Don't make the 4% error
by Doug Brodie
In this blog:
/1. How was the 4% Rule calculated?
/2. How not to get lost
/3. Don’t drive your lifetime savings without accurate navigation
/4. Hey Uncle Sam, slow down there a minute
In October 1994 Bill Bengen published his paper summarising a number of empirical simulations of historical market behaviour to attempt to identify a percentage of a pension that could be drawn down each year as income without fear of the money running out. It was later branded the Safemax rate, and was set at 4% per annum.
Bill is a smart cookie – his undergrad degree was in aeronautics and astronautics from MIT in Boston and he co-authored Topics in Advanced Model Rocketry. (Ergo, without exaggeration he’s a rocket scientist). When he was 40 he moved to southern California and set up a financial planning practice.
/1. How was the 4% Rule calculated?
In 1994 Bill put together data tables of actual stock and bond returns from 1926 looking at a retirement income needed for 30 years. What he wanted to ascertain was what YEAR ONE drawdown % could be used, with that cash value then being increased by inflation every year thereafter, without the pot of money running out.
That’s a great question, and is a worthy structure for calculating a ‘safe’ income. It includes the most severe stress test we have ever seen with modern markets – the 1929-31 crash when US markets fell -61%, and the oil crisis inflation drama of 1973-74 when US inflation jumped +22.1%.
Oddly, we find many people and firms in the UK use Bill’s 4% Rule when planning their own, or clients’ pension income. These are summary points of why the 4% Rule should only be used in ‘Mrs Buffett’ cases. (See * below re Mrs Buffett).
Bill later clarified that 4% was intended as the worst case scenario for retirees in the US, using the hypothetical example of someone who retired in 1968 at a US market peak, heading into the coming inflation storm of the early 1970s. He later said closer to 7% may have been feasible, and at other times 13%, summarising his reviews in later years as 4.5% for tax free income accounts and 4.1% for taxable. Bill was using US investment accounts, not UK, they are not the same.
Bill used ONLY US market data, taking 10.3% annual equity growth, 5.2% for bonds and 3% for inflation. In sterling terms the figures are materially different – the Dow share price was 7.3%. If you add in dividends for total return the figures start to fall over due to lack of real data – the most accurate we could find was from 1987 (so 37 years) and that gives 7.4% for the Dow in £ terms, versus 5.1% for the FTSE All Share over that period. Before you panic about the FTSE returns, the chart below shows what has happened; let me summarise bluntly, US tech valuations have run away with ‘irrational exuberance’, and Brexit has proved to be a calamitous failure of the UK listed market (well publicised in the media).
Last word? The Dow has a p/e ratio of 27.13, the FTSE All Share is 11.8. This roughly means that each $1 of US profit is valued at $27 whilst each £1 of UK profit is valued at £11, which is $13.70, roughly half. Go figure, as they say…..
3. Next, Bill uses US bond data and the UK has no such index, indeed no such constituents. In the US local authorities can issue debt. This is the municipal bonds market (muni) and is currently worth $4.1 trillion, which is more than the whole UK GDP ($3.08 trillion).
4. Bill increased the annual draw down each year by RPI – from 1926 to 2023 the annualised RPI for the US was 2.98%, in the UK it was 4.53%, being 52% higher.
I’ll stop there – Bill’s calculations used investment returns 31% higher than the UK, and increased the annual drawdown at 34% lower than needed in the UK.
UK and US – not same, same
(Photo courtesy of Great British Mag)
* Mrs Buffett – a widely mis-quoted quote of Warren Buffett’s was that he’d told his wife that after he’d gone she should simply invest in trackers. That was not because he thought trackers are better than other funds, what he meant was that as his wife has no interest or skills in equity investing then she should not be an ‘enthusiastic amateur’ and risk getting it all wrong – just leave it to Mr Market, at least then you can blame the market, not a fund manager.
/2. How not to get lost
I’m pretty sure everyone reading this has had the experience of driving around at least a part of the M25 at some time. If it’s to be a successful trip we need to know where we’re starting from just to work out if the M25 is going to be relevant at all; next we need to have an idea of what the landscape should look like to give us reassurance that we are likely on the right road; after that we keep our eyes peeled for the road signs, and even those telling us of different places are references we use (we know Watford is north of London, so if the driver above is heading to north London they are probably heading the right way, it’s a relevant reference point); then we need to be told via the signs which exit we need.
If we get it wrong we can spend a long time lost, with wasted time, cost, anxiety and extreme disappointment with our road system and signage – we always blame the council, other drivers, UK Highways Agency, Margaret Thatcher, the weather, this damned satnav… When it goes completely pear shaped we give up, forget the initial plan and head for home:
/3. Don’t drive your lifetime savings without accurate navigation
We spend around 15,000 hours per year checking the navigation for our clients to get from the start of their investment journey to their destination (we have had two clients reach 102. Our financial planning works ensure that we and you both know precisely where the journey is intended to start, and when (traffic’s lighter after 10, can you start then? Avoid the school holidays, don’t invest at the peak of the market, phase your investment).
We know the reference points for successful income investing – we know that pushing the speed limit ostensibly gets you there faster, however, we know that frequently doesn’t happen as you just hit the traffic on the M5 a lot quicker – in the same way as quick as a fund like Scottish Mortgage runs up, so its comes back down – hare and tortoise? You absolutely intend for your retirement to be long and enjoyable, and at our age we know that to run a marathon the biggest error is to start at a sprint.
You need to know the destination, and the waypoints. Part of our role is to point out that although it’s half the distance to Little Langdale on that road called Hardknott Pass you’ll probably be better off on the A395. It’s your money, you travel your own path, our job is to ensure you have accurate expectations.
Hardknott Pass - you know you want to…
/4. Hey Uncle Sam, slow down there a minute
We often describe our position as knowing who the clever people are, and we certainly include Sarasin Partners in that coterie. This week they put out their thinking about the difficult ‘last mile’ to get inflation back under control. (All data & charts here are from Sarasin Partners, with thanks).
The US economy is proving a troublesome child – you can see that where things were supposed to tail off, that’s not happened, price increases are stubborn and more jobs than expected are being filled:
We think the chart below is particularly insightful – here it looks like President Biden is dutifully following the Keynesian playbook with government spending:
[ We’d mention as an aside that we love that President Biden has just cancelled $7,400,000,000 of student debt, freeing 277,000 people from the financial burden of their education. The Biden/Harris administration has now cancelled $153,000,000,000 of student debt for 4,300,000 people – we think student debt is a financial error by any government. Education should be a right, not a privilege.]
The meat on the bone of Sarasin’s research summary is what affects you and me today – interest rates, now and this year.
The speed and size of the cuts might be disappointing to us, however, I think we’d agree that this summary looks responsible, cautious and conservative. The higher interest rates suggest that there will be strength in the greenback relative to sterling which would be good for exports (Ed: if we had any).
Reading into these projections, if they do indeed pan out (nothing ever guaranteed, as Putin & pandemic teach us), then bond yields stay higher for longer which we suspect means that the investment trust discounts are likely to continue – that’s good news, it means each £1 of income is cheaper than it would otherwise be, over the coming years the share prices will rise as yields fall. We’ve said this before, the opportunities with trusts will not last forever, now is the time to invest if you are looking for long term income – ‘waiting for prices to recover’ just means that person doesn’t understand the maths behind investing!