Type ‘4% rule’ in Google and you get over 40-million hits. Investopedia, the first link that I got, defined it well enough : The four percent rule states that you should not withdraw 4% of your portfolio each year in retirement for a comfortable life. It was created using historical data on stock and bond returns over a 50-year period. Seems simple enough, right? Not really! I’ve addressed the 4% rule before and you can find that article here and here. However, two critical elements keep nagging on me from the back of my mind: life expectancy and diminishing needs. So, I decided to address them.
Who wants to live forever? asked Queen in the song written by Brian May in 1986. It’s a good question, but the better one is:
“How long are you going to live?”
I’m going to use figures for life expectancy in Western Europe to illustrate. If you live in a developed country, you can use these as a proxy.
When looking at, or researching life expectancy, the first thing you realize is that it is dependent on a whole range of things, with your lifestyle being obviously the number 1 factor. However, I’ll put that aside as even the most healthy, vegan eating, yoga stretching, anti-alcohol individual can be hit by a car crossing the road. Given this, looking at averages should be good enough for financial planning.
The first main concept is Life Expectancy at Birth, which looks at how long people should live, on average, based on their date of birth.
In Western Europe, the current expected Life Expectancy from birth, for a male and female, is around 78 years and 84 years respectively.
The second way to look at Life Expectancy is Healthy Years expectancy from birth, or disability-free years, which measures the number of healthy years an individual will live on average. In Europe this is currently around 64 years for both men and women. That means the first 64 years will, on average be disability-free, followed by about 20 years of life with a disability. If ever there was a strong statistic to preach for early retirement, then this is it!
The third concept to look at is life expectancy now based on your current age, as life expectancy now is for babies born now, which for my readers won’t be the most applicable stat. For EU stats, one can find that life expectancy for people who are 65 now is projected to be, again on average, about 20 years. That takes us to around 85 years, which is the age we are expected to live to.
The above 3 concepts help us target how long we might live, on average and so how long we might need our portfolio to cover our expenses.
However, just the use of the word ‘average’ should come will all sorts of alarm bells. Just because something is average doesn’t mean it will apply to you.
When looking at average, you also should look at the standard deviation to the average. In research from 2008, it was found that the standard deviation in life expectancy for developed countries was 15 years. Standard deviation tells us how much life expectancy differs from the average.
Essentially, we can interpret a 15-year standard deviation meaning we could actually live 15 years more or less than the average. Given the distribution curve of longevity, this means currently you have a very small probability that you’ll live beyond one standard deviation.
This has important implications for retirement planning.
However, we all believe we’re going to keep on living, and it is that emotional bias that means we try and forecast retirement savings to go beyond 85 years and sometimes even beyond 100 years.
But is that rationale?
Of course, the answer is no, but it is hard to completely work it out of the equation as ‘what if’ – and that’s a big ‘what if’ you live beyond 85 years old?
Is there a simple rule to life expectancy?
It is important to understand that there is no simple rule, but if you’ve rationally understood the above, you’ll realize that you’ll most likely live to around 85 years old, give or take a few years, with a fairly good chance of clocking out before that.
Also, something as simple as the 4% rule doesn’t really apply, as that assumes perpetuity and no draw down on your capital. The 4% rule is a safe withdrawal rate and is calculated based on historical research that shows that on average minimum annual returns tend to be around 4% after inflation.
The 4% rule shouldn’t be used as a measure of what your maximum expenses should be.
Hopefully you’ll understand why by reading the above, but just in case:
You don’t live forever and so your portfolio doesn’t need to either.
How do you then work out how much of an investment portfolio you need to retire?
Ideally you want to forecast out your expenses, assume a fairly low key 4-6% (thanks Trinity study!), after inflation, return rate on your investments and then see what amount you could draw or take out of your portfolio, forecasting it to be down to Zero when you get to somewhere between 85 to 100 years old.
This is some simple Excel, however if you’re interested in a sample spreadsheet, shoot your Chief Money Man an email and you’ll receive one to help you work through this. I’ll work into creating a downloadable file directly from this post over the next week.
Another important consideration in early retirement is the composition of your portfolio and how much real estate you have. And more importantly how much debt attached to that real estate you have.
Real Estate is another important asset class most people have, and the generally accepted rule is to retire when you are debt free.
But what if you want to retire before that?
The general trend today (especially given the low yield environment) is to use debt to finance real estate assets. Repayments increase expenses and hence require higher usage of your investment returns than if you had no debt.
But, that repayment will one day come to an end and your outgoings/expenses will thus decrease. This will of course then impact your future withdrawal rate off your investments.
This means that in that you’ll need a higher return in the short-term to cover the repayments and you can settle for a lower return later on.
Real estate assets are also assets that can change their use over time. A primary residence may get too big once the kids have left the coop and could then be used to generate an income, while you downsize elsewhere.
Real estate Downsizing
Downsizing or more appropriately “right-sizing” your primary residence is a great way to decrease financial outgoings/expenses, if you have a mortgage, or a way to free up extra financial resources if you have a property that has been paid off fully.
Decreasing your monthly expenses allows you to decrease your withdrawal rate (take less of your investment returns) and allows your investment portfolio to last longer.
While this is easy to say and easier to write, you may actually like your home or feel a strong emotional connection to it. This may hinder your ability to downsize, however that shouldn’t stop you from trying to turn it into an extra revenue stream. Websites like Airbnb have taken the world by storm and enabled as easy route to turning your primary residence into a cash making machine, which helps your portfolio go even further.
My advice, if you like your home, is not to consider downsizing, but rather use it as a fail-safe or extra insurance should future returns be way below the 4-6% you are using to forecast your road to early retirement.
Working out your own rules is important, and you should realize by now that the 4% rule of thumb needs to be nuanced. You won’t live forever. Create a fail-safe – real estate is a good one. And then forecast yourself to early retirement – hopefully way earlier than you had previously calculated.
Remember, one size doesn’t fit all and if in doubt, your Chief Money Man is here to help.