The 4% Rule – A Castle in the Air

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The Old Man
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The 4% Rule – A Castle in the Air

Post by The Old Man »

TL/DR: The 4% Rule has a high likelihood of failure due to demographics and the limitations of monetary and fiscal policy. Labor productivity improvements are a wildcard.

Summary: The 4% Rule implicitly assumes a 3% long term growth rate. Due to demographics this assumption will not hold. Fiscal and monetary counter measures will not solve this problem and will likely lead to substantial negative unintended consequences. A sustained substantial increase in labor productivity beyond that experienced in the last 50 years is a possible, but unlikely solution.

The convention wisdom is that 4% is a safe withdrawal rate for a retirement commencing at the standard retirement age (~30-year retirement). For early retirement a more conservative figure of 3% is recommended. All the data and detailed analysis support these figures. What could go wrong?

The 3% figure is equal in real terms to the long-term growth rate of the USA economy. It would make sense that a safe withdrawal rate measured in decades would be similar to the long-term growth rate of the real economy.

There have been two exceptions to this 3% rule (growth of the real economy): (1) The Great Depression (1930s) and (2) NOW. The real growth rate of the USA economy has been around 2% since 2000. Now in the early 00s this underperformance could have been considered to have been a momentary blip, but now since this under performance has been going on for two decades you have to reconsider that it may now be the new normal.

It goes without saying that if the real growth rate of the US economy going forward (not backward looking) is 2%, then “The 4% Rule” will not hold.

Crestmont Research:
https://www.crestmontresearch.com/docs/ ... Decade.pdf

Federal Reserve Bank of San Francisco:
https://www.frbsf.org/economic-research ... dp-growth/

The FRBSF states the slowdown stems mainly from demographic trends. Labor force participation is also down. A wild card is labor productivity.

Governments worldwide have been attempting to deal with the slow growth problem (of which lack of inflation is a proxy measure) through monetary measures. In the case of Japan, they have also tried massive fiscal measures as well. These measures have been singularly unsuccessful in restarting the growth engine; although, these measures may have staved off economic collapse.

Low and negative interest rates are a symptom of this slow growth problem.

It should be noted that a Google search indicates much interest by governments in how to implement deep negative interest rates by dealing with the cash problem (the zero-lower bound). Deep negative interest rates will lead to a form of inflation (i.e. less money in real terms available to purchase goods).

In the 1960s-70s there was an attempt to “end the business cycle” through monetary measures. The end result was Stagflation - high inflation and high unemployment. I suspect the fascination with the negative interest rate policy will end the same way. In short, you cannot solve a sustained aggregate demand problem through monetary measures alone.

The aggregate demand problem has arisen through demographic trends, so the slow growth problem will be here for a long time. It is possible to solve this problem through fiscal measures (i.e. World War II is given the credit for ending the Great Depression). The limiting factor is how much debt can be carried.

“This Time is Different: A Panoramic View of Eight Centuries of Financial Crises”
https://www.nber.org/papers/w13882.pdf

“US Debt Ceiling and its Current Status”
https://www.thebalance.com/u-s-debt-cei ... es-3305868

The first link shows governments have repeatedly defaulted on their debt. The U.S. is not immune to this as there have been repeated debt ceiling crisis’ whereby the government debates whether it should raise the national debt ceiling. Not raising the ceiling would lead to default. The second link discusses this phenomenon further.

Fiscal measures to compensate for the aggregate demand shortfall caused by demographics would require an enormous outlay on an ongoing basis. I don’t see how this could be sustainable, so default (or hyperinflation) would be likely. China as the largest foreign holder would not be pleased. The U.S. Dollar would cease being the world’s reserve currency.

The 4% Rule requires a 3% long term growth rate. Demographics will not support this growth rate and fiscal and monetary measures will not successfully compensate for the shortfall. Increases in labor productivity could potentially compensate, but is considered unlikely since the magnitude required is beyond that historically experienced in the last 50 years.

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fiby41
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Re: The 4% Rule – A Castle in the Air

Post by fiby41 »

The Old Man wrote:
Tue Sep 17, 2019 10:15 am
Due to demographics this assumption will not hold.
My suggestion is to play our small part in solving the demographic problem by having 2.1 children.

Which is why my magic formula is I am truly FI when rate of return is (inflation+3)% and a spare-child to take care of me and housework for when I will no longer be able to do it myself.

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Seppia
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Re: The 4% Rule – A Castle in the Air

Post by Seppia »

I'm maybe missing something very obvious here, but why can't an asset yield 4% unless it experiences a 3% top line growth?

Mister Imperceptible
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Re: The 4% Rule – A Castle in the Air

Post by Mister Imperceptible »

It can as long as debt is expanding. When debt unwinds the asset will yield less than top line growth. Leverage works both ways.

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Seppia
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Re: The 4% Rule – A Castle in the Air

Post by Seppia »

Still missing something.
Let's say I have a business that has 0% top line growth with 4% net net earnings and pricing power (=it can sustain inflation).
No need for growth whatsoever.
I'm thinking cigarettes, utilities etc

Mister Imperceptible
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Re: The 4% Rule – A Castle in the Air

Post by Mister Imperceptible »

If 4% nominal is 0% real, isn’t the yield just baked-in inflation? Presumably the people who are forced to pay increasing prices for cigarettes and utilities are seeing increases in their own pay, and if not then they are either cutting down consumption elsewhere or they are incurring larger debts. So somewhere, the cigarette company is maintaining its yield at something else’s expense.

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Seppia
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Re: The 4% Rule – A Castle in the Air

Post by Seppia »

My business is i take sugar, water and aromas, mix them and sell them for a profit (my name is Coca Cola).
I don't need top line growth to make a buck.
I just have a built in profitable business, regardless of growth, that cranks out a profit even at stable volumes/turnover

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unemployable
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Re: The 4% Rule – A Castle in the Air

Post by unemployable »

Four percent assumes you never adjust your real spending, go back to work or have supplemental income coming along later (pension, inheritance).

Also failure is ending up at $0, not simply ending up with less. At a constant zero real return you have 25 years of living expenses. To have 30 years you need a constant real return of 1.22%. Three percent real, still well under the long-term return of the US stock market, gives you 47 years.

If I'm at 30 years' living expenses and suffer a 50% loss over one year I now have 14 years' living expenses. More than that probably, as deflation will likely occur. Some working stiff who needs every penny of his paycheck to pay his bills OTOH just lost his job and unemployment is now 20%. Which one of us is more screwed?

If this happens because we move to socialism, it won't matter because we'll have Universal Basic Everything anyway, right?

Mister Imperceptible
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Re: The 4% Rule – A Castle in the Air

Post by Mister Imperceptible »

@Seppia

That’s fine unless Coca-Cola is increasing its debts, or the cost of debt increases with a rise in interest rates. And even if its profits are maintained, if investors have bid up the price of KO on margin, the price of KO is susceptible to decreases of margin debt, which is also susceptible to the debts of its consumers, a rise in the real cost of borrowing for investors, or a tanking of overall sentiment.

It’s not like MSFT ceased to be profitable after its share price crashed in 2000.

@unemployable

UBI also fine until milk costs $12 a gallon.

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Seppia
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Re: The 4% Rule – A Castle in the Air

Post by Seppia »

I don't see what debt has to do with it.
The point the op is making is: unless there's 3% top line growth, 4% withdrawal is impossible.
Regardless of the fact that I too think 4% WR is optimistic today, I just think that's not a necessarily true statement.

Mister Imperceptible
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Re: The 4% Rule – A Castle in the Air

Post by Mister Imperceptible »

4% or better is possible for individuals, but not the aggregate. Unless raw materials and the cost to produce goods and services decreases indefinitely. Or unless debt increases indefinitely. You can’t squeeze blood from a turnip.

Edit: If banks are willing to loan me a million dollars at 0% I can outbid other economic actors, unless they also have million dollar loans at 0%, in which case asset prices go up with all of that liquidity baked in. That only works until the liquidity is removed, or the purchasing unit is devalued fractally. Even if KO is ran responsibly, outside agents bid up the price of KO to unsustainable levels.
Last edited by Mister Imperceptible on Tue Sep 17, 2019 4:36 pm, edited 1 time in total.

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Seppia
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Re: The 4% Rule – A Castle in the Air

Post by Seppia »

Are you basically negating the existence of margins and profits?
I’m really not understanding this.

Mister Imperceptible
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Re: The 4% Rule – A Castle in the Air

Post by Mister Imperceptible »

A 4% yield sounds great until the asset either halved in price or the purchasing unit is halved in purchasing power.

Tyler9000
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Re: The 4% Rule – A Castle in the Air

Post by Tyler9000 »

The Old Man wrote:
Tue Sep 17, 2019 10:15 am
Summary: The 4% Rule implicitly assumes a 3% long term growth rate. Due to demographics this assumption will not hold....

The convention wisdom is that 4% is a safe withdrawal rate for a retirement commencing at the standard retirement age (~30-year retirement). For early retirement a more conservative figure of 3% is recommended. All the data and detailed analysis support these figures. What could go wrong?
I really appreciate the depth of your post and thoughtfulness of your argument. The thing is, I think it's built on a false assumption. Not all data supports the 4% and 3% figures. In fact, I would argue those numbers are based on an extremely myopic definition of investing steeped in data availability bias.

The 4% rule, as established by Bengen and reaffirmed by the Trinity Study, was based on the idea that the only two investing options available to an investor are an S&P500 index fund and an intermediate bond fund. Given that assumption, then sure -- economic growth is extremely important to make that assumed portfolio operate. But break that assumption and look at many types of assets and portfolios, and all bets are off.

Concepts like risk parity and modern portfolio theory change the game quite a bit. For example, a portfolio with 60% stocks and 40% gold experienced a 30-year SWR about a half percent higher than the same portfolio with 40% bonds. And gold has basically no growth over time! In that case it's all about economic cycles and the benefits of regularly rebalancing uncorrelated assets. That's how things like the Permanent Portfolio (with 50% low-growth gold and T-Bills) sustained a SWR north of 5% since 1970.

So IMO, even though I personally agree that the 4% rule is a bit antiquated I see it very differently from you. The evidence suggests that a well-constructed portfolio does not require constant economic growth to support even higher SWRs than 4%. It's all about creating a strategy that performs consistently in all economic conditions rather than betting so heavily on economic prosperity. They do exist, but you have to think beyond old-school stocks and bonds and over-simplified economic models focused a little too intently on long-term averages of individual assets.

Mister Imperceptible
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Re: The 4% Rule – A Castle in the Air

Post by Mister Imperceptible »

Great post Tyler, and also The Old Man.

Seppia, I’m sorry if I sounded terse, I unfortunately have not had the time to sit down and write a more thoughtful post. I don’t know if that means I would have been better not posting at all.

For an idea of how KO might perform in the next decade, check out its share price from 1970 to 1980.

https://www.macrotrends.net/stocks/char ... ce-history

I acknowledge the advantages of margins and pricing power, particularly for consumer staple stocks, but that doesn’t justify a price heading toward infinity.

Dave
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Re: The 4% Rule – A Castle in the Air

Post by Dave »

Mister Imperceptible wrote:
Tue Sep 17, 2019 6:17 pm
I acknowledge the advantages of margins and pricing power, particularly for consumer staple stocks, but that doesn’t justify a price heading toward infinity.
I don't want to put words in Seppia's mouth, but I get the impression he is saying that if you bought an asset like a stock at $100 and it pays $4 in dividends (a 4% dividend yield), and you have reason to believe the business has sufficient pricing power to grow that dividend with inflation, you need no real growth to get your 4% on a real basis.

The 4% is not nominal. It's the actual yield on this theoretical asset today. You get that $4 of cash this year. And next year, because this business can grow earnings at the rate of inflation, you are earning a real 4%, too. This doesn't require the business to grow at at someone else's expense, it just requires the business to grow its earnings stream at the rate of inflation, which would be the case for some businesses.

Notice the 4% return is completely independent of the share price after the purchase is made and there is no implication that the price would go to infinity, although it would track changes in the dividend (in other words, it would move with inflation). On a real basis, the share price would offer no gains in this sense. But, the investor would continue to earn 4% on a real basis relative to his initial purchase. So, our theoretical investor can earn 4% real from this investment indefinitely without the asset growing faster than inflation.

Unless I'm misunderstanding something you're saying, it sounds like you are talking about how you can't get 4% real growth without varying levels of debt, whereas we (I think) are saying you can get a 4% return when you factor in the yield (which is a function of the dividend and very importantly, the price paid) and the characteristics of certain businesses.

Mister Imperceptible
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Re: The 4% Rule – A Castle in the Air

Post by Mister Imperceptible »

The OP was speaking about the fact that we are near the end of not just a business cycle but a longer term debt cycle or supercycle, with parallels to the Great Depression of the 1930s and the Great Inflation of the 1970s. In such periods, traditional investment strategies fail. It’s not that debt is inherently bad, but that it has become so large that it now produces dramatically diminishing returns, especially considering the demographic issues he cited.

I understand the thinking behind dividend investing but like anything else it can be carried to extremes. 4% yield would not have helped you much in the 1970s as the share price of KO went sideways and the dollar lost 65% of its purchasing power. And the 1970s didn’t feature a massive cohort of Baby Boomers all selling their stocks at once and pensions becoming insolvent.

steveo73
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Re: The 4% Rule – A Castle in the Air

Post by steveo73 »

These ideas come up all the time. They are another version of "this time it's different". I think this shows a misunderstanding of the 4% rule.

So what is the 4% rule. It's just a statistical analysis of past performance of a simple asset allocation that lasts 30 years about 95% of the time. So you withdraw 4% (+ inflation) based on your starting asset allocation and does it last based on the available data.

The 4% rule has withstood hyper-inflation, wars, trade crises etc. Sure we may be at one of those periods where if you retire today and blindly follow the 4% rule you will run out of money. It could happen but we don't know that today.

No special criteria based on today being worse than the past invalidates the 4% rule. The only way to invalidate the rule is to run the same test in another 30+ years (or year on year) until the 4% withdrawal rate for a 95% success rate becomes a 3% or 2% rule but you can't state that today. It's just as likely that the 4% rule becomes the 5% or 6% rule. We might be at a time when going forward a 6% WR will work.

We should also recognise that the 4% rule is a great guideline for everyone but it has lots of limiting assumptions. I doubt many of us will blindly follow a 4% WR year on year for the duration of our retirement. We may get pensions or inheritances or work longer part time. Your expenses may go down (or they could go up).

Instead of worrying about the 4% rule I think a better approach would be to look at your specific situation and see how comfortable you are with your approach. For instance I will qualify for a social security pension at 67 that should be enough to live off. I'm also 46 and won't be retiring till say 50. I also have 3 kids who cost a lot (they aren't spoilt compared to their peers) and I expect these cost to decrease over time. I therefore don't really have to concern myself too much with the 4% rule holding true. My specific situation is very different compared to the assumptions underlying the 4% rule.

If you are 25, on a tight budget and have no kids maybe you need to retire on a 1% WR because your spending may increase.

To sum up the 4% rule is definitely not a castle in the air. It's a great piece of statistical analysis that we should all understand and utilise in tandem with understanding our specific situation.

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Re: The 4% Rule – A Castle in the Air

Post by 7Wannabe5 »

It seems to me that there is a whole other level on which the 4% rule merits some reconsideration. The big number that tops the screen when I open up my teeny-tiny investment account is annoying to me, because simultaneously highly distracting and relatively meaningless. Maybe this is because I used to run an inventory carrying business with an "intelligent" pricing mechanism. It's easy to go out to the hinterlands of the theoretically perfectly fluid market and find huge spreads between bid and ask. Like where the edges of an old map would read "Here Be Dragons" there are some mysterious characters known as market-makers signaling "F*ck if I know."

George the original one
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Re: The 4% Rule – A Castle in the Air

Post by George the original one »

Mister Imperceptible wrote:
Tue Sep 17, 2019 7:30 pm
And the 1970s didn’t feature a massive cohort of Baby Boomers all selling their stocks at once and pensions becoming insolvent.
Neither will the 2020s or 2030s or 2050s because Baby Boomers (like myself or our parents from the greatest or silent generations) living off their investments are not going to be zeroing out their balances. Remember that one of the golden rules is that wealth concentrates, even for early retirees.

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