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How do you know when you can stop working?

When future expenses are covered by passive income streams, a person is typically considered to be financially independent. In this situation, you no longer need to work to support yourself.  This doesn’t necessarily mean that you will stop working, but it does mean that you can choose to do the kind of work that makes you happiest.


There are many ways to figure out how much income a portfolio can sustain.  You may have heard of the 4% Rule, which states that in any historical market environment, it would have been safe to withdraw 4% of the initial value of the portfolio in the first year and adjust that amount upward by inflation each year for 30 years.  Subsequent research showed that the safe withdrawal rate rises to 4.5% if investing in a diversified portfolio such as the ones that I recommend to clients (the original research used only US Large Stocks and government bonds).  In today’s market environment, with low interest rates and high stock valuations, some researchers are suggesting that the safe withdrawal rate may be lower than 4%.


If one can tolerate some variability in retirement spending, I prefer to use a method developed by a financial planner named Jon Guyton and published in the Journal of Financial Planning in 2006, with several updates since then.  The general idea is that it is safe to start with a higher initial withdrawal rate as long as the investor is willing to modify spending if the markets perform poorly.  There are several rules developed to add “guardrails” to adjust spending either up or down depending on market performance.  In most cases, spending increases by the inflation rate.  The “safe” initial withdrawal rate varies over time depending on market conditions and asset allocation.  As of early 2020, for a portfolio with 75% equity, the initial safe withdrawal rate for a 30-year retirement is approximately 5.25%.  For a portfolio with 50% equity, the initial safe withdrawal rate for a 30-year retirement is approximately 4%.  These numbers are based on analysis by Wade Pfau published on the Retirement Researcher website.  If retiring early, it’s prudent to reduce the rate by 50-100 basis points (100 basis points is 1%).


Assuming an initial withdrawal rate of 5%, the rules are listed below.  Note that this withdrawal strategy can support indefinitely long retirement periods.  The portfolio will never be depleted, although the amount that is withdrawn from the portfolio may be reduced based on market performance.


  1. Withdrawal Rule - Each subsequent year, the withdrawal amount is increased by the prior-year inflation rate, unless the prior-year investment return was negative and the new year’s withdrawal rate would be above 5%.  In this case, use the prior year's withdrawal amount.  Essentially, when bad investment returns happen, don’t take the inflation adjustment.

  2. Capital Preservation Rule - If the current-year withdrawal amount is more than 6% of the portfolio, reduce the withdrawal amount calculated above by 10%.  This rule is no longer applied after age 80.  This reduces portfolio withdrawals when market returns are poor.

  3. Prosperity Rule - If the current-year withdrawal amount is less than 4% of the portfolio, increase the withdrawal amount calculated above by 10%.  This allows an increase in spending when the markets have performed well.


Recent research adds a component of valuation-based asset allocation to this strategy.  If the percentage of equity in the portfolio is adjusted based on predetermined market valuation ranges, then the initial withdrawal rate can be increased by up to 1%.


If the household requires some minimum level of income, this method can be combined with Social Security and/or an immediate annuity to provide guaranteed income for life.  The disadvantage to an immediate annuity is that there is no upside (i.e. you will never be paid more than the guarantee in the contract) and no residual value to the investment (i.e. the principal is not available to heirs). The advantage is that an annuity provides longevity insurance - it is not possible for someone to outlive their portfolio, although a long retirement may suffer from purchasing power degradation since most annuities are not adjusted for inflation.  Social Security income is inflation-adjusted, so maximizing this income stream through delayed claiming can be an important component of a retirement income plan.

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