The motivation behind this is clear: Pick the right winners, and BIG returns will be yours!
There’s just one problem: Most fund managers, the very people who work with stocks every single day of their careers, can’t beat the long-term returns of simple index funds (famously paraphrased from Vanguard founder Jack Bogle).
So then if we can’t seek out greater returns, what should we put our energy into?
Yes, I know. What a dry topic, right? Make no mistake! When it comes to crafting a reliable retirement plan, knowing what works and what doesn’t can shave literally hundreds of thousands of dollars and years of saving off of your timeline. No joke!
Let me show you what I mean, and I think you’ll easily see why focusing on the mechanics (rather than trying to pick the next winning stock) is where you want to be!
Picking the Right Safe Withdrawal Rate
Have you ever heard of something called the 4 Percent Rule?
The 4 Percent Rule first came about in 1994 when the Journal of Financial Planning published an article from a then unknown financial planner from California named William Bengen.
At the time, all Bengen wanted to do was answer one very important question: What withdrawal rate should financial planners recommend to their clients that will give them the best odds of overcoming Sequence of Returns risk and lead to a successful retirement?
Using rolling periods of historical returns from 1926 onwards, Bengen was able to demonstrate that a safe withdrawal rate of 4 percent (with annual inflation adjustments) from a portfolio of 50/50 stocks and bonds would be successful for a minimum of 33 years.
The Trinity Study
A few years later, another article dubbed the Trinity Study made a similar conclusion about the 4 percent safe withdrawal rate.
In addition to inflation adjusted withdrawals, the Trinity Study also provided which withdrawal rates would work without inflation adjustment. In their 2011 update, they stated that a rate as high as 7.0 percent would work if you did not adjust for inflation. Although this is not directly useful, it does give us some indication that not adjusting every single year for inflation could improve the longevity and security of our funds.
Financial researcher Michael Kitces published a very intriguing study in 2008 that correlated withdrawal rates with market activity in the first 10-15 years of retirement. This was connected to an economic factor called the Shiller CAPE that could be used to reasonably forecast the market performance over the next two decades.
In terms of retirement planning, Kitces was able to show that in times when the Shiller CAPE is low, the market is under-valued. This means that retirees could safely use a withdrawal rate as high as 5.5 percent from their nest eggs; ultimately meaning you could save a lot less or possibly retire sooner.
How Knowing the Right Safe Withdrawal Rule Becomes Useful
Okay. So how exactly does a difference in the safe withdrawal rate of 4 or 5 percent translate into needing less for your nest egg?
Allow me to demonstrate ….
Let’s say you’re someone who is looking to create a passive income of $50,000 per year from your retirement savings. In order to make that happen, you could choose to follow the traditional 4 percent rule and see that you’d need to save up the following:
- $50,000 / 0.04 = a nest egg of $1,250,000
What if after looking deeper into the 4 Percent Rule and Trinity Study you see that these values are indeed quite safe, and you could actually stand to tolerate a little extra risk using a withdrawal rate of 4.5 percent instead? Now your savings drops to:
- $50,000 / 0.045 = a nest egg of $1,111,111
What if you could scale back your inflation adjustments (say until Social Security kicks in)? Or better yet, what if we time our retirement when the Shiller CAPE is low and the market is under-valued? If you got your rate all the way up 5.0 percent, then your savings target drops even lower:
- $50,000 / 0.05 = a nest egg of $1,000,000
That’s a spread of $250,000! Ask yourself: How long would it take you to save up that much extra money?
This is where knowledge becomes power! By taking in the facts and research of others, we’ve potentially put ourselves in a position to do a whole lot more with less, and get closer to the goal of financial freedom. That’s not a bad return on your effort!
Author bio: DJ is the author of the book “How Much Money Do I Really Need to Retire & Achieve Financial Independence?” and blogs at My Money Design. He feels very passionately about helping others find a way to achieve financial independence. Connect with DJ via Facebook or Twitter.
Featured image courtesy of Flickr