Karsten at ERN suggested I write a post for his site so I’m giving it a test drive here. If he picks it up I’ll probably delete it since it’s old hat to my readers. If he likes it I’m hoping we can somehow cut and paste it
David Graham wrote a great post on this site regarding the 4% rule. What is the 4% rule really? You save 25x your yearly need and put it at some risk in a portfolio and then try to extract 30 years of value from the portfolio by extracting 4%/yr. 25x is the principal. You have to inflation adjust the withdrawal, and then you risk the principal at some interest rate above inflation. Let’s say you have 1M, you pull out 4% above inflation (and SORR doesn’t eat your lunch) you will still have 1M 25 years later. You can re-retire for another 25 years on that 1M and still pull out 4%. So if inflation is 2% you need to make 6% on your money to run this money machine. 6% is the leverage on your future, That’s the “math” behind the 4% projection.
What’s the problem you say? The problem is volatility. The problem is the market can not guarantee 6% and 2% inflation. Return is all over the map as is inflation. One year you may make 12%, the next year loose 20%. One year inflation maybe 2% and 5 years later 13% (1979). If your lucky it’ll work out you tell yourself, probably will work out, I read it on the internet! So what’s the probability?
This graph is generated by a Monte Carlo engine at Portfolio Visualizer a free to use financial tool kit. The analyzer works like this. It creates a model from a given portfolio (in this case 50% US total stocks and 50% US total bonds) and then runs it through 10,000 sequences from -3 to +3 Standard deviation where 0 is the mean. It mixes in inflation and a standard sequence of return risk, and spits out a Gaussian plot of the 10,000 probable futures from most likely to least likely. The most likely is the mean and is the 50% line the least likely graphed probability is the 10% line and the 90% line. The are successes below 10% but at some point there are failures. the 10% line represents 30 years of overall poor returns, but when all is said and done you still have 561K in the bank at 30 years with poor returns. Another calculator in the suite the efficient frontier calculator calculates the nominal rates of risk (as SD) and return for the 50/50 portfolio described above with data going back to 1987.
with a 50/50 you can expect on the average 8.56% return, 2.56% above your 6% limit. These are quantitatively calculated statistical values not just guesstimates, useful and more granular knowledge than guesstimates.
In the above example over 30 years of normative sequence out of 10,000 simulations 9838 succeeded to make 30 years the rest failed before 30 years. When did the failures start?
by year 18, 3 people had failed, year 17 nobody failed. Quite a bit of information on a simple 2 fund 50/50 portfolio. Useful information in planning your future, since this is a future looking calculator.
What happens at 80/20 AA?
9504/10,000 succeed the rest fail
The first failure is year 11 out of a 30 year retirement.
The 10% guy at 80/20 only has 396K left in his account compared to 561K for the 10% 50/50 guy. Quite a bit more information
What about bad SORR? You can adjust the SORR by putting the bad SOR in the first years of the model. So if youretired in 1972 you had about 3 years of bad SOR plus very high inflation, It happens. Here is a nominal 3 year bad SOR scenario with a 80/20 AA
Only 6722/10,100 survive the rest fail
The first failures are at year 9 and the 10% line is out of money at year 16 AND the 25% line is out of money at year 23. This is with a 30 year retirement. What about 50 years of 80/20 AA 3 bad years of SOR first?
Only 3508 survive and 10% 25% AND 50% are out of money before 50 years
The first failure is year 8
So that’s what you’re messing with with a leveraged future. Remember this is the nominal 4% x25 retirement plan everybody quotes. Sober you right up doesn’t it?