In two previous posts we discussed how to determine your “sustainable lifestyle number” and some of the issues with regards to long term financial independence planning. This post deals with more of the “rule of thumb” or “back of the envelope” thinking with regards to determining “how much is enough?” This work, while less assuring than doing a more sophisticated assessment, can provide important benchmarks to understanding progress to long-term financial independence.

There has been considerable work done on what is in fact a reasonable portfolio withdrawal rate. There are several practitioners who have put forth opinions on what the portfolio withdrawal rate should be. Notable among them is William Bengen and the number of articles he has published. His work entitled “Determining Portfolio Withdrawal Rates Using Historical Data” is often cited in others work. Others have also weighed in on the topic but we find Bengen’s work to be the most conservative and therefore “most likely to succeed” in uncertain times. Often this work is referred to as the 4% solution. Bengen looked at multiple time series using varying portfolio allocations. These periods began in January 1926, before and through the great depression, war etc. In his analysis he found that a 4% withdrawal rate, using a 50% Stock and 50% Bond Portfolio was able to sustain itself and allow for the withdrawals to be adjusted for inflation as well.

In a follow-up piece Bengen looked at various withdrawal rates with different allocations and evaluated the probability of the portfolio lasting 30 years or more. He found that a portfolio with a 6% withdrawal rate only had a 41% chance of lasting 30 years or more. A 5% had a 71% chance and 4% had a 100% probability of success.

Personally I would rather count on the 4-5% withdrawal rate. I don’t want my money to die before I do! Let’s look at an example of this in action. Let’s say I need, after my calculations in the two previous posts, $200,000 a year pre-tax. I would take $200,000 divided by .04. My result is $5,000,000 of capital required to have maximum assurance of meeting my goals on an inflation adjusted basis. If I’m willing to accept a little more uncertainty and use a 5% withdrawal rate the math would be3 $200,000 divided by .05 or $4,000,000 of invested capital needed.

Clearly a more sophisticated analysis can be and in many cases should be done. Most mistakes are made in the assumption phase of the analysis however. Underestimating the dollar amount of lifestyle needs or overestimating the rate of return are unfortunately very common. Careful and rigorous evaluation and assessment are always relevant when one is preparing to move into relying exclusively on monetary resources to support lifestyle and rules of thumb or back of the envelop approaches should be looked at as a beginning.

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