Wealth warning: This post should at best be taken with a pinch of salt and at worst should be likened to crystal ball gazing. I’m posting it because this blog is about retirement and particularly early retirement so it is particularly relevant.
If in retirement, including early retirement, we decide to use a strategy that generates an income by drawing down on our wealth, as opposed to say buying an annuity for example, then there are 4 key decisions that we need to make. They are what withdrawal rate are we going to make (which could be fixed, variable or fixed with an annual inflationary increase to name but three), how much risk (where risk is the likelihood of wealth depletion) are we going to take, what does our asset allocation look like (the equity : bonds ratio) and how many years do we want our wealth to last (the duration). The aim is to settle on a combination that suits our needs while ensuring we don’t run out of wealth before we run out of life. The one decision that is unfortunately out of our control is the sequence of returns that Mr Market is about to provide.
The 4% Rule is but one combination of these variables. Based on historical returns it states that if you settle on a 50% US stocks : 50% US bonds allocation, accept risk that will historically fail 4% of the time and a 30 year time period then you can take a maximum withdrawal rate of 4% of your wealth on day 0 and then increase this by inflation annually.
This post, which for some reason received very little interest from readers but which was highlighted by somebody I respect very much, then shows the historic maximum withdrawal rate available to us for a given asset allocation, risk and duration.
The problem with all of this work is that if history repeats and we are reasonably prudent in selection a withdrawal rate it more than likely results in us leaving wealth on the table (or more inheritance than planned) at the end of the duration. Historically that is also a very large sum in sum instances. Take the 4% Rule for example. Historically it fails 4% of the time which means it succeeds 96% of the time.