Friday, November 6, 2020

Four percent rule

 This rule was advertised by the finance industry since mid-90s, when a paper had been circulated stating that withdrawing 4 per cent from your portfolio a year will make it last for at least thirty years.

Before we look into the background and underlying assumptions lets have look at the 30 years of retirement. This is particularly important to note that healthy working life expectancy at the age of 50 years is on average 9.5 years for men and 8.5 years for women. This means that the healthy working life expectancy at age 50 years in the USA and the UK is below the remaining years to State Pension age.  So out of the average life expectancy of 80 years old, last twenty are in poor health, where people are unable to enjoy the life.

Interesting that the four percent a year withdrawal underlying assumptions are largely omitted by the finance bloggers and the mainstream media.  There are three main ones:
#1 Firstly, after you spent four percent in the first year, you need to increase that amount by inflation each year. 
#2 Secondly, your withdrawal rate is four percent of the initial portfolio. Whatever happens you need to keep it that way, for the calculations remain true.  Imagine, even if your portfolio would increase substantially due to the stock market growth, you should keep your initial withdrawal rate constant.
#3 Thirdly, you need to keep your nest egg invested in a 50/50 mix of equities and fixed income, re-balancing it back to 50/50 each year as the market moves.  The imaginary portfolio that was used for calculations, was also consisting of intermediate term Treasure notes. The long-term average for them was 4.41%, while current rate is 0.81%. In the most recent years, it is 1.8%. The government policy in the USA is to keep them that way for the next five years or more. The UK is even worse, where the long-term gilt yields are at their lowest level in 300 years, depressing prospective investment returns.

Additionally, the writer asserts that the lower exposure to stocks will not provide enough growth. On the other hand, if you put more than 50% of your financial independence nest egg into stocks, higher exposure will leave you less fortunate. There were some periods where early equity market collapses resulted in huge losses having to be realised in order to generate the required drawdown, and the remaining assets failed to last 30 years.

Of course, the financial press is aiming to twist this, by claiming that: “when you retire is important. If markets have just gone pop, or inflation is raging, then you may be in trouble.”  This is false, as you cannot predict the future and 30 years is a reasonable retirement time.

My nest egg is currently one hundred percent in shares. I think when I reach 50/50 or 75/25 asset allocation using just additional savings, I am financially independent.  Essentially this will be $1.2 million in the current money. I think by the time this happens the house will be paid off and the kids are out of the house. $36K a year before taxes will be able to cover the expenses.

However, my view is that four percent rule is no longer relevant. Four percent above inflation returns is in the past. Last decade or more it is more like three percent. Furthermore, if the planning period is any other than 30 years, the four percent rule should not be used. Three percent is more realistic.

While I was on the subject, I compared the pension benefits for the various people in the English society. I guess this will be very similar in all “developed” countries.

Pension benefits for different type of salaried employees:

-       An average Joe.  In the UK to buy a guaranteed pension (annuity) of $1,000 a year you need to have $20,000 in your pension savings. A twelve years ago it was just $13,000 to buy the same pension.  Government in the UK mandates that everybody has to participate in a pension scheme. You and your employer contribute.  If you earn $103,000 a year you will get $8,000 a year contribution with the UK auto-enrollment pension. This will buy you $400 of pension a year.

-       Government official. If you work as an elected official (member of the parliament) your base pay is $103,000 a year and for every year of service s/he gets $2,600 of guaranteed pension if contributes $12,000 a year from the salary.  This is excellent deal, as for a citizen the ratio is 1:20, for public servants the ratio is 1:5.

-       Chief Administrator. If you are a CEO, its even better, as frequently their pension contribution is 100% of their base salary. What this means is that is CEO salary is $103,000 a year s/he gets $5,000 of a guaranteed pension. Without adding anything out of the pocket!

Pension benefits for different salaried employees, earning $103,000 a year:

Pension benefits in the UK for different categories of workers
Even if the Joe contributed $12,000 he would get $600 in his pension. If you double it (assuming  compounding interest with time) it is still only $1,200.  But of course, the average Joe will never get $103 K a year and  CEO base salary 10 times more (so is the pension). This is for one year of service.

Fun fact: In Australia, where the government has allowed members early access to their pension superannuation funds, the result has seen some 600,000 people — most of them under 35 — wiped out their savings altogether.

The governments around the world prevent people to invest their pension into what the governments classify as “ultra-high risk”. This prevents the capital outflow from the failing economies, enabling people to earn higher returns. At the same time in the US and the UK, the governments allowed employers to stop contributions to pension schemes, making the poor people even poorer.

3 comments:

  1. You seem to be assuming that the $8000 is converted immediately into $400 worth of pension rather than growing until retirement and then buying an annuity? In Australia defined benefit schemes are now rare outside of the public sector and many in the public sector don't have them either. Very few people would buy an annuity voluntarily when they retire here.

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    1. Hello David,
      Man thanks for stopping by.

      Indeed, in the table there is such assumption was made. However, down below there is clarification, that if Joe will put aside $12,000 he would get $600. Assuming, that he has 20 years to wait, his pension will be $1,200 (inflation adjusted). Typically when average Joe reaches $103,000 a year there is no time left for compounding interest. This is well above average salary in the UK.

      The defined benefits schemes are thing of the past in the UK too. Hence I was taking current market conversion of $20,000 in pension savings will buy $1,000 a year of pension for life. This amount is adjusted for inflation, in line with the government published CPI.

      I was aiming to compare apples to apples in the last part of the article. For me it is also hard to imagine that somebody in his 70s will be managing his /her pension otherwise.

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  2. You need, and merit (and subsequently SHOULD EXPECT) unprejudiced financial counsel to your greatest advantage. https://europa-road.eu/

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