Many retirees are faced with a daunting question. What is a safe withdrawal rate based on my assets? There are a ton of online calculators out there, and your financial advisor certainly has a calculator they swear will work. There is also the 4% rule for easy napkin math. However, all of these guesses leave me uncomfortable in today’s market of high valuations. What happens if you retire today based on the 4% rule and valuations plummet tomorrow? Is there a better way to calculate a safe withdrawal method?
Here is my theory. If holdings stocks is the same as being a part owner in a company, what if you only withdrawal at the same rate as earnings for your holdings? It would be like only spending the money your own private business makes. So if you have $1M in stock that produces $80k in earnings per year, you should limit your retirement spending to $80k? Does my theory work? Does it make sense? Let’s explore the numbers a little.
Given today’s market, if you regularly spend $150k/yr, how much S&P 500 stock would you need to own?
The S&P 500 is currently earning $158.76 per share. So you would need ~945 shares of the S&P 500, which is currently valued at $4,594. That would bring the total to $4.341M dollars. Which would give us a withdrawal rate of 3.4%, which is strikingly close to the 4% rule, but a little more conservative.
Does this even work in theory?
Let’s start with the simple idea that all earnings are permanently retained by the companies. No dividends. So we are forced to sell some stock each year in order to pay our bills. The first issue is what if the valuation crashes from a 27 P/E to a 13.5 P/E? Well, if that happen you suddenly are forced to sell twice as much stock to survive, you’d have to sell 7% of your stock a year, even though it is earning great returns. The good news is that the next year, your leftover stock should appreciate at about 7%, as that is the S&P’s earnings growth rate. You’ll also need to sell another 7% of stock. But those two factors should offset each other.
Taxes
While needing $4.3M in S&P 500 stock in order to retire and spend $150k/yr forever might make some sense in theory, taxes complicate things. At a bare minimum, you are going to pay some capital gains taxes, and some of the earnings will be distributed as ordinary dividends. Using some online calculators shows that if $50k is from dividends and $100k is from selling stock, you’d pay about $15k in taxes. Unfortunately, that means we need to sell even more stock to cover this $15k shortfall. We’d need to sell $120k in stock, or $170k in S&P 500 earnings. Ack. When you back out the numbers, you really would need $5M to retire and have $150k after taxes.
Back testing
For a sanity check, I created this spreadsheet. It isn’t well formatted, but it attempts to give CPI raises to an earnings based retirement approach that starts in 1960. In general, the theory seems to work well. You get a fair amount of income from dividends, but also need to sell some stock each year. However, stagflation kills this strategy, even after all the growth in stocks through the 60’s and early 70’s. The easiest way I found to make the numbers work is if you continue to think of your stocks as “your company”. You have to take a pay cut when your stocks earnings drop below how much you are wanting to spend. It’s not a fun thought to be 20 years into retirement and needing to find ways to save money, but I think if you keep an eye on your portfolio’s earnings and don’t spend more than that amount, your odds of going broke are basically zero, but you could get stuck in a cycle of spending less and less each year.
Combined approach
A good approach would be one that limits spending such that you don’t make either of these two big mistakes. The first is relying on permanently high valuations, and the second is selling too much stock when they are cheap. I suggest you’ll do well if you limit your spending to the lower of the 4% rule or my earnings rule. That way if stock valuations drop to cheap levels, the 4% rule will keep you from over spending. If stock valuations are really pricey (as in today), my earnings rule will keep you from inflating your lifestyle to a level you can’t possibly expect to sustain.
Just a theory
It’s just a theory and exercise for me, but I like the idea of limiting how much you can spend post retirement based on the earnings of your investments, not the current valuation of your investments. The ability of the business you own to produce earnings is what you should rely on, not on current market sentiment.