Maximising withdrawal rates in retirement

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.

That’s it. I’m calling it. It’s my Financial Independence day!

“Financial independence is generally used to describe the state of having sufficient personal wealth to live, without having to work actively for basic necessities. For financially independent people, their assets generate income that is greater than their expenses.” 

Source

3,186 days ago I started on a journey to early Retirement which at the time I defined as work becoming optional.  Only later did I discover that the more appropriate terminology for what I was chasing was FIRE – financially independent and retired early.  Every week since that journey started I’ve sat down and updated my financial position and progress to FIRE.  Today this stared back at me:

Click to enlarge, Path trodden towards financial independence

Yes you’re reading that right.  Today at age 43 I’m officially stating that I am financially independent (FI).  You’d think we’d be out celebrating but in the RIT household this week (and in the run up in recent weeks) there has been calm as I’ve actually been umming and ahing about whether I can actually call myself FI.  The main reason for this is that over the years I’ve diligently planned for just about every financial situation that I can think of however what in hindsight I’ve actually glossed over is the risk of politicians just blatantly changing the rules.  In the past few weeks we’ve seen some of this appear via the Brexit vote which for somebody who intends to emigrate to an EU country as soon as they FIRE has brought real risk.

One of these is the risk that my State Pension might not be triple locked or at least increased with inflation.  Now in my financial planning I’ve never assumed I’d be entitled but I’d always planned on continuing to pay in voluntarily as my insurance policy against financial Armageddon.  Now that insurance policy might be almost worthless as we all know the damage that inflation can inflict.  A second is the risk that at State Pension age I won’t be entitled to the same public healthcare as a local in my new adopted EU country courtesy of UK PLC.  This might mean private healthcare into our dotage but what if we do fall into poor health and our chosen private provider decides we’re no longer profitable enough for them.

At the other end of the scale we’ve seen the government of one of my potential homes, Cyprus, reduce Immovable Property Tax (IPT), which is the equivalent of Council Tax, by 75% in 2016 with a plan to then subsequently abolish it in 2017.  This is a country with so much debt that the Troika stepped in to bail them out only a few short years ago and now they’re cutting taxes by 75% or more.  Sure it plays into my hands for now but it’s not much good if it leads to bust and closed cash points later.

So in light of all of this what right do I actually have to call myself financially independent?  Below is my justification.

Sobering retirement income drawdown demonstrations – 9.5 years in

Unless you’re one of the lucky ones sitting on a defined benefit pension (although it’s likely you’ll also need some other income source in the early years if you’re going to FIRE) or you intend to buy an annuity (again, not likely for the early years of FIRE) or you’re just planning on living off the State Pension then income drawdown in FIRE (or even just plain old retirement) is relevant.

This is the annual update of a series of drawdown demonstrations that are now some 9.5 years in.  To put this in perspective we are now within a whisker of one third of the way through the period that the 4% rule is based upon and this simulation assumes retirement was taken on the 31 December 2006.  If this date sounds convenient then you’re right.  The date was deliberately chosen as it is the year prior to the commencement of the global financial crisis and so hopefully represents a modern worst case.  Someday it may even go down in history as one of the time periods which saw a poor sequence of returns however of course that will only become clear when we are firmly looking in the rear view mirror many years hence.

Over the years readers have suggested various alternatives for these demonstration portfolios however for long term consistency I want to make as few changes to the original assumptions as possible so will stick with them for now.

Where we left our retiree’s last year can be found here.  In brief, the key assumptions are:

• Our retiree’s are drawing down at the stated withdrawal rate plus fund expenses only.  This means any trading commissions, wrapper fees (eg ISA, SIPP fees), buy/sell spreads and taxes have to be paid out of the earnings taken.  For example, our 2% initial withdrawal rate retiree is actually drawing down at between 2.1% and 2.2% dependent on the asset allocation selected.  
• 6 Simple UK equity / UK bond portfolios are simulated for our retiree.  The UK equities portion is always the FTSE 100 where the iShares FTSE 100 ETF (ISF) is used as the proxy.  This fund currently carries expenses of 0.07% however this has been as high as 0.4% in the past.  For the bonds portion a simulation is run against UK gilts (FTSE Actuaries Government Securities UK Gilts All Stock Index) where the iShares FTSE UK All Stocks Gilt ETF (IGLT) is used as the proxy and the bond type I have preferred in my own portfolio, UK index linked gilts (Barclays UK Government Inflation-Linked Bond Index), where the iShares Barclays £ Index-Linked Gilts ETF (INXG) is used as the proxy.
• All calculations are in real (RPI inflation adjusted) terms meaning that a £ in 2006 is equal to a £ today.
• The wealth accrued at retirement (the 31 December 2006) is £100,000.  To simulate a larger or smaller amount of wealth just multiple by a constant. For example if you want our retiree’s to have £600,000 just multiply all the subsequent pound values by 6.

A 4% Initial Withdrawal Rate

UK Retiree Real Portfolio Value, £100,000 Initial Value, 4% Withdrawal Rate, 30 June Value, Click to enlarge

I always start with a 4% withdrawal rate because of the often quoted 4% safe withdrawal rate rule.  The 50% equity : 50% gilts portfolios (the red lines on the chart) are the closest representations to the 4% rule with obvious differences being that:

• the 4% rule was for a US based investor with US based investments while I’m simulating UK investors with UK based investments; and
• the 4% rule doesn’t consider fees where I’m capturing the OCF’s of the ETF’s which makes my withdrawal rate very slightly higher.

2 Commas = £1,000,000

Today, as I have done pretty much every Saturday morning since October 2007, I again sat down and updated my wealth and progress to FIRE (financially independent retired early).  This morning was however a little different as when I usually look at the wealth column of my spreadsheet after entering the data I see 6 figures and a single comma.  Today, for the first time, I saw a second comma indicating that my wealth had passed the £1,000,000 mark.

Click to enlarge, Wealth spreadsheet snapshot

This number means I am now 98.9% of the way to FIRE.

Click to enlarge, RIT path trodden to Financial Independence

Retirement Withdrawal Rates vs Probability of Success

The 4% Rule gets bandied around pretty loosely (I sometime think dangerously so) in the personal finance (PF) world these days and on some of the forums people seem to believe in it almost religiously.  What I’m not sure about is if these same people have actually read the T&C’s of the 4% Rule.

Within the T&C’s there are a couple of pertinent points relevant to this post.  Firstly, it is based on US historic data which doesn’t seem to hold for the UK, a global portfolio or for many other countries for that matter and of course history is not necessarily a predictor of the future.  The other point about it is that it gives you a 96% chance of success historically.

Having debated/discussed PF topics and specifically FIRE topics with many of you over the years I’m finally (I can be a bit slow and a bit stubborn at times) starting to realise that I’m a fairly conservative creature and that I also like to go to a level of detail that probably few others would have the patience for.  These traits lead me to selecting FIRE withdrawal rates after expenses of 2.5% that hopefully will give me a 100% chance of success at planned spending even though I know I have the ability in my plans to cut back on discretionary spending in severe bear markets.

Brexit vs FIRE to the Med

So the UK has voted, Article 50 of the 2009 Lisbon Treaty will soon be invoked and over the next couple of years we’ll negotiate (hopefully sensibly) our way out of the European Union.  Of course I have no idea what those negotiations are going to result in but I also don’t really want to hang around and wait.  After all I’m trying to become financially independent in less than 6 months from here and retire early to the Med in less than 12 months.

It therefore seems worthwhile to get my initial thoughts down on paper which can then be modified as I learn what is happening and being negotiated.

Wealth to FIRE

Post referendum there was plenty of economic doom and gloom around however there was also plenty of exuberance in the days prior.  Priced in £’s my portfolio actually ended the week 1.9% higher than my position at the end of last week and priced in Euro’s I’m down 1.2%.  Hardly FIRE destroying leaving me very much still on for financial independence in less than 6 months.

Click to enlarge, My path trodden to financial independence

As a person positioned as a UK investor right now I’m also stress testing my portfolio against a £ to Euro exchange rate of 1.123.  It’s currently 1.2307 so this is still also looking good.

Getting in the door

One of the founding principles of the European Union was the free movement of its people across its countries borders.  The RIT family were planning on taking advantage of this to enable the move to the Med.  I would say there is a definite risk now, that with us Brexiting, this right will be taken away for UK passport holders not already resident in their new EU country.

My Early Retirement Financial Strategy and Portfolio

With FIRE now on the doorstep it’s time to finalise what my early retirement drawdown strategy and portfolio is going to look like.

Firstly, let’s look at the strategy and portfolio that has put me where I am today.  I first published it in detail in 2009 and then polished it slightly in 2012.  In brief it was about building significant wealth (at least for me) in quick time.  Quick time was less than 10 years which meant I needed to be accruing wealth in relation to My Number at just a little less than 1% per month.  A very aggressive target when I look at it that way in hindsight but one which provided Mr Market behaves for just a few more months looks real.

By living frugally while focusing on earning more I believed I could Save Hard.  To date my Savings Rate has averaged around 52% of Gross Earnings so that has played out.  This then advantaged me when it came to investing as I didn’t have to take great investment risk giving me an increased probability of success.  I called it Investing Wisely.  As it turns out since starting my annualised investment return has been 5.9% which is 3.3% after inflation.

When I came out I stated that at the point of Early Retirement I wanted wealth of £1 million (it was actually £1,011,000).  Today my trusty Excel spreadsheet is telling me that once I hit £1,023,000 I’m good to retire.  At this point it’s then no longer about building wealth but instead the simple problem of ensuring I outlive my wealth which will be drawn on as I’ll have no other earnings.  I suspect it may require a slightly different strategy and investment portfolio to that which I have today.  That said the principles of tax efficiency, low expenses and a diversified investment portfolio, with a key decision of what Bond to Equity Allocation Percentage at its core, I intend to keep.

Given the seriousness of this topic it’s about now that I have to pop in a wealth warning:  History is not a predictor of the future, this is not financial advice, I’m not a financial planner and I’m just an average person who’s made investment mistakes on a DIY Investment journey to Financial Independence.  The post is also just for educational purposes only and is not a recommendation of any type.  Ok let’s move on...

My current estimates, based on my forecast FIRE date, suggest I’ll actually overshoot my FIRE wealth Number with circa £1,117,000.  A Mediterranean life will then mean a life priced in Euro’s.  The average exchange rate with the £ since the Euro’s inception has been 1.3742.  I’m not going to bank on that.  Instead, I’m going to use the worst average year since inception, which was 2009, with its rate of 1.123.  That gives me EUR1,254,000 of wealth to buy a home with and live from for the rest of my life.  I’m going to assume a 40 year retirement period.