Let’s put the 4% safe withdrawal rate to the test

I’m sure you have all heard about the 4% rule. This is something which always comes up in FIRE blogs. So naturally, I will discuss it a little bit as well.

The 4% rule refers to the amount (plus annual inflation) you can safely withdraw from your investment portfolio without ever running out of money. This figure is from a famous financial study by William Bengen. It’s best to explain the 4% concept with an example. Let’s say you need to safely withdraw £20,000 from your portfolio to cover your annual living expenditure. Based on the Bengen 4% rule, you need a portfolio of £500,000 (£20,000 / 4% or £20,000 x 25) to do so to avoid running out of money in your lifetime (although the study only looked at 30 years of making these withdrawals if I remember correctly but you could be relying on these withdrawals for much longer). This is why they say that once you have saved up a 25 X multiple of your annual expenditure, then you’re done – you have achieved FIRE.

I think it would be interesting to look at the 4% rule in practice and do a little backtest. Let’s say we start with a portfolio of £500,000 fully invested in the S&P 500 in January 1985. Please note a bit less than 3 years later the market crashed by circa 21% (in October 1987).

Let’s assume that we withdraw £5,000 each quarter plus inflation (this works out to be £20,000 p.a. i.e. 4% from the starting figure of £500,000). What would that actually look like over the following 35 years?

The following chart shows the impact of these withdrawals:

As you can see the chart continues to increase in value over time even though we are withdrawing at least £20,000 each and every year. It’s not the smoothest ride out there but the initial £500,000 becomes circa £4.25m by the end of the backtest (this is in inflation-adjusted terms). Therefore, we keep getting richer over time. The worst year for this strategy was a 37% loss and worst drawdown was 51%. However, overall we got a fantastic result and this should give you a massive confidence boost when it comes to the 4% rule.

S&P 500 backtest with 4% withdrawal rule

I deliberately kept the backtest very simple. We were always fully invested in the S&P 500 without any allocation to any other asset classes (no fixed interest, or gold or emerging markets etc). If I was at work, I’d call that a very aggressive investment portfolio, which is not for the fainthearted… but why make it more complicated? Why mess with it if it works?

The problem is that people find it difficult to stay invested when their portfolio loses 20%, 30% or 50%. How much can your portfolio go down in value until you say that it doesn’t work any longer? The pain can get so bad, that investors sell at or close to the bottom and miss out on the recovery because they have lost faith in the stock market. Sometimes the best thing (and also the hardest thing) to do is to sit on your hands and do exactly nothing. There’s no need to check the value of your portfolio every single day or even multiple times a day as I used to do. Now I aim to only look at my monies once a month – I’ve only succeeded in a handful of months so far but I’m still learning…

The main thing to remember is to stick to your plan. In the example portfolio above, the plan was very simple: stay invested for the rest of your life and make no further investment decisions and only withdraw £5,000 plus inflation each quarter. This would have worked so well if you were able to actually implement the simple plan or strategy as intended.

You can always choose to make life more complicated and aim to reduce the ups and downs (i.e. the volatility) in your portfolio. Let’s now test a 60% shares (S&P 500) and 40% fixed interest (bonds) portfolio where we rebalance the allocation annually. Again, we start with £500,000 and withdraw £5,000 each quarter. This is what the 60:40 portfolio (red line) would look like compared to having it all invested in shares (blue line). Please note, the charts start from January 1987 (not January 1985).

S&P 500 VS 60:40 portfolio with 4% withdrawal rule

You can see that the 60:40 portfolio ends up with circa £1.5 million in today’s money. We were able to maintain the quarterly withdrawals of £5,000 plus inflation and continued to increase our wealth. The ride was much smoother this time around as the maximum drawdown was 31% and the worst year lost 20% – this makes it much more palatable to continue staying on course and sticking to the plan. However, we ended up with less at the end of the test compared to the strategy where we were fully invested in the S&P 500 (blue line).

You can argue this both ways. You could say that it should only matter what you end up with i.e. try to maximise how much you have at the very end. Alternatively, you can argue that it’s absolutely pointless to invest in a strategy, which could be the best over the long term but is not one an investor could actually follow as the ups and downs are far too scary – imagine going from £2m all the way down to £1 million in less than a year and continue to keep a smile on your face. It’s difficult, very very difficult.

The major caveat with all of the above is, of course, that past performance is not an indicator of future returns. You can end up with less than what you started with. This post should not be treated as a source of financial advice.

It doesn’t matter whether you start with a £500,000 portfolio or £100,000 portfolio. The concept and results remain the same, it’s only the scale of things which changes. The 4% rule has worked really well over the last 30 or so years. The only impact I can think of is the increased performance drag due to transaction costs on the smaller portfolio. Another thing to remember is that taxes were assumed to be zero in my backtest – but this can successfully be engineered in the UK with the use of different tax wrappers (e.g. ISA, GIA, pension, investment bond) and strategic withdrawals where you make use of your available tax allowances (stay tuned for a post on this in the future).

There’s a lot of talk and debate about the safe withdrawal rate being something different in today’s markets because interest rates are low and bond yields have changed etc. The reality is that nobody knows what the future is going to look like. I think 4% is a good starting point and the two tests show that historically things would have been OK. I wish the dataset had more price points and I could extend the backtests maybe to 50 or even 100 years. Even better if I could use the UK stock market in the backtest. Now that would be powerful! However, 30+ years of US market performance data will have to do. If I figure out how to add in the UK stock market I will do a post about it in the future.

The way I see it is that even if the market tanks the day you retire, you have a range of options available to you for extra income. I mean you could go back to work, do a side-hustle or move to a lower cost-of-living area. There’s plenty you can do to survive the tough times. On a similar note, I remember reading the Escape Artist’s excellent blog post about going into Monk Mode where he discussed the benefits of doing so. Go check it out! His blog is pretty good.

As is often the case, it doesn’t need to be all or nothing. You could decide to be an aggressive investor until say age 55 and then move on to the 60:40 strategy. This approach could provide you with more investment growth during the years when you still have potential to earn a salary (in case markets tank and things get scary) and reduce the volatility in your later years so that you can have more peace of mind. This is something I’m thinking about doing. I’m happy to take investment risk now when I’m young and gainfully employed and then will gradually de-risk my portfolio as I get older and protecting my nest egg becomes more of a priority. By the way this is exactly what “lifestyling” or “target dated” investment funds do – I wouldn’t be surprised if you have these in your work pension today (they are the popular choice for default investments for auto-enrolment pension schemes).

I hope this article has provided you with some food for thought and given some courage to plan for the 4% withdrawals in the future. The stock market might look relatively grim right now but in the long run, it will probably recover. Stay on course and stick to your investment plan. You can do this!

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