How to Retire Early (The 4% Rule?)

Nobody can predict the future, but stock valuations  matter a lot to expected future returns. In the 2019 edition of Aswath Damodaran's  annually updated paper Equity Risk Premiums, Determinants, Estimation and Implications  Damodaran demonstrated that the earnings yield   is the best predictor of the future equity  risk premium. Its still far from perfect, but it is the most reliable metric that we  have for forecasting future stock returns. The earnings yield can be found by taking the  inverse of the Shiller cyclically adjusted earnings. 

For example, if the Shiller CAPE for US  stocks is currently 29.71, we take one divided by 29.71 to find the earnings yield. This gives us a  result of 3.36%, which is the expected real return for US stocks. The geometric average real return  for US stocks from 1900 through 2019 was 6.5%. Interestingly, 6.5% is roughly what the historical  average Shiller CAPE ratio would predict. Think about that for a moment. We are looking back  at 119 years of data for US stocks during which the 4% withdrawal rate was sustainable, but over that period valuations were considerably lower, and the average historical returns that we see are commensurate with those lower valuations. 

Today's high stock valuations  forecast much lower future returns. Applying any historical analysis to  today's starting point does not make sense. Knowing the limitations of historical data due to currently high valuations, one approach to testing spending rules involves using current expected returns and simulating future periods using  Monte Carlo simulation. Monte Carlo involves randomly sampling returns from a defined distribution of potential outcomes. Using Monte Carlo for a 60-year period with current expected returns for a 100%   stock portfolio consisting of Canadian, US, and  International stocks, and ignoring taxes, I find a 2.5% safe withdrawal rate where safe means a 5%  chance of failure. This analysis is interesting for more than observing the safe withdrawal rate.  It also allows us to see the range of outcomes. 

In the worst 10% of outcomes our 60-year spending period left the investor with $1m adjusted for inflation, while in the best 10%, they were  left with around $30m adjusted for inflation. That massive range of outcomes  seems inefficient, and it is. In a 2008 paper titled The 4% Rule—At What  Price?, William Sharpe and two co-authors explain: Supporting a constant spending plan using a volatile investment policy is fundamentally flawed. A retiree using a 4% rule faces spending shortfalls when risky investments underperform, may accumulate wasted surpluses when they outperform, and in any case, could likely purchase exactly the same spending distributions more cheaply.

In simple terms, retirees who use a fixed spending rule from a portfolio of risky assets to fund their inflation-adjusted lifestyle needs are overpaying for the potential of investment gains that they do not need to meet their retirement income goals. More efficient solutions to this problem are mathematically dense and often involve complex financial products like options, leverage, and  annuities, but there are some spending rules out there that approach a more efficient solution without getting too complicated to implement. 

In a 2017 paper, Vanguard explained some potential approaches. The authors explain that there is a spectrum of spending rules that depend on the  preferences of the retiree. Constant spending rules like the 4% rule cater to the preference of spending stability while risking premature portfolio depletion or inefficient consumption. At the other extreme, spending a constant percentage of the portfolio each year results in no chance of depleting the portfolio and more efficient consumption, but it also results in potentially wild swings in the annual spending amount. The Vanguard paper suggests a middle ground  where spending is a percentage of the portfolio, but is only allowed to increase up to a ceiling or decrease down to a floor. The ceiling and floor can be tailored to the needs and preferences of any retiree, keeping in mind the trade-offs at each extreme. In their paper they use a 5% ceiling and a 2.5% floor. 

Keep in mind, though, that in bad markets there could be multiple years of spending reductions required to follow the rule. Finally, I think that one of the most important considerations for any early retiree is their ability to earn an income. That might  sound counterintuitive - are you really retired if you are still earning an income? If you are able to do something that you love and earn a little bit of income doing it, you are effectively  introducing a large safe asset to your portfolio.

This changes all of the retirement math -  maybe you only need a 2% withdrawal rate to supplement your earned income. Plus, work is important for humans! Martin Seligman's PERMA theory of well-being suggests that there are five building blocks... Positive Emotion, Engagement, Relationships, Meaning, and Accomplishment. Working at something that you love to do, even if it doesn't make a ton of money, is a great way to get engagement, meaning, and accomplishment. 

For early retirees, the 4% rule is not  useful. Based on a longer time period, global data, and current market valuations a more reasonable guideline might be closer to 2%, and even then, constant inflation adjusted spending is both risky and inefficient. Alternative spending strategies like Vanguard's dynamic approach might be part of the solution, but any early retiree should also keep in mind the possibility of finding ways to turn themselves into a safe asset by continuing to earn a bit of income.