Are you sitting down? Yes, then good. If not, you might want to pull up a chair. I’ve got a confession to make. You know that 4% safe withdrawal rate that me and other early retirement bloggers go on and on about, which is suppose to be the amount you can safely pull out each year and not run out of cash over a 30 year time frame. Well it turns out that most of the assumptions used to model that don’t really apply in real life (for full details, you can read this long, but excellent article). The real truth of the matter is that a ‘safe withdrawal rate’ isn’t a constant at all but rather another variable.
What?!?! Then how do you model that into your retirement plans? Simple, you can’t. Depending on the situation your ‘safe withdrawal rate’ can range anywhere from 1.8% to 25%. This all depends on several factors like the amount of fees you pay on your investments, the rate of return on your investments and the sequence of those returns, and your personal rate of inflation. In a nut shell you can’t model it yourself because it becomes a circular reference, which you might be familiar with that error if you have ever had to do complex modeling in Excel. In a nut shell you series of references to other variable results in your last object referring back to your first object, you end up with a closed loop that can’t be solved.
So if you can’t model it why are you telling me about it? Ah, that is the right question. I mention this fact because in reality, when you are actually living on your savings in your early retirement period you shouldn’t have a constant withdrawal rate. Instead you should ramp it up and down depending on those factors I already mentioned. So in today’s current context with low returns, low interest rates and slightly higher inflation you should consider lowering your withdrawal amount below 4%. Then when you hit some good years like those leading up to 2008, you can take an extra vacation if you want.
This really isn’t that hard as people already do this in real life prior to retirement. If you lose a job, your spending doesn’t keep going out at the same level. You adjust your spending to your lower income as much as you can to ride out the bad times until your income level comes back up. Yet doing this requires you to have some fat in your budget to cut back on, if you purely rely on cutting back spending. The other alternative is to increase your income by getting some short term work or selling a non-income producing asset such as your vacation property.
So the lesson in all of this is you don’t want to retire early on the absolute lowest point of your spending, you want to in fact have a bit of fat or safety margin in your plans. This is somewhat obvious risk planning, but you might be surprised how often the obvious isn’t really seen by people. So please have a few backup plans when you retire early including some extras in your budget. That way you can cut back during the lean times if you need to.