Dreaming of Retirement

I recently found myself on a beach in Maui. We had some airline vouchers we needed to use before they expired and decided Hawaii would be a great way to burn them (it was). As I laid there on the warm sand and listened to the ocean waves gently breaking on the shoreline my thoughts drifted to retirement.

 

‘It sure would be nice to do this full time.’ I thought to myself.

 

This happens to me every time I lie on warm beaches anywhere. Now when most people dream of early retirement they dream about all the wonderful things they will do, all the places they will travel to, or how their golf game will finally become respectable. I am not most people. My demented, slightly geeky brain did what is only logical in this situation, and that is to perseverate about the philosophical and probabilistic limits of the 4% rule in early retirement…

 

Wait…what?

 

First a little background. Maybe you don’t even know what the 4% rule is. Many interested in early retirement or financial independence are familiar with the 4% rule, or have at least heard about it in passing. I didn’t learn about this critical tool until my mid 30’s so don’t feel bad if you don’t know about it.

 

This guy, William P. Bengem, a financial planner probably as geeky as me, first articulated this rule of thumb in 1994 with his very sexy sounding article titled Determining Withdrawal Rates Using Historical Data.

 

Using a portfolio of somewhere between 50/50 and 75/25 stocks and intermediate treasuries he came to the following conclusion:

 

Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe.

 

Basically your money should last at least 30 years if you only spend 4% of it each year (inflation adjusted).

 

Four years later in 1998, the Trinity study (written by three dudes over at Trinity University) confirmed this. By back testing a variety of asset allocations, they came to essentially the same conclusion (although they used high quality corporate bonds instead of treasuries).

 

There have been tweaks and reexamination of the 4% rule since these initial studies with more asset classes added and tested, but more or less the rule is accepted by most as pretty solid. There are countless online explanations and discussions of the 4% rule if you are interested. My favorite one is here.

 

Here are a couple of ways to look at the 4% rule if you are having trouble wrapping your head around it.

 

• For every 40k/yr you want to spend in retirement you need 1 million dollars (40k is 4% of a million)

• If you multiply your desired spending by 25, this is the asset base you need. (eg. 55,000 x 25 = $1,375,000).

 

NOTE: The 4% rule does NOT include investment costs (ie: fund expense ratios or fees paid to a financial planner.) These need to be taken into account.

 

Every FIRE (financial independence early retirement) blog I’ve read uses the 4% rule as a basis for planning. To question it is considered heresy by some. Some even think it is too conservative because most of the time you can actually withdrawal more than 4% and be just fine. Although the 4% rule is a decent place to start, there are some serious flaws and limitations to be considered. I don’t see these discussed much in the FIRE community but they are important. Although these problems are mildly important in conventional retirement, I feel they are especially important to the early retirement community.

Efficiency

Efficiency is a great thing. It’s beautiful actually. It drives innovation and is a force multiplier in our lives. Many people seeking early financial independence achieve it primarily through efficiency.  The opposite of efficiency is wasteful, and no one wants that. Another term for this is frugality.

 

There are many examples of people who retired early simply because they could live a great life on a fraction of what the average person can. Combining this with an above average income it is almost impossible not to achieve financial independence earlier than most.

 

They may use spreadsheets to track their spending and waste nothing. They scour the internet for the cheapest cell phone plan and have grocery shopping down to the lowest cost per calorie possible. They travel hack everything using credit card points and frequent flyer miles to take incredibly cheap vacations. They may live in an extremely low tax environment and have found out how to maximize the tax code to their advantage.

 

Their life is designed around efficiency. Some are living a lifestyle spending 30k/yr that is more or less equivalent to someone much less efficient (ie: a typical average person) spending 2 or 3 times as much.

 

This is a great thing to do with your life and my hats off to these who can do this well. The more efficient you are with your limited resources the more you can have in life. Money is time and freedom. The less money we require the freer we become.

 

Unfortunately at very high income levels I see many people become incredibly inefficient with their money. As money becomes less scarce it is not treated with the same respect and it is often wasted. It is a little painful to watch, especially if they are not happy with their jobs.

 

For every dollar that we don’t spend on an excessive phone bill or unnecessary gadget is a dollar that we can spend on something else we truly want in life, but there is a dark side to being so efficient. Once you maximize efficiency everywhere where do you cut spending when you need to?

 

If everything is optimized then, by default, it is a more vulnerable system. If you are paying the absolute lowest cost for everything then you are more vulnerable to inevitable cost inflation. It becomes more difficult to substitute for lower cost alternatives when you are already using the lowest cost alternatives.

 

If there is an unexpected increase in a cost you have little control over (property taxes, health insurance, electricity, etc.) there are simply fewer places to offset these costs when life is already at maximum efficiency. Everything becomes a point of potential stress on the system as a whole.

 

If you pay $10 a month for cell phone service instead of $100 this is fantastic, but when you are on the $60 a month plan you can always cut to the $10 plan and $1080 magically appears in your bank account each year. At $10 even throwing away your phone and cancelling service only saves you $120 (and I know you can’t live without your cell phone).

 

Now I’m not advocating less efficiency or more expensive cell phone plans when cheaper ones are available, but I am saying the 4% rule has a greater chance to inadvertently become the 4.5% rule or 5% rule if your spending needs increase unexpectedly and you can’t find fat to cut elsewhere from your budget. Increasing spending as a percentage of assets will absolutely increase the failure rate.

 

If you are planning an early retirement with maximum efficiency/frugality I would caution against relying on a 4% withdrawal rate, not because the math is faulty, but there are simply too many things that can go wrong such as:

 

Health

Health is everything. As I write this I’m a bit under the weather. Last night I think I sweat out about 5 pounds of water while whatever horrible virus I have savagely attacked my immune system. Having shaking chills and being scalding hot at the same time is quite miserable. At least the skull crushing headache is gone now. Over my life I have overall enjoyed pretty good health, but there have been times where it has not been optimal.

 

I won’t bore you with the details but life is just harder and more expensive when you don’t feel well. All that efficiency goes out the window when you have severe pain or are debilitated by illness. It’s tough to not get depressed when your health is suffering and depressed people sometimes have difficulty being frugal and efficient. Many things you once did yourself in good health you may now need to outsource (pay for) while in poor health.

 

Being healthy is cheap, but healthcare is insanely expensive.

 

That bare bones, narrow network, high deductible catastrophic plan you are planning on getting in early retirement will absolutely destroy you if you develop an expensive chronic medical condition, or if multiple family members require medical care over a multiyear stretch. Health insurance works great when you are healthy. I’ve noticed many in the early retirement blogosphere are in perfect health and in their 30’s or early 40’s. They don’t worry about their health because they have never experienced poor health.

 

There is selection bias here. This is great, and I wish them a long and healthy life, but just be warned that health care becomes a big expense for many people in their late 40’s and 50’s, even for people that live very healthy lifestyles. Just because you are not a chain smoking, alcoholic, morbidly obese diabetic doesn’t mean you will not have significant health problems as you age. Vegans that do yoga and CrossFit every day still get cancer, have heart attacks and develop expensive, weird autoimmune disorders.

 

If you are living a life of maximum efficiency at 30k/yr it may be a shock when your medical expenses jump from $100 to $10,000 per year. This is not hyperbole; I’ve seen this happen to lots of people. Our health care system is great if you are extremely poor or extremely rich, and awful if you are in the middle with crappy health insurance (from an expense metric, not quality).

 

I know a few will roll their eyes and say they will just move to another country where they can get good health care for pennies on the dollar or some other such scheme, but this is easy to proclaim when you are healthy. It’s tougher to put into practice when you are really sick. When you are truly sick you just go to the doctor and beg them to fix you. This is a hard thing for someone who has not really been sick to understand.

 

As you age you will be hit with two terrible health care economic realities:

 

1. You will probably require more health care and spend more money on it.
2. Health insurance will become more expensive with costs rising much faster than inflation.

 

The 4% rule doesn’t really care about this or take it into account. Remember it is usually employed by people at normal retirement age most likely getting ready to jump on Medicare. It assumes spending growth exactly equal to inflation. If your spending inflates faster it falls apart, and it can go into a death spiral faster than that cheap health insurance you just bought.

 

The ACA beautifully addressed some of the economic issues with health care in early retirement mainly through the subsidies and cost sharing, but it is likely these will be heavily modified or eliminated during the next administration. If health insurance is a big percentage of your retirement spending it may even push people back into the work force in worst case scenarios.

 

It doesn’t take much to amass big medical costs as I found out earlier this year. A trip to the ER with an x-ray and a few stitches was several thousand dollars out of pocket using my high deductible HSA insurance. To add insult to injury the ER doc who saw us was not contracted with our insurance company for some reason so I got a $700 bill from her while my insurance company only applied about $400 to my deductible (effectively increasing my annual family deductible by $300).

 

This evil practice is called balance billing, and depending on the composition of your in-network providers you may see a fair bit of this. It has the nasty side effect of dramatically increasing your out of pocket costs above your deductible. If I was on Medicaid I’m guessing this trip to the ER would have been completely covered. Again, health care is great if you are really poor, really rich, or you have great insurance (this is becoming rare). Everyone else gets screwed.

 

Just in case you don’t believe me I went over to Healthcare.gov and plugged in some numbers to see what health insurance would cost a married couple near me with no kids at various ages. The only variable I changed was the ages. The results should alarm the early 30’s 4% rule early retirement crowd.

Age of married couple	Monthly premium ($)	Annual premium ($)
30	674	8088
40	760	9120
50	1060	12720
60	1612	19344

 

Let’s assume 40k/yr spending and a post ACA world with no subsidies (I know, maybe not probable, but within the realm of possibility). I picked a middle of the road silver plan with a $5,000 annual deductible. At age 30 insurance will cost $8088/yr or about 20% of annual spending; pretty freaking high but maybe manageable. At age 60 premiums increase to $19,344 or 48%! This is not manageable as it does not even include the $5000/yr deductible that you will more likely be spending a greater percentage of at age 60 than 30 anyways! Your spending on all other items will have to decrease from $31,912 to $20,656.

 

If you are already living with maximum efficiency how the F%^$ are you going to live off of 35% less income when you are 60? Hopefully you didn’t run into a problem with sequence of returns risk (poor portfolio performance in the early years of your retirement). You are either eating cat food, working at Walmart as a greeter or clinically depressed and cursing all those “the 4% rule can never fail” blogs you read when you were in your 30’s. Maybe all three. Actually, come to think of it, I haven’t seen a greeter the last few times I’ve been in a Walmart so maybe that isn’t an option anymore.

 

These numbers will look even worse in the future if health care costs increase more than general inflation (although I can’t see how that is sustainable long term). Bottom line is that health care is a real problem in the United States for people that want to retire early or call themselves financially independent. It is a risk that is difficult to hedge against. One would be wise to keep this in mind and not dismiss it. I guess an option is to drastically lower taxable income, live super frugal and go on Medicaid (assuming it is not dismantled in the next 4 years), but this option will not appeal to or be feasible for many people. Furthermore, if your income is too high you will not qualify for Medicaid anyways.

 

 

Divorce

Nobody wants to talk about this, but about 41% of first marriages end in divorce. It is 60% and 73% for second and third marriages respectively, in case you were wondering. Divorce can be a financial weapon of mass destruction. No one thinks it will happen to them, but it is too common of an event to completely dismiss no matter how happily married you are.

 

The good news is divorce seemed to peak in the 1970’s and early 1980’s, perhaps related to the feminist movement that had long lasting structural impacts on society. As women gained more economic freedom, the traditional model and reasons for marriage were disrupted. People now are marrying later in life, and probably for slightly different reasons. Traditional rolls are not as clear as they once were. I’m not going to argue whether these are good or bad, but it seems to be having a stabilizing effect on marriage, as the divorce rate is declining whereas the freedom to get divorced is probably increasing.

 

It is worth the thought experiment to examine what you would do economically if you found yourself divorced tomorrow with a suitcase and 50% of your assets. For some, they would be in a better economic position, but most would be in a tough spot. Most of my friends that went through divorce did not come out the other side in a financially better position.

 

Marriage is usually financially efficient, especially when spouses are on the same page and have the same financial values. I can tell you this; if you were planning on living on $40k as a couple it is unlikely you will be happy living on $20k as a single. Throw a couple kids into the mix and things get complicated and expensive really fast.

 

I’m not saying you should keep working in a job you hate on the off chance you will become divorced, but there are a lot of people sitting in bars all around the world looking at the bottom of a beer mug wondering what went wrong. The stone cold truth is that people change. The person you are at 40 or 55 is probably pretty different than the person at 25 that got married. Multiply that by two people, add in human nature and you have a probability of failure that is greater than zero.

 

Kids

Speaking of kids, they are not free. If you are a 32 year old DINK couple and planning on retirement in a couple years because you read a cool blog and they told you kids don’t cost anything, they are lying to you. Yes, it is possible to spend very little on kids, people on limited income do it all the time, but in reality part of the fun stuff in my life is being able to provide cool things for my kids to do and see.

 

Plane tickets are twice as much for a family of 4 than a family of 2, but I don’t want to stop traveling. The club sports and music lessons are also expensive. I don’t have to pay for them and I wouldn’t if I had very limited resources, but I do because it brings me happiness. You can go bare bones expenses with kids, many people do and are completely happy, but budget appropriately and don’t be surprised if they cost more than you think they will.

 

 

Lifestyle inflation

Most retirement studies show that spending slowly decreases over time in retirement and overall this is good news to those relying on the 4% rule, but all of these studies assume a conventional retirement age at around 60 or 65. If we look at demographic spending over the entire population we see that our peak spending years are between 45-54, with 35-44 not far behind. When most people need the 4% rule to work their spending is already on a naturally decreasing glide path.

What this means is that if you retire early and it is based on your spending patterns in your late 20’s and early 30’s, you may not be accounting for the natural inflation in spending that normally will happen as you enter peak spending years from ages 35-54. As you fight this natural uptick in spending what would normally feel like healthy frugality may instead feel like deprivation.

 

The 4% rule must account for this increase in spending to make sure it is robust enough to withstand time. Of course this will not affect everyone, but it affects enough people to make a nice pretty bar graph with striking differences in spending by age.

 

Additionally, I want you to go re-read the above paragraph on health insurance. That graph does include the cost of health insurance, but when I dug into the data there was only about a $1500 difference between the 25-34 and 55-64 cohorts. This is much different than the over $11,000 difference I observed comparing the unsubsidized cost of a silver ACA plan at age 30 and 60. This is likely due to the fact that most of these people are either working (and their health insurance is being heavily subsidized by their employer), on Medicaid (not paying premiums) or are buying lower quality insurance as they age because they cannot afford it. The true cost of health insurance for an early retiree is hidden and excluded from this data.

 

 

I’ll just go back to work

This is the default position of every article I read regarding portfolio failure, and I think every early retiree has to consider this a non-zero possibility. For many this would not be a significant problem, but there are some factors to consider here. If your portfolio is failing the 4% rule it is doing so either because of one or more disasters in your life (divorce, health problem, poor investment strategies, massive unexpected costs), or a disaster in the general economy (major recession or depression, war, etc.). In both of these scenario categories it may be impossible or extremely difficult to:

 

1. Find work or

2. Actually do work

 

If you suffer a traumatic head injury requiring ongoing medical treatment and physical therapy it is unlikely you will be able to find meaningful work. When the unemployment rate is 12% and the stock market just fell 51% it is unlikely a 55 year old who has been out of the workforce for 10 years is going to be the first or even 100^th pick for a given job opening. When bad things are correlated they have compounding effects and this can be devastating. Just when your need to generate income is at its highest your ability to do it may be at its lowest.

 

For someone in a highly specialized, high barrier-to-entry field, it may be very difficult to actually get back into that field. My guess is that it would be very difficult for a physician, lawyer or software developer to get hired in their field after being out of the workforce for 20 years. There is age discrimination in many industries, and this may be a big factor in one’s decision to leave the workforce.

 

Thanks for destroying my hopes and dreams

By this point you are probably a little depressed. This is understandable so let me cheer you up a bit. The 4% rule is still a good rule regardless of its flaws. First of all, the 4% rule is designed to work for 30 years in all economic scenarios regardless of when you retire if you follow it’s rules. In order for it to fail, you have to retire in a year that has been worse than every other year in modern history. If you are retiring at or beyond traditional retirement age with less than 30 years of life expectancy with social security and Medicare in reach I would consider the 4% rule pretty much bulletproof. Additionally, in most years of retirement the 4% rule is actually too conservative. Most of the time you will end up with far more money than you need.

 

Also the 4% rule does not take into account money from:

 

1. Social security income.

2. Pension income.

3. Inheritance or gifts.

4. Additional income through part time work or side projects.

5. Income producing real estate.

 

It is pretty unlikely that someone who retires early will not have one or more of these sources of money at some point in the future.

 

Nor does it take into account decreased spending due to:

 

1. Paid off mortgage.

2. Downsizing.

3. Decreased expenses related to kids.

 

The point being, there are variables in your life that will alter the probability you will stick to your inflation adjusted 4% both positively and negatively. Relying blindly on a rule of thumb to apply to your life is unwise as it will play out differently for each of us.

 

 

In order to save the village we had to destroy it

There is somewhat of a paradox regarding the issue of efficiency I want to touch on. Please excuse the tangent. Although being more efficient creates a lower margin of error in some ways I discussed above, it opens up many more possibilities of making a side income that will actually matter to you.

 

Someone who can live off 30k per year can go earn 15k per year and increase their income by 50%, whereas if you are at a baseline spending of 100k/yr this is only a 15% increase. The absolute dollar amount is the same, but the impact felt will be much greater for the person living off a lower income. Nearly anyone able to work can find a job that pays 15k/yr if needed, regardless of their background.

 

As is usual though, it is more about the psychology than the math. I think it is much more psychologically challenging for someone in a high paying former career to go back to a lower paying, and most likely entry level job, often times with a much lower level of autonomy than in their former career. When you were making $400k/yr as an intellectual property lawyer it may be a bitter pill to find your skillset obsolete and have to take a job that pays 10X less in your mid 60’s.

 

As I ponder the 4% rule for myself I am acutely aware that there is absolutely nothing I can do with my time that will guarantee me more money per hour than what I do right now without taking a tremendous amount of risk or getting very lucky. Once I am out of the workforce for a decade or two, I can’t reenter as a physician for all practical purposes. This is my chance to build up my war chest, so I have to be sure there is enough there before I drop everything to go surf full time in Hawaii.

 

I have to make sure my plan is robust enough to withstand at least one or more of the following: major medical disaster, drastic increase health insurance costs, some lifestyle inflation or a divorce. In fact, I have already seen mild lifestyle inflation seep into my life over the last 5 years (as long as I have been accurately tracking my spending).

 

Now that I am working part-time I have more flexibility and time to travel. We bought a car and did some house renovations which I did not account for in initial retirement planning. Of course I cannot design a plan that will survive every disaster because life is just too unpredictable.

 

If I plan for everything then I just have to keep working forever, and that is not what I want to do. I can’t let fear rule my life, but I would rather work a bit longer now than have to go back to work when I’m 60. Maybe I’ll want to work anyways at that age because I’m bored, but I want the absolute freedom to make that choice for myself.

 

My approach

I won’t tell you what to do, but I will share with you how I am approaching this situation. I simply changed the 4% rule to the 3% rule. This is completely arbitrary, but it gives me a 25% cushion. It gives me peace and quiets my constantly worrying mind. I will give you some arbitrary made-up numbers to ponder to see how this could affect someone.

 

Example

Let’s say I want to live on $40,000/year and my current net income after taxes is $80,000. Using the 4% rule I would need an asset base of $1,000,000. Using the 3% rule I would need $1,333,333 or an extra $333,333. This sounds like a lot, but it is not really as big of a burden as you may think for a high level saver. Since I would be saving $40,000/yr (because no rational person who wanted to retire early would save less than 50% of their income at this level) how many more years would I have to work? If we assume a 7% return and 3% inflation it’s about four more years of work (actually I would need a base of about $1,500,000 four years in the future because the $40,000/yr spending would have increased to $45,000/yr with inflation).

 

Yikes! 4 years of work is a big price to pay for such safety, but there is an upside. First I can quit any time during those 4 years if my risk tolerance or assessment changes. Second, if I am too safe the penalty is I work an extra 4 years, but the reward is now I have a big pile of assets at my disposal. If I aim for 3%, but the 4% rule would have worked I will end up with more money than I can spend. This is a pretty great problem to have.

 

Some consider this a failure because they worked too long, but I don’t see it this way. You can decide to either give it away to causes that are meaningful to you, or you can spend it on luxuries that were considered out of your reach. You can buy mosquito nets for destitute people in malaria infected areas, have a room named after you in that new cancer center the hospital is raising money for or blow it all on exotic cars, strippers and cocaine – whatever makes you happy.

 

The 4% rule is designed for a theoretical life. It is an academic construct. It is not a study where they took large cohorts of real people and followed them through retirement as they lived off of 4% of their assets to see what happened. It doesn’t take into account the messiness of life whether that is accidents, mistakes or tragedy. Behavior is usually what causes failure, not math. For early retirement all we have are a few case studies that are incomplete at this point. I haven’t stumbled upon many blogs or articles that have a real stress test thrown in there. If you find them show them to me. Just be clear on what the 4% rule is, and what it is not.

 

Regardless of what you decide to do, building margins of safety into your plans is always a good idea. Have alternate ways to make money if needed. Develop multiple streams of income. Have ways to cut spending if needed. Be extra cautious if retiring during periods of time where market valuations are extremely high, or interest rates extremely low. Keep adjusting your plans to changes in tax and health care law.

 

The 4% rule is a great place to start, and it will work the vast majority of the time if you follow the set of assumptions it is based upon, but realize its limitations for your personal situation and be flexible. There is a real cost to being more cautious and only you can decide if it is worth it.

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*When applying the 4% rule you also need to take into account state and federal taxes. Although many people account for property tax because it is wrapped up in their mortgage payment many people do not account for state and federal taxes when planning. These will likely be lower for the early retiree but will be heavily dependent on where you withdrawal money from in retirement (traditional IRA’s, Roth, non-qualified accounts, etc.), how much you are realizing as income and the tax code of the state you live in. These are real costs that will have to be considered. The good news is the federal tax code is currently very favorable to the low spending early retiree and using the proper tools one can get their income pretty high with negligible federal tax. Don’t feel guilty; you have likely already paid significant tax on this money, especially if you were a high income W2 earner in your pre-retirement life. The bad news is if you live in a state with high state income tax this will probably be a significant expense regardless of your income. There are a handful of states with average income tax rates over 9%!

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