Why I Use 5% Withdrawal for Retirement
I wrote an earlier post about Why I’m Chasing FIRE (Financial Independence / Retire Early) and in it, I said that my definition of FIRE is when my investable assets are equal to 20 times my annual expenses. 20 times your annual expenses means you would have a 5% withdrawal rate in retirement. This statement goes against conventional wisdom so I rightly got a few comments about being more conservative. Most people recommend a withdrawal rate of 3-4% which is 25-33X expenses. So why am I going against the flow on this one and going with a 5% withdrawal?
Where Does The Conventional 4% Come From
There is clearly a lot of speculation and controversy in the retirement community about the ideal Safe Withdrawal Rate (SWR). The problem is everyone is just guessing because past performance doesn’t guarantee future performance. The two biggest unknowns are inflation and market performance. The 4% SWR came from the Trinity Study that was done to answer this very question.
The Trinity Study was a comprehensive research project into determining a safe withdrawal rate in retirement. They looked at various stock/bond portfolios over different 30 year periods from 1925 to 2009. They concluded that portfolio success was all but assured with a 4% withdrawal rate or less. This means you should expect market returns of around 7% and inflation to be around 3% thus leaving you with 4% to withdrawal.
Here is a link to the Wikipedia page if you want some more info.
50/50 Is Pretty Good
Okay, there is the study why not follow the advice that was given? Do you want to run out of money? The thing is in the study they concluded that 4% withdrawal all but guaranteed success. This means retiring at the worst possible moments in history you would have still been okay. At most other times 5% or higher would have been okay.
So what would happen with a 5% withdrawal? Actually, a 5% withdrawal gives you a roughly 50% chance of lasting through retirement. That is retiring at 40 with a $1,000,000, $50,000 in annual expenses, and planning to live to 100. FireCalc gives me a 47.1% chance of success. Now 47.1% is pretty good but I would never leave my retirement up to a coin flip.
I Will Earn Something
The big underlying assumption in the Trinty Study and using FireCalc is that once you retire your only source of income is your portfolio. That means no part time work, no side hustle, no rental income, no social security, no inheritance, no twenty bucks at Christmas. This isn’t realistic for most people and especially not me. I am chasing an early retirement but retiring to me is about being free to choose how I spend my time without worrying about money.
We expect to have at least one rental property and at least one side hustle that I am passionate about. I love some engineering but I would much rather write for the blog or train clients out of my home gym. If we earn a modest $1,000 a month in retirement our success rate goes to 75%. My rental income afters taxes and insurance alone would exceed that number. If I make another $1,000 a month from a side hustle my success rate goes to 98%. But I’m retired so I don’t want to feel like I “have” to make any money.
Finally, there is an inheritance, social security, severance. I’m planning on never seeing a penny from any of them but in reality, I probably will. 5% withdrawal isn’t looking so bad when you consider what a small amount of retirement income can do for you.
My Expenses Aren’t Fixed
The other big assumption with these calculators and the Trinity study is that your expenses are fixed. They assume that you will just spend yourself out of every dollar and pay no attention to the market. While $50,000 a year might be what we want our expenses to be we could certainly do a lot of trimming for a year or two if needed. In fact, if we could adjust spending down to $40,000 during bad market times our success rate goes from 47.1% to 74%.
I also don’t know how much our expenses will be in retirement but most studies say you will need less. Health insurance is the big question mark here but every other category I would say we would spend less in. Only one car, less driving, no more business clothes, vacation offseason/midweek, less/no daycare. Like I said it is tough to know what the expenses are going to be like but the big thing is we are somewhat in control of them.
My House Isn’t Include
I am shooting for investable assets to be 20 times our annual expenses. I do not include the value of our home because we need to live somewhere. That said I think it is very likely that we would downsize dramatically once any kids have moved out. The house would be paid off at that time so I could see netting a big profit from that kind of move. Not counting on it but it is another big potential income source.
One More Year Syndrome
One more year syndrome is meeting your portfolio goals and then deciding you need “just one more year of work” to be sure. I have heard and read of many people in the financial community falling victim to working just one more year. For some people, this goes on for several years. They end up building these massive portfolios and passive income streams that could support triple their annual expenses.
I acknowledge that I will probably not be immune to this. I will fight it but I doubt the second our investments hit 20X we will both be putting in our two weeks notices the next day. It is likely that we will transition out slowly. If we spend a year or two transitioning we might end up at 21-22X expenses. So I didn’t get out right at 20X but still much earlier than if I set my goal at 25-33X.
I Will Still Be A Licensed Engineer
Let us say that all hell breaks loose at the worst possible time. We just retired and the market completely tanks. Our net worth drops 50% overnight and is recovering at a snail’s pace. We can’t cut expenses that low, I can’t find any tenants or clients, the blog is barely paying for itself, and healthcare costs have tripled. So that is it for us, no other options but to wither up and die broke? We should have had a bigger egg before we sat out to retire.
Except for the fact that I am still a licensed engineer. While I wouldn’t want to, I could go back to work if I had to. Even if the economy was total crap I could still get some kind of a job. I would have the flexibility to offer my services for half of what others would be. Once the market recovered and we got back to 20X expenses I would pull the plug again.
See I’m Not Crazy
I understand why some people might not feel comfortable with a 5% withdrawal rate but I am willing to take on a tiny bit of risk if it means escaping the rat race earlier. You might read some of the above and say I am being too optimistic. I honestly think I am still being conservative. There are just too many levers you can pull if you need to. If I run a conservative but realistic simulation of starting with a million, planning to withdraw 5%, being able to adjust income between $40,000 and $55,000, earning $12,000 per year from rental income/side hustle, getting $20,000 per year from social security at age 70 and either inheriting $100,000 or making $100,000 from our home sale I ended up with a 100% success rate using cfiresim.com. With a median inflation-adjusted portfolio value of $4.5 million.
So what do think? Is 5% still too risky? What is your goal number?