Once you’ve started saving and investing for financial independence, you want to know when you’re actually financially independent.

The answer should be straightforward, but it starts out with a simple number and then piles on the fine print.

Here’s an example:  “You’re financially independent when 4% of your investment portfolio can cover your retirement expenses.” *

And the fine print:

* “An initial portfolio withdrawal of 4%, raised each year for inflation, when invested in an asset allocation of at least 50% equities (and 50% stocks), should survive for at least 30 years… 95% of the time. This is backtested on nearly a century of data, assumes that the future is no worse than the past, and expects that today’s equity markets resemble those of the 20^th century.”

If you’ve spent some time reading about stock-market returns and asset allocation, you can probably poke a few skeptical holes in those assumptions.

The authors of that 4% conclusion, now known as the Trinity Study, thought their work was complete. They concluded:

For stock-dominated portfolios, withdrawal rates of 3% and 4% represent exceedingly conservative behavior. At these rates, retirees who wish to bequeath large estates to their heirs will likely be successful. Ironically, even those retirees who adopt higher withdrawal rates and who have little or no desire to leave large estates may end up doing so if they act reasonably prudent in protecting themselves from prematurely exhausting their portfolio.

Yet millions of readers have responded to that conclusion with a rebuttal:

Yeah, but 95% is less than 100%, and I want a guarantee that my retirement will not be one of the failures.

Researchers have spent over a decade since the Trinity Study trying to pin down the “0% failure” numbers. Most efforts tinker with the asset allocation to figure out the best combination of survival rate and withdrawal amount. If you’re willing to take on more risks of failure (longevity, volatility, and loss of principal) then the portfolio can handle a higher withdrawal rate. Or, if you’re willing to assume more risks, then the longer the portfolio will survive and the less likely you are to run out of money. You just have to figure out how well you’re going to sleep at night.

Other researchers have tried to rise above the history by simulating more data and projecting retirements out to 50-60 years. Monte Carlo calculators offer lots of data runs but still suffer from approximations that don’t quite perfectly match the stock market. (As the Great Recession reminded investors– again– the stock market can still behave unpredictably.) If investors can’t find the perfect asset allocation, at least they can try to find a portfolio that never fails, no matter how much data you throw at it.

Others have tried to dismiss failure rates by focusing on “good enough”. At least one popular author has suggested that a portfolio success rate of over 80% is just meaningless. Retirees should be willing to accept the uncertainty of a century that included two world wars and a Great Depression. The future won’t be this bad, so stop worrying about it!

It’s been nearly 20 years since the first researcher suggested that the safe withdrawal rate is 4%, and we’ve spent most of that time bickering over the details. Investors still want two separate goals that might conflict with each other: (1) Zero failure rates, and (2) Minimum portfolio size. In other words, we want to retire the microsecond that we’re guaranteed to achieve financial independence.

Luckily Wade Pfau is on the job again, both through a new article that he co-authors in the Journal of Financial Planning– as well as on his blog.

(Wade has to be rigorous and academic in his peer-reviewed articles & research papers. However, he’s much more informal in his blog, and it’s a great read. If you want to learn more about the challenge of portfolio survival, then subscribe to his blog. It’s refreshing to read small doses of economic research from someone who writes in a conversational tone– rough drafts and sketches and all. This is not the writing of an ivory-tower academic who has his stone tablets hauled down the mountain every 3-4 years for everyone to scratch their heads over and try to decrypt into plain English.)

Pfau gained some notoriety a couple of years ago by pointing out that the “4%” rule only seemed to work in 20^th-century America. Other countries around the world during that time had much lower withdrawal rates. A year later he brought more balance back to the debate by looking at ways to minimize failure rates while still being able to withdraw 4%.

Now he’s digging deeper into an area that I think holds a lot of promise: figuring out how human behavior and variable spending will improve portfolio survivability. I think it’s very interesting to see him translate “risk tolerance” into concepts that help real-life retirees sleep well at night, and to figure out what will keep a retiree’s portfolio from being one of the “unfortunate failures”.

Wade Pfau’s article in the Journal of Financial Planning speculates that the 4% withdrawal rate may actually be too low. That’s right, we may not be spending the money fast enough. We’re so failure-averse and so risk-shy that we’re willing to leave a lot of money on the table– just as the Trinity authors predicted.

So, what’s the magic formula for a safe withdrawal rate?

There’s actually two factors in the formula. First, thousands of financial advisors and researchers have observed that retiree spending declines with age. It’s anecdotal, not certain, but it’s widely observed. (I’m only 51 years old and I can already see it coming.) When you are 82 years old you’re probably not going to be scampering around raising kids and paying college tuition and taking expensive vacations and driving fast sports cars and carousing in bars three evenings a week. You’ll still spoil the grandkids at Disneyland’s Autopia ride and contribute to their college-savings accounts. You can still spend a month on your fantasy cruise, but you’re not going to spend as much per month (every month) as you did 40+ years ago. You have less energy and less stamina, and it takes your body longer to recover. The activities which bring you pleasure at that age don’t require lots of money. Unfortunately at this age it’s also likely that a number of us will have passed away, and the surviving partners tend to spend less.

Second, when the stock market drops then retirees spend less. This is investor behavioral psychology, not logic. Researchers just don’t have the computer power or the algorithms to accurately simulate this yet, but when the bear market hits then you’ll spend less. You should buy stocks when they’re on sale, but most retirees don’t have paychecks or “dry powder” cash for it. Retirees react to bad markets by trying to conserve their spending cash and squeezing an extra month or two out of that year’s stash. They don’t use up their cash to buy cheap assets.

If we’re going to behave like that anyway, no matter how risk-tolerant we think we are, then why not make it part of the plan?

If retirees can cut their spending during bear markets, then that means their budgets have some discretionary spending. They’re actually using two retirement budgets: one that they’d like to spend most of the time, and a “bare bones” budget for tough times. If their spending declines with age, then their portfolio is under less pressure during later years.

Neither one of these spending behaviors are modeled by retirement calculators. The 4% rule was derived from assuming constant inflation-adjusted spending throughout retirement. So even though a few of the 4% scenarios failed during computer backtesting or simulation, the realities of variable spending mean that retirees would probably not run out of money.

What if this “probably not run out of money” could be a guarantee?

The answer is an annuity. If retirees can annuitize their “bare bones” retirement budget, then they know that they won’t run out of money (as long as the insurance company stays in business). In fact, some of a retiree’s portfolio is already guaranteed by an inflation-adjusted survivor-benefit deferred annuity: Social Security.

Pfau’s research brought up another interesting investor behavior. When retirees knew that their minimum budget was guaranteed by an annuity, they felt more comfortable taking risks with the rest of their retirement portfolio. In other words, by insuring against the risk of longevity and total portfolio loss, they were more willing to risk volatility and some principal loss.

There’s no magic formula. It’s a matter of guaranteeing a basic income. It’s understanding that your retirement spending will vary with the economy and actually decline when you’re an elder. It’s also a matter of feeling comfortable taking more risks with the remaining portfolio, secure in the knowledge that the annuity means you’ll never face a total loss.

Military veterans have an even bigger advantage.

If you’re one of the 17% of servicemembers who retires with a pension, then you’ve already annuitized a large portion of your retirement portfolio. You’re probably able to cover a bare-bones budget just with the pension and Social Security. You even have inflation protection and survivor benefits. Not only can you easily handle 4% withdrawals from the rest of your portfolio, you’ve guaranteed that you’ll never run out of money. You can take more risks with the rest of your retirement portfolio. I’m not suggesting that you invest in penny stocks or foreign-exchange futures, but you can certainly put more of your asset allocation in low-cost equity index funds and less in TIPS.

If you’re a military veteran without a pension, then you can still annuitize a portion of your retirement portfolio. Your Thrift Savings Plan can purchase an annuity, also with inflation protection and survivor benefits. (It’s not as good as a military pension but it’s still one of the most affordable annuities available from a reliable insurer.) Once again, between the TSP annuity and Social Security, you’ve guaranteed a portion of your portfolio and can comfortably withdraw 4% from the rest. You can also take more asset-allocation risks with the rest of your portfolio.

Pfau’s research even indicates that an annuity, coupled with an aggressive asset allocation in the rest of the portfolio, could raise the withdrawal rate as high as 7%. Some retirees might happily push that envelope. For the vast majority of retirees, military pension or not, annuitizing a bare-bones budget makes a 4% withdrawal rate safe for the rest of the portfolio.

Now that you’ve read this research, how much longer will you work for financial independence?

And once you retire, how much are you going to leave on the table?

[There are two footnotes to retiree spending declining with age. The first is that retiree medical expenses do go up. Once you reach Social Security age, some of that higher cost is deflected by Medicare. If you’re receiving a military pension, then most of the higher cost is handled by Medicare and Tricare For Life. However, the best insurance is still a healthy lifestyle. Second, this data on retiree spending does not include expenses for long-term care. The strategy for that situation is either long-term care insurance (available at a discount for veterans) or Medicaid. It’s also an entirely separate subject for another post.]

Related articles:
Wade Pfau in JFP: Spending flexibility and safe withdrawal rates
Wade Pfau’s blog on the article: “How Much Will You Leave On The Table?”
Is the 4% withdrawal rate really safe?
Tailor your investments to your military pay and your pension
Asset allocation considerations for a military pension
Details of the 4% Safe Withdrawal Rate
The original Trinity Study

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