I was recently talking with a couple who had significant wealth from a successful IPO a few years ago. (Ahhhh, those were the days.)
I asked them to finish this sentence: “The role of money in my life is to…” One of them said “provide flexibility.”
And I found it fitting that what this client wants of their money is the exact same thing that their money needs from them: Flexibility. The ability to adapt to new circumstances.
In the absence of certainty and predictability, flexibility is your most useful tool for, in general, living life successfully, and in specific, ensuring that your IPO wealth can last you the rest of your life.
Why I’m Thinking About This So Much Nowadays
This year I’ve been pursuing a new professional designation: the Retirement Income Certified Professional® (RICP®, which until very recently I would describe as the “Retirement Income Something Something”). It’s largely targeted at advising clients at a more-traditional retirement age of 65-ish.
So why am I, a planner who works with clients generally in their 30s and 40s, taking it? Well, I have a more thorough blog post percolating for when I finally get the designation. For today’s purposes, this answer is enough:
Many of our clients have achieved financial independence through tech IPOs, and many are, as a result, “retired.” At least for the nonce. I want to know: What tools used for traditional-age retirees can be adapted for use for much younger retirees, whose wealth needs to last decades longer?
As I learn more about serving these 65+ year olds, it’s giving me an even healthier appreciation for the size and shape of the challenge for people who “retire” way earlier.
There are many good, useful strategies and products to use. Some are relevant in some circumstances, not in others. Some are in conflict with other strategies and products. The one constant is the need for flexibility. And the longer the time frame, the bigger the need for it.
4% Withdrawal Rate: A Good Starting Point. A Horrible Ending Point.
Much of modern financial planning, especially retirement planning, can be tied back to a single research paper in the early 1990s, by a man named William Bengen.
Looking at historical data, he concluded that, for even the worst 30 year period of retirement in the 20th century, in the US, you could have started your retirement by withdrawing 4% of your investment portfolio in Year 1, then adjusted that dollar amount withdrawal upwards with inflation each subsequent year, and you would still have money left in your portfolio at the end of 30 years. It is a Worst Case Scenario calculation.
For example, if your portfolio is $1M, in year one you can withdraw $40,000. In Year 2, if inflation is 3%, you can withdraw $41,200. And so on.
There’s a lot of detailed academic work here, which I have no desire to reference here, for both our sakes. For our purposes today, all you need to know is that for a long time “You can withdraw 4% of your portfolio every year!” has been the byword of “how to live forever off your portfolio.” The ur-FIRE guy, Mr. Money Mustache, talked a lot about the 4% “rule.” (It’s not a rule. It’s a study of historical data.)
I think it’s a great number to have around to start grappling with the ballpark value of the portfolio you need in order to live off of it, assuming you know how much you’ll spend each year. It’s also great to start understanding ballpark how much you can spend each year, given the size of your current portfolio.
But that specific 4%? It’s not a mathematical theorem, rigorously proven. It’s a conclusion drawn from historical data.
All it “proves” is that had you:
- retired in the 20th century (in fact, during the portion of the 20th century that the original research paper covers)
- lived in the US
- invested your portfolio half in US stock (the S&P 500 to be exact) and half in bonds (intermediate term Treasury bonds to be exact)
then you could have withdrawn up to 4% of your portfolio (adjusting for inflation each year) each year, and your money would have lasted.
It proves nothing about any other time frame (including the future we’re all trying to plan for), any other country, and any other way of investing your money.
That 4% also didn’t take into account the drag that taxes or investment fees would have on the growth of the portfolio, and therefore the reduction in the safe withdrawal rate. (The RICP program says that for a 1% investment fee, the safe withdrawal rate is reduced by ⅓%, so, for example, from 4% to 3 ⅔%. The tax drag depends on which kind of accounts you’re taking money out of: taxable, tax-deferred, or Roth.)
It’s a useful and interesting framework for evaluating things, for sure! And boy did it kickstart a huge, ongoing trend of research and professional development around safe withdrawal rates (also safe spending rates). But its direct usefulness to individual people has been oversold or misunderstood. (I’m not being contrarian here. Many good financial advisors say the same thing and did long before I did.)
There Is Simply Too Much Life (An Abundance of Life!) Left When You’re In Your 30s and 40s.
Perhaps the most glaring way in which the 4% rule/finding/whatsit doesn’t apply to our clients is that our clients have a waaaaaay longer time frame than 30 years. I mean, we’re literally talking well over half a century we’re planning for.
Research presented by the RICP suggests that for every decade longer than 30 years you want to live off your portfolio, you need to subtract 0.5% from the safe withdrawal rate. They explicitly discuss a 40 year timeframe.
But if we can extrapolate further, if you want to live off your portfolio for 60 years, then the 4% falls to a 2.5% safe withdrawal rate. There’s clearly a limit to this effect (because eventually you get to a 0% withdrawal rate, and that’s silly). But this is part of our challenge: there simply is so little information out there about making portfolios last for that long! It’s not a solved problem!
A withdrawal rate that low can make even a $10M portfolio look not that amazing. That’s a $250,000/year withdrawal. Nothing to sneeze at certainly, but meaningfully less than many of our clients earn from their jobs in tech.
So, not only is that 2.5% pretty damn low, but also:
THAT’S SIXTY YEARS!
I just don’t see how anyone can be 40 and rely on never having to work again. Life happens a lot. Marriage and kids and grandkids college and vacations and new jobs and accidents and health scares and deaths and moving and house buying and and and.
Not to mention what can happen in 60 years in the country and economy: wars and hyperinflation and fuel shortages and booming economies and health pandemics and soaring stock markets and terrifying real estate crashes and have you seen the insane weather and natural events in this country lately?
You Have to Be Able to Adjust Your Spending Levels (and Probably Everything Else).
So if everything is unpredictable, what do you do?
I still think, in general, especially when you’re so young, living off a low-percentage withdrawal rate (lower than 4%) of your portfolio is a reasonable place to start.
But then you gotta, you know, do that “bending with the wind” thing.
The Impact of Investment Performance on Your Ability to Spend
If you find that the markets are kind to you over the years, then sure, that gives you a bit more ability to take money out of your portfolio. If the markets are bad over several years (as the last couple years have been), then you’d do yourself a huge favor if you withdrew less this year. Lower withdrawals means lower spending. Is it necessary? Only time will tell.
Even in a more typical 30-year retirement timeframe, your ability to spend can be volatile, because your ability to take money safely out of your portfolio is. (Here’s a nerdy paper from Morningstar [in a .pdf] about this.) There are many ways to address this, but in almost every way, you will have more money to spend in some years, and less in other years. And the more able you are to adjust your spending down in tough years, the more you can spend more in other years and overall.
One way to ease the challenge of reducing your spending (which yikes, can be hard! We get so accustomed to spending what we spend) is to put expenses into two categories: essentials and discretionary. Identify some discretionary expenses that, yes, you might like, but can be easily eliminated in “down” spending years. This is, of course, entirely personal, but some examples are taking one fewer vacation this year, buying a cheaper car, or delaying that home remodel.
You’re 40. You’re Gonna Get So Booooored.
If you’re 40 (or 30 or 50), it’s basically impossible that you will never earn income again. At least, not if you’re like our clients. Even if they’re not working now, they’re too educated, too experienced, too interested in being productive and getting involved in interesting projects and engaging with co-workers to forevermore not work. And when you’re working, you can live on that income instead of off your portfolio.
(Technically, it might be smart tax-wise to live off of money you take from your portfolio while shoveling your salary into a 401(k) or IRA or other workplace tax-advantaged retirement plans.)
Continuing to work and earn money gives you so much more flexibility.
Some clients will use their salary to generally reduce the amount they need to withdraw from their portfolios, so that their withdrawal rate is closer to, say, 2%, a very conservative rate.
Others use a bit of “mental accounting” and choose to pay for their “normal” lives with their salaries and use their portfolio only for special expenses.
Change Usually Doesn’t Happen Overnight. You’ll Have Time to Adjust.
Rarely is a change going to occur like the Covid-19 pandemic did: One day we’re walking around our town, bumping elbows with neighbors, and the literal next day we’re all trapped in our homes not allowed to go to public places.
I believe that most changes, even if big, will give us time to adjust. This is why revisiting your plan every year or so is so important. You don’t have to be hypervigilant (she says from the safety of her suburban home in the United States), but you have to be somewhat vigilant.
If you’re in your 30s, 40s, hell, 20s, and have come into millions of dollars through an IPO, obviously, congratulations! Despite what it might feel like if you live in a place like the Bay Area, this is rare and amazing.
This money can give you tremendous flexibility and choice in your life. What it asks of you, poetically, is that you be flexible with your money, especially how much you take out of your portfolio.
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