yet the executive summary ironically cites “the current bond environment” as a rationale for avoiding a bond heavy asset mix. And when exactly is “current”?
May 2021!
Why not just require these contributions? Isn’t that where this is headed?
Vanguard shows why most 401(k) plans leave savers short
Then it would be a tax! You would have stealthily accomplished what some have been trying to do overtly for years … raise SS taxes and invest it in the stock market.
It’s not hard to understand why it’s very popular on Wall Street and in Corporate America. Trillions of captive capital shunted directly into stocks effectively free of shareholder oversight. Not many 401(k) participants are voting on executive pay proposals. Not so good from the perspective of the captivated though … it assures that the once independent SS system is no longer and goes down when the stock market does … goodbye diversification.
That was meant as a semi-jest.
But here comes tax from the very cradle:
Trump Accounts will auto-enroll children, potentially adding 60 million accounts: Treasury
Auto-enroll.
With the children’s money funneled directly to Wall Street:
“Money in a Trump Account must be invested in mutual funds or exchange-traded funds (ETFs) that track a broad-based index composed mostly of U.S. companies — the kind of fund that tracks something like the S&P 500 …”
https://www.countrytaxcalc.com/tax-guides/usa/trump-accounts-guide-2026/
Corporate welfare, anyone?
Agree with your point on corporate welfare, especially when the markets are already historic highs. Channeling more passive capital into them is not a good look.
Having said that, under more realistic market conditions, this could be a good thing.
I speak from personal experience on this with the Child Trust Fund in the UK.
Announced by Gordon Brown in 2001, when he was Chancellor, the scheme was a long-term, tax-free savings or investment account set up by the UK government for children born between 1 September 2002 and 2 January 2011.
The concept was presented as part of a radical wealth-redistribution strategy known as “asset-based welfare.” The policy aimed to ensure that every young person, regardless of their family’s wealth, started adult life with a financial safety net.
The government initially seeded these accounts with vouchers of £250 to £500 (or more for low-income families). In addition, while the account holder is still under 18, parents or family members can continue to add up to £9,000 per tax year tax-free.
An account in the name of our younger child was opened and we added small amounts to it on a regular basis. Over an 18 year period, it’s grown reasonably well even though the contributions were minimal. For our older child who didn’t qualify, we opened a different type of account and made similar contributions.
But for the trigger of the child trust fund, I doubt if we would’ve opened these investment accounts. I guess we were different by being intentional here. A vast majority however appear to have not added to the initial seed investment and around 750,000 young adults are yet to claim their mature funds, averaging £2000/account.
So, while the UK scheme can’t be considered a roaring success, for those who used this as a launchpad or stepping stone, it would make a meaningful difference. It’s probably be the same in the USA, with the added factor of potential market dislocation in the early days of the Trump accounts.
The case is stronger in the UK. As a whole UK stocks are a far better value and a bigger benefit to the buyer. I’m more skeptical in the case of the US. The accounts aren’t objectionable in concept (though some consolidation of an increasingly bewildering array of special account types each with its own maze of rules is in order) but the list of approved (promoted) investments is suspect. Buying US stocks disproportionately benefits the seller and ultimately the corporate insider, potentially at great cost to the buyer. Government efforts to herd J Q Public into stocks weren’t so popular decades ago when they offered the buyer real value.
I’m similarly skeptical about the motives for raising the age at which RMDs (required minimum distributions) from traditional IRAs and 401(k)s kick in. Cynical might be a better word. I don’t recall a big public outcry to lift those ages … it seemed to happen almost effortlessly, as if a powerful puppetmaster were pulling strings in Washington. This is a move that cost the Treasury big money, not something done without a powerful constituency behind it. Those RMDs are fully taxable at ordinary income tax rates and bring in a lot of tax revenue. Of course the move was touted as a benefit to the common man, but his lobbying group seems far too puny to do such heavy lifting. Maybe some folks in high places realized that letting JQ leave his nest egg in the market for a few more years might benefit someone other than JQ. I’m from the government and I’m here to help you is a sarcastic cliche not for no reason.
A similar thread runs through interest rate policy. Once upon a time, JQ could put his money in the bank and earn a positive return after inflation … actual inflation. Even as recently as the early eighties money market funds sported double digit yields. As that opportunity faded into history, it slowly dawned on JQ that saving was a losing proposition. Funds that once went safely into low risk accounts were squeezed into stocks and bonds. That someone has been benefitting big is evidenced by the explosion in the ranks of billionaires … and now even trillionaires … almost exclusively corporate insiders. If it were the JQs benefitting so much we wouldn’t be seeing consumer confidence numbers in the cellar while the stock market was making new all time highs.
That the government is making policy on behalf of the rich and powerful isn’t hard to believe. Call me cynical, but one plausible narrative is first goad them to buy stocks by repressing interest rates, and when that’s no longer tenable, resort to more coercive means. I truly don’t believe the trillion-dollar corporate behemoths that so dominate the modern economy got so big naturally and organically with no help from federal government. On one hand they’re subsidized with cheap capital courtesy of the central bank and on the other from more favorable tax treatment than many individuals even receive. Government plays Robin Hood on stage while playing reverse Robin Hood behind the curtains.
We might look to times when prosperity was much more widely shared for guidance. Broadly the second half of the twentieth century. Interest rates were higher than inflation. Stock dividend yields were competitive with if not higher than interest rates and bond yields, and stock prices were bargains compared to today. That was before the era of ultralow rate policy. Concentration grew with falling interest rates and with that era the wealth gap has exploded and social division with it.
Forcing people to buy overvalued stocks is a bandaid destined to backfire. A true solution would get at the crux of the problem and roll back the policies that created such widespread economic insecurity in the first place.
Don’t look now, but it’s possible that’s just what the new Fed Chairman has in mind.
How much monthly income could a $400,000 annuity provide?
This article gives an excellent overview of commercial annuities. The example it cites, for someone in their mid-sixties, is of an annuity bought for $400,000 that provides a $2500 monthly income for life. This is equivalent to a 7.5% portfolio annual withdrawal rate … but without the risk – indeed the likelihood – of running out of money. Commercial annuities aren’t for everyone, but this would in my opinion be far superior to applying the snapshot “4% Rule” to a portfolio of the same size.
If you want your portfolio to act like an annuity, nothing beats the real thing. No sequence of returns risk, your income lasts as long as you do, with nothing left over. The 4% Rule imitation product tries to do this and fails. It either leaves you with money left over or you run out of it … and you don’t even get to decide which.
Apportion your resources according to your priorities. Social Security and, if you have one, a pension, may be all you need for this type of income. If it’s not, this is the next place to look. Look at it as a complement to portfolio income that you produce by withdrawing a fixed percent (eg 3%) from an investment portfolio each year as discussed in the post.
There are some caveats. The 7.5% annual rate example cited is a fixed income … your annuity “portfolio” is effectively a bond allocation, so your investment portfolio would be mostly or even all equities and commodities.
The alternative is to buy an “inflation” indexed annuity. This would better complement an investment portfolio that also includes bonds. The same initial investment will produce a lower yield as the cost of the indexing escalation.
How you allocate between these two different types of retirement income is a personal choice. If you intend to leave a substantial legacy to heirs or charity, the bug of having assets left over is a feature, and you would naturally prefer more of the portfolio type income than the annuity type. If you have little or no use for money left over, you would instead prefer more of the annuity type income.
This is fundamentally the main allocation decision you make when planning your retirement income, whether intentionally or by default. Make it intentional. Looking at it in these big picture terms before you work out the details puts it in a framework that can greatly clarify your decision making.
I had looked into what an annuity would offer years ago during the ZIRP years and the rather poor returns aside, I could not get over my discomfort with the counterparty risk. There are rumblings that the AI bubble has created a tremendous amount of paper that is being held by the insurance industry and some of the insurance companies are not run very conservatively.
All the more reason for me to distrust and especially not rely on insurance products.
Fair point … to be clear this isn’t a general recommendation of commercial annuities. They do require due diligence and they can get complicated if you go beyond a simple annuity. People with adequate Social Security coverage don’t need them. On the other hand, rates have improved a lot since the ZIRP era, and for those that don’t have adequate other annuity type income for their priorities, and do have enough assets to devote a portion of them to one (not as a substitute for portfolio income, but as a complement to it), a carefully selected annuity from a financially sound firm is less flawed than the one time snapshot 4% Rule, especially if the portfolio it’s applied to also rests on a lot of bubble paper like most popular stock indexes do.
Schwab’s SCHD spotlights rare formula for $500 monthly
This article makes a good springboard for another deeper point. SCHD, an equity income fund, is very popular because it has produced an dividend yield in excess of 3% with a dividend growth rate that has smartly exceeded the CPI, something the 4% Rule (take one snapshot and adjust by CPI) doesn’t do.
SCHD is an excellent fund and I own shares myself, but isn’t broad enough to be relied upon alone for retirement income. The 100 stocks it holds are less than 1% of the 10,000+ readily investable stocks on the world market, exclude real estate investment trusts and include no treasuries or commodities. For a complete investment program you need a much broader foundation.
The 3% withdrawal strategy applied to a well diversified portfolio (Model Portfolios) effectively turns the entire portfolio into dividend fund that yields 3% and has exceeded CPI growth but which rests on a far broader asset base including the entire world stock market, the treasury market, and commodities.
It’s an ideal complement to an annuity portfolio including Social Security, pensions, and possibly commercial annuities, together which create a foundation for lifetime financial security.