When someone is facing the decision (whether of their own design or that of another’s) to retire, knowing the relationship between SWR and net worth-to-expenses is critical. This multiple is a function of your net worth (hard to change) and expenses (much easier to change than net worth).

The point is to be able to plan effectively, Evan.

Say that you have $1 million and are 60 years old and are interested in the idea of early retirement. Say that you need $70,000 per year to live the life you want to be able to live in retirement. Say that you have read that stocks provide an average long-term return of close to 7 percent. Going by that, you might hand in the resignation. A 7 percent return gives you $70,000 per year, which is what you need.

The Old School SWR studies (to their credit) showed that it doesn’t work this way. Because the 7 percent return is an average and does not apply each and every year, the only way to know whether you have enough to retire or not is to look at the worst-case scenario of the possible returns sequences and see whether you would be okay in those circumstances. This is where the infamous 4 percent rule comes from. A 4 percent withdrawal worked in the worst-case returns sequence that we have seen in the historical record.

I view the Old School studies as a huge advance. It was not too long ago that Peter Lynch was telling aspiring retirees that they could count on a plan calling for a 7 percent withdrawal working out. Scott Burns pointed out to Lynch that the Old School SWR research proved him wrong and Lynch apologized for the error.

I believe that we now face a situation where the Old School SWR authors themselves need to acknowledge an error. The Old School studies do not adjust for the valuation level that applies on the day the retirement begins. it is true that a 4 percent withdrawal is safe for retirements that begin at times of moderate valuations. But at times of high valuations, the SWR can drop to 2 percent and, at times of low valuations, it can rise to as high as 9 percent.

If retirees don’t invest in stocks, they don’t need SWR analysis. If you are invested in inflation-protected bonds, you know exactly how much your portfolio is going to throw off and can count of living on that amount for your entire retirement. It is the volatility of stocks that causes the confusion and the planning difficulty. The purpose of SWR analysis is to make retirement planning efforts more effective.

It is my strongly held view that the Old School studies fail to do what they set out to do. These are dangerous studies because they give retirees a false confidence that things that are very unlikely to happen are almost certain to happen. But I think that the idea of SWR analysis is a wonderful advance. Telling people that 4 percent is always safe is wrong but it is whole big bunch better than telling people that 7 percent is always safe. So I do think it can fairly be said that things are moving in the right direction. We are learning more about the realities of stock investing and retirement planning over time and that is of course a good thing.

Rob

If you need $100K to live does it matter whether that is 3 or 4% of your investment portfolio?

Any more, and people are kidding themselves over the long run.

We have embedded this in our web application, but we are partnered with Money Tree Software (www.moneytree.com). They have a tool where you basically input your retirement assets, set your likely spending bumpers (90% to 125% of projected income), your portfolio’s historical standard deviation rate, and the number of years you plan to draw down the portfolio. It spits out a percentage likelihood of your nest egg surviving the variations in the market, inflation, and spending.

Also, I see Rob has added his SWR calculator as well. If someone is nearing retirement and concerned about withdrawal rates, I highly suggest using a monte carlo analysis to figure it all out. Often the analysis can tell you if your investment allocation is too aggressive or conservative as well.

@Dan – funny you mention purgatory for 1 and 2 star funds. A study completed several years back found that 1 and 2 star funds were unlikely to make it out of the 1 and 2 star categories. In other words, avoid them because purgatory actually does exist for these poor souls.

Calculating the number correctly makes a big difference. The Old School studies claim that the SWR is always 4 percent for a high-stock-allocation portfolio. The New School studies show that the SWR can drop to 2 percent at times of high valuations and rise to 9 percent at times of low valuations. There will be millions of middle-class Americans who will suffer failed retirements because of the demonstrably false claim made in the Old School studies (not one of these studies has been corrected in the seven years since the errors in them were publicly revealed).

John Walter Russell and I co-developed the only accurate SWR calculator available today on the internet, The Retirement Risk Evaluator. It puts the SWR for those retiring today with a high stock allocation at 4.1 percent.

Rob

So I wonder – you gave the 4% withdrawal rule of thumb. Would you follow the 4% rule, yourself? Or are you intending to have a nest egg you don’t touch until late in retirement.

I intentionally tried not to get too specific, because what’s right for one person could be totally wrong for another (allocation-wise). If you’re looking for a great read on asset allocation to help you narrow down your choices, I recommend The Intelligent Asset Allocator by William Bernstein.

And he’s right about small changes in return making a large difference in your nest egg. I wrote a post about how big the difference can be: http://bit.ly/7eDhN

Points for addressing the mutual fund management fee issue. But you used the adjectives “high quality” and “low cost” to describe funds we should by. What, pray tell, is a high quality fund? Today’s 4 and 5 star rated funds could be tomorrows dogs. Does 1 or 2 stars sentence a fund to permanent mutual fund pergatory?

Sorry if I seem a bit demanding, but the articles that mean the most to me (and keep me reading) are actionable plans. And I can’t take action if I have no idea what a high-quality fund is.