Most early retirees bank on the safe withdrawal rate of 4% for their financial assets to last their entire (well, almost) life. This rate was backed by the Trinity study carried out in 1998. So the aspiring early retirees vouch by the study, and declare their financial independence once their financial assets reach 25 times their sustainable annual expenses. For instance, if the current annual costs are $40,000, the required cash to be financially independent is $1 m.
This is how it goes: While the annual costs increase by the inflation rate each year for the retiree to sustain, investment returns exceed inflation rate by some margin. The assumption behind this is that the assets are invested to yield a real return of 7%, and therefore, a 4% withdrawal rate would almost never deplete their portfolio. The 3% difference is the cushion that protects the portfolio and even helps it grow.
The purpose of this post is to check whether the market's real returns are 7% in the long run. Let's assume that the retiree invests entire cash in the total market index of S&P-500. Here's the story:
The first thing to note is that returns without dividends reinvested are lower, mostly by about 2%. More importantly, the real returns are mostly lower than the expected return of 7% when dividends are not reinvested. That should affect the 4% rule significantly.
for today's early retiree
I have collected the 40-year period data to check the actual returns of the S&P-500. An early retiree usually will have 30 to 40 years of financially independent life. If one were to retire now, the past data suggests that if dividends were not reinvested, the real returns were lower than 7% during all of the past periods except from January 2013 to date. Even after dividends reinvested, there were 2 periods when the real returns were lower than 7%. In fact they were much lower 3.58% (from January 2000) and 5.12% (from January 1998). This is due to the dotcom buildup during 1998 to 2000. However, the past 5-year returns have been excellent; real returns exceeding 12%. This is mainly due to the financial crisis of 2008 which supplied much lower base to recover from. Which one of this we would like to expect on a more sustainable basis in the next say, 30 or 40 years?
for 2013 early retiree
For those who were looking to retire in 2013, the data is more interesting. None of the years showed more than 5.50% real returns before dividends. Even after dividends invested, the information is scary. Only on 3 occasions did the real returns exceed 7%. I am sure the aspiring retiree would have thought a bit before concluding that the markets would yield expected real returns of 7% in the subsequent 25, 30, 35, or 40 years. Past information did not much support this claim.
for 2008 early retiree
The story is not very different for the 2008 retiree. Even after dividends reinvestment, the real returns are far behind the expected 7%.
for 2003 early retiree
I wouldn't bet on the 7% for 2003 aspirant as well. The past actual real returns were not very comforting to conclude that the expected real returns were going to be 7%.
what to do then
I am not going to argue against 25 times number because the word early retiree is actually a misnomer. Nobody sits on the couch sucking thumbs during the financial independence years. That person is more likely going to be doing something of interest and passion which usually translates into money. So it is more likely that bills are going to be paid by the money earned through matters of fun rather than withdrawing from portfolio. Some take up part time work just so that bills can be paid. Most find ways to earn cash and not touch the portfolio. That makes sense.
Yet, my take on the required cash is a bit different. I like to assume a zero real rate of return on the portfolio. After that, the math is easier and is a function of annual costs and number of years. For annual costs of $40,000 and 40 (expected) years of financial independence, the required cash is $1.6 m. This is 60% higher than that is expected by the 4% rule, but more conservative and more certain to last.
I reckon the financial independence aspirants will be better served if they tone down their expected returns from the equity market index. In fact, when the allocation is between both equity and bonds, the expected returns fall much lower. Then the 7% real returns becomes a farce.
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