Safe withdrawal rates have always been a discussion point for early retirees. You want to know how much of your portfolio you can withdraw without risking to run out of money. The Trinity study has tried to calculate a safe withdrawal rate based on US stock and bond performance. Is it still valid? Soon, my second interview with Financial Independence Europe Podcast will be released (edit: it is released), where Alvar and I speak about this topic, but I wanted to give you guys an article already! Let’s do this!

The Importance of the Safe Withdrawal Rate

The safe withdrawal rate, or SWR, determines two things when you try to retire early. The first thing is the risk of running out of money, and the second thing is the amount of money you need to retire on.

Because of the importance of the SWR, the FTB Early Retirement Calculator uses the SWR you can set yourself to determine when you are able to retire.

This highly important number in your financial planning is at the same time a highly controversial topic within the financial independence community. The reason is that the safe withdrawal rate of 4% is based on a study done quite a while ago, plus, it only considered US data, and a 30 year retirement period.

Now let’s look at how the safe withdrawal rate actually works.

How Does a Safe Withdrawal Rate Work?

First, let’s have a look at the mechanics of the safe withdrawal rate. Because I’m a personal finance nerd, I will include some math here to explain what the SWR actually does. I see on forums that a lot of people don’t understand how the SWR really works, so I want to break it down in little pieces for you.

To make this explanation easier to understand, I will use an example of someone spending 40,000 euros per year, retiring on a 4% safe withdrawal rate. By definition, this person needs a one million portfolio to be able to retire early. After all, 4% of one million euros is 40,000 euros. But… 40k this year buys you way more stuff than 40k some thirty years from now.

Consider Inflation!

This might be the most important piece of advice when looking at the SWR and how it works. The thing is, when you retire you might think that 40,000 per year is enough to live on.

However, with inflation running at an average of 2% per year in the Eurozone, that 40,000 euros will be the equivalent of 22,000 euros after thirty years. That means your retirement got halved after slightly more than thirty years…

This is an issue, so you have to account for inflation. The original Trinity study looked at how portfolios perform when you increase your withdrawals every year with inflation and I agree with them.

This means that our hypothetical early retiree withdraws 40,000 the first year, and 40,800 (102%) the second year and so on. This enables them to keep living to the same standards as they did before, even considering inflation.

The calculation to find your withdrawal amount in year n is simple:

Withdrawal amount in year n = original withdrawal amount * (1 + inflation) ^ n. In our example, after thirty years this person has to withdraw 40,000 * (1+0.02) ^ 30 = 72,450 euros per year to be able to live the same life as when they retired.

The First Years are the Most Important to Determine Safe Withdrawal Rate Succes

You can imagine that the first few years are super important when looking at how safe your chosen safe withdrawal rate actually is. If you retire right before the market is going up for a few years, you’re probably set for life. If you retire right after the peak of the market, you will have a hard time staying afloat.

Let me illustrate this with two examples below. I took the returns of the S&P 500 index with dividends reinvested of the years 2000-2018 to look at how the safe withdrawal rate works out when you retire at the worst moment and at the best moment.

My assumptions in the next section are that you will retire with a withdrawal rate, adjust that for inflation (2%) and that you have no other income than this. The numbers are based on the S&P 500 index, so they might not be representative for a European asset allocation. However, the examples here are just to illustrate the point.

Retire Right After a Stock Market Crash

Right after a stock market crash is the best time to retire. Of course, the problem is to time the market correctly (and as Bob taught us, this doesn’t make sense).

However, let’s assume you made the right call to retire in 2003. The down market of the three years before is over, and you’re all set to experience some growth!

If you retired in 2003, you’ve done well for yourself. Even with a 4% withdrawal rate and adjusting for inflation, in 2018 you’re sitting on a nest egg worth over 2.6 million euros! That’s quite comfortable!

The reason for this is that in the first four years of retirement, your portfolio is generating returns larger than your withdrawals. This gives you quite a nice additional layer of security for the bad times.

And yes, bad times always come as 2007 shows us. You lose slightly more than what you’ve just built up, but then again, afterwards your investments are going up and to the right again. You’re living off of a comfortable 2% withdrawal rate, and you will likely never run out of money again.

This effect is even stronger when choosing a lower safe withdrawal rate.

Retiring Right Before a Stock Market Crash

Maybe you were not as lucky as in the example above, and you’ve decided to retire three years earlier in 2000. This was a bad mistake (although it was impossible to know that back then) since now you’re exposed to three years of losses eating away at your starting portfolio.

If you retired in 2000 with a 4% withdrawal rate, you are probably screwed. In 2018 your portfolio is still alive, but at 554k you have almost depleted half of your original portfolio. On top of that, you now have to withdraw almost 60k per year to live the same life as in 2000. This means your actual withdrawal in 2018 will be over 10% of your portfolio, and unless we will see another decade with 12% or more returns per year, you’re going to lose this game.

Actually, the Trinity study sees this issue with the 4% rule as well. They’ve looked at all 30 year periods, and see that about 5% of these periods fail. That means your success rate is about 95% when using the 4% safe withdrawal rate, based on the Trinity study data.

Let’s have a look at what happens when you lower your withdrawal rate to 3.5% and then to 3%.

With these scenarios, your life looks a little bit better. Especially the one where you’re withdrawing only 3% per year looks like you’re going to make it.

The actual withdrawal rate in 2018 is now slightly over 4% and if you’re lucky, you’re going to make it. If another down market starts in 2019 it will be hard, but if you get a few more years of great returns you might just pull through.

Things to Keep in Mind

Remember, the case study I presented here is rather simple, and this topic is quite difficult. It’s important to know that you can’t just base all of your assumptions on my numbers above. They are just there to paint the picture and look at how things could have worked out using the strategies presented.

As you’ve seen in the data above, you have to be lucky to be able to sustain a high withdrawal rate. The Trinity study called 4% their “safe withdrawal rate”, but as we’ve seen this doesn’t guarantee great results.

An alternative might be to lower your withdrawal rate, but the problem is that you need an incredible amount of money to be able to do this. So let’s look at some other alternatives.

Alternatives to the Trinity Study 4% Rule

Now that we’ve looked at the inner workings of the safe withdrawal rate, using a rather simplified case study, let’s take a shot at some of the alternatives. Can we find something that works better than the Trinity study 4% rule?

Simply Don’t Retire

Of course, not retiring is an option when you’re looking to alternatives to the safe withdrawal rate problem! As long as you keep working, you won’t have to worry about whether 4% is right or not.

Some people just want to become financially independent, and not retire early. I get that. If you truly love your job, then I’d say why not? I mean, if you are FI, that means you have a nest egg that allows you to do things of value to you, instead of doing things that only pay the bills. It can help you live life more freely, you don’t have to retire early per se.

Using a Lower Safe Withdrawal Rate

This one is a little bit obvious, too. With a lower withdrawal rate than originally posted in the Trinity study, you can increase your chance of success. This makes sense, the more you withdraw, the higher market returns have to be to sustain this withdrawal. When going through a bear market, you can mitigate some of the risks by withdrawing less.

However, there is a massive downside to using a lower withdrawal rate. You will have to work that much longer to achieve financial independence… The effect is really big.

Take for example the difference between withdrawal rates of 4% and 3.5%. Half a per cent doesn’t look like much, right? Well, consider this example. With a yearly spend of 40,000 per year, withdrawing 4% means you need a million to be financially free. At 3.5% you need over 1,14 million, or more than 14% more additional capital.

Looking at the FTB Early Retirement Calculator, that means you have to work quite a bit longer. Here’s an example from someone spending 40k per year, earning 60k per year, and wanting to retire early. For illustrating purposes, this person is 30 years old and already saved up 100,000 euros towards retirement.

Now the difference of two years might not seem much, but remember this increases when your total spend increases or when your savings rate is lower.

In my eyes, lowering your withdrawal rate below the Trinity study advice is not a feasible alternative. I also see working longer as a risk.

Keep Working Part Time

Working part time can be a very nice strategy to not rely solely on the 4% rule. The effect of having even a small piece of active income after you reach financial independence is huge.

Personally, I don’t plan (at this moment, things might change…) to fully retire once I declare myself financially independent. I might take on some passion projects, and only work on things I truly enjoy. Most likely, I won’t work five days per week anymore, nor will I work in a stress-inducing environment.

But when asked to do a small project, why not? I like working, and if little pieces of work here and there can fund part of my retirement that means I can retire so much sooner!

My friend Zach over at Four Pillar Freedom has posted an article visualising the effect of having active income in retirement. I highly recommend you to check this out!

Using a Bond Tent or Cash Cushion

Man that sounds fancy doesn’t it? However fancy this sounds, it can be an expensive strategy due to opportunity cost. If you have a lot of money either in cash or in safe, low-yield bonds, you could be losing out on gains in more volatile investments such as stocks.

Using a bond tent means that you will build up a large portion of bonds in your portfolio when you approach your retirement date. I’m talking several years worth of expenses here. Then, when you retire, for the first couple of years you will only withdraw from this bond part of your portfolio. When you have depleted the bonds, you will continue withdrawing from your regular portfolio.

The cash cushion is a similar strategy, it is used to lower the volatility of your portfolio during the first few years of your drawdown strategy. Remember, the first few years are the most important to determine whether your portfolio is going to survive or not.

As you’ve seen in my examples above, people who retired in 2000 might have a hard time staying afloat, if they’re using a regular 4% withdrawal strategy. Now imagine, they’ve invested in a bond tent or cash cushion to live off for the first 5 years out of retirement. They would not be experiencing the troubles they are going through now!

As with everything, there is a downside to doing this. You give up a significant portion of returns when you are building such a large bond or cash position. When the markets are going down, this will act as an insurance policy against your portfolio failing. But when the markets keep going up directly after retirement, you’re losing out on these gains.

Having a Variable Withdrawal Rate

Big ERN from Early Retirement Extreme wrote an entire series on the detailed workings of different withdrawal strategies.

If you like this post so far, I’d recommend you to check out his series as well. Make yourself a nice cup of tea and take some time (like a week or so) because his series is so incredibly detailed.

Anyway, back to the topic of this post. I’d like the idea of having a variable withdrawal strategy, meaning you withdraw more in years where the market goes up, and less when the market goes down.

A way in which you can do this is a calculation based on the CAPE metric, a way to value equities over long term time horizons. The math behind this gets a little complex, and I am definitely considering writing another article solely on the numbers behind this strategy.

Other possibilities are using a fixed percentage (say, 4%) of your portfolio, not your initial balance. This increases the chance of your portfolio surviving, because after a drop in the market you will withdraw less. However, you would have to stomach losses of income that, percentage-wise, can be as high as the drops in the market.

As an example to the above, say you retired in 2008 with a million in the bank and a 40,000 per year spend, you would suffer a 37% loss so now your portfolio is worth just 630,000. The next year you withdraw 4% of that amount, or 25,200. It could be hard to live on that, given your initial requirement of having 40k to spend. The CAPE based variable withdrawal rate smoothes out this change in withdrawals.

Building Streams of Passive Income

Earning passive income could be considered an investment as well, but if you can create a somewhat steady income stream without too much hands-on involvement, you need to withdraw less money from your stock market portfolio. This, in turn, lets you either invest less, making you financially independent sooner or have a higher withdrawal rate.

If you consider real estate as a source of passive income (which can be debated!) instead of adding it to your investment portfolio and calculating a safe withdrawal rule from there, you can lower your portfolio target.

This works for all income yielding assets by the way, not just real estate. Say you need 40k in retirement. Real estate is providing you with 15,000 net income. That means that from your portfolio you need 25,000 – or 625,000 if you use the 4% rule from the Trinity study.

This 15,000 in income lets you work with 375,000 less capital. If you can build this passive income stream with less than this amount of capital you’d effectively lowered your total invested assets for the same cash flow in retirement!

Taxes are Another Problem with the Safe Withdrawal Rate

Another problem with calculating your SWR are taxes. This depends a bit on the way taxation works in your country, but let’s look at countries that have a wealth tax, such as The Netherlands.

The calculation now changes from S (spend) / WR (withdrawal rate) = I (investments) to account for the higher spending because taxes are expenses in my eyes.

The problem, however, is that when you add taxes to your expenses, your goal investment amount goes up, and that has you paying even more taxes.

In The Netherlands, we pay a wealth tax. That tax used to be a flat 1.2% of your financial assets (bank accounts, stocks, real estate investments) with a tax-free part that used to be 20-25k (indexed every year). These days, the system is a little bit more complex since there are tiers now.

Let’s assume an average rate of 1% to make our calculations a bit easier. Your investment goal is not equal to S / WR anymore. The equation changed to I = (S + 0.01 * I) / WR. If we want to solve for I we have to move the 0.01 * I over to the left side of the equation and get this:

I = S / (1 – (0.01 / WR) * WR )

If we solve this equation for a 40,000 spend and a 4% withdrawal rate, the goal investment becomes I = 40,000 / (1 – (0.01 / 0.04) * 0.04 ) = 1.3 million. This means that because of taxes, your total investment balance needs to go up by quite a lot!

Conclusions on the Trinity Study and Safe Withdrawal Rate

Although the Trinity study has come up with a great framework for early retirees, simply using their recommended safe withdrawal rate is not feasible in all scenarios. In this article, I’ve looked at some of the problems, such as the sequence of return risks and taxation. Also, I’ve presented some alternatives to using a plain safe withdrawal rate strategy.

In other articles I would like to go into depth on the calculations behind different variable withdrawal rates, as well as looking at how the safe withdrawal rate from the Trinity study would have worked in the scenario of an European investor’s asset allocation.

What do you do regarding your early retirement withdrawal strategy? Are you basing everything solely on the 4% safe withdrawal rate or do you employ other tactics such as the ones mentioned in this article?