A well-known result about the largest sustainable real annual disbursement that can be made from a portfolio is the 4% Rule. In a study published in 1994, William Bengen reported that a 4% initial disbursement from a portfolio of stocks and intermediates could be sustained in real terms for 30 years without running out of funds. These results had serious reliability issues as the tests were based on a small number of consecutive series of historical returns. Nevertheless, the 4% Rule achieved considerable fame as it was simple, and met a need for retirees seeking guidance as to how much they could disburse from their investment portfolios to cover expenses.
Subsequently, the reliability of the tests has ceased to be a problem as such tests can be made using a very large number of series of investment returns generated by a Monte Carlo process on a computer, as is done at this site. Moreover, assuming disbursements will be made until a portfolio runs out of funds is unrealistic. Surely, the disbursements will be reduced well beforehand to stop that from happening. At this site that limit is provided by the Retrenchment Rule. The risk faced by beneficiaries is not running out of funds, but the sustainability risk posed by future declines in the disbursements of varying size. Also, finding the largest constant stream of disbursements that can be sustained in real terms ignores the possibility that large extra disbursements may be required to cover emergencies.
A critical issue in using simulations to run tests for sustainability risk is the historical period to use as a basis for the investment returns. Model provides two polar sets of returns based on the historic returns on intermediates before and after 2008: the Pre 2008 Returns, and the Lower Returns. In either set, the expected return on stocks over intermediates is .04 as observed in the returns prior to 2008. The very strong returns on stocks observed since 2009 are due in part to the decline in interest rates, and have little likelihood of being repeated. The Pre 2008 Returns and the Lower Returns are used as the basis for possible best and worst cases.
Suppose simulations are run using the Pre 2008 Returns. Over a 36-year period it turns out that a 4.0% initial disbursement has some small chances of declines, but in general has very good sustainability. The 4% Rule is validated. Now suppose that the simulations are rerun using the Lower Returns. The simulations now show that the sustainability risk of a 4.0% initial disbursement is very high. To get the same low sustainability risk as obtained when validating the 4% Rule, the initial disbursement must be reduced from 4.0% to 3.0%. Instead of using the Lower Returns, suppose now that the possibility of emergencies is included in the simulations as given as an option in Model. Doing so causes about half as much sustainability risk as using the Lower Returns. To get the same good sustainability as a 4.0% initial disbursement with the Pre 2008 Returns and no emergencies a further reduction in the initial disbursement is required from 3.0% to 2.5%.
The next step is to add to these funds any highly sustainable funds from other sources such as Social Security, and consider the highest priority activities that can be covered with this highly sustainable funding. For a few beneficiaries that funding may be sufficient, but for most living on highly sustainable funding will require significant painful retrenchment. These beneficiaries will want to consider accepting sustainability risk to obtain more funds from their portfolio. When doing so, the activities that cannot be covered with highly sustainable funding are arranged in descending order of priority, and risks considered that might be the most comfortable to accept to obtain more funds to cover these activities.
One risk that beneficiaries might be willing to accept to avoid retrenchment is using better investment returns in making the simulations than the worst that seem reasonably possible. Suppose, for instance, that the Mid Returns given in Model are used that are midway between the Pre 2008 returns and the Lower Returns. Doing so increases the initial disbursement from 2.5% to 3.0% without any increase in sustainability risk. To avoid initial retrenchment beneficiaries may also be willing to take their chances with respect to future emergencies. Excluding emergencies further increases the initial disbursement from 3.0% to 3.5%. Finally, it makes sense to retrench initially to avoid serious retrenchment in the future, but not to avoid any retrenchment. Beneficiaries will surely be willing to accept some future declines in disbursements and retrenchment to reduce initial retrenchment. Accepting some future declines and retrenchment further increases the disbursement to 4.0%.
Thus, a New 4% Rule has been developed. The original 4% Rule was a one size fits all. The New 4% Rule tailors an initial disbursement to the needs and risk preferences of individual beneficiaries. The New 4% Rule says that in the 2020s a 4% initial disbursement has risks. Many however, may be willing to accept these risks to avoid painful retrenchment. It is possible that some may be willing to further increase the initial disbursement to 5.0% or even 6.0%, when necessary to further reduce painful retrenchment. Simulations show the costs and benefits of these further increases so that a decision can be made when necessary. The general rule is that the initial disbursement should be increased until the marginal cost in terms of increased sustainability risk exceeds the marginal benefit of the activities that can be included with the additional funding.
Validating the 4% Rule
Charts 5.1 and 5.2 show the cumulative probability distributions of the disbursements at years 12 and 24 when starting at 3.5% and 4.0% with an initial horizon of 36 years. The results for year 12 indicate the sustainability risk at the front of the disbursement period, whereas year 24 indicates the risk at the back of the period. The Pre 2008 Returns are assumed. Allocation found for the Pre 2008 Returns that the best fixed stock allocation for a 4.0% initial disbursement is 30%. That is also the best fixed allocation for a 3.5% initial disbursement, and those allocations are assumed in these charts. Page, RDR, shows that the best RDR is at least .02 above the expected return of the portfolio. For an allocation of 30% the expected return is .042, which makes the RDR equal to .062.
The chances of a decline are shown by the probability on the vertical axis where a curve begins to turn to the left. For instance, when starting at 4.0%, Chart 5.1 shows that there is about a .05 chance of a decline by year 12. The chances of declines of varying size are shown by differences of probabilities on the vertical axis. For instance, when starting at 4.0%, Chart 5.1 shows that there is about a .01 chance of a decline of more than half a percentage point. There is about a .04 chance of a decline of up to half a percentage point. The charts themselves give a quick overall impression of sustainability risk without the need to look at specific probabilities. The charts show that there is almost no sustainability risk when starting at 3.5%. There is no risk of a decline by year 12, and only about a .05 chance by year 24. The marginal cost in increased sustainability risk of an increase from 3.5% to 4.0% is small. The chances of a decline by year 12 increase only to .05. At year 24, the increase is only from .05 to .15. Moreover, at year 24, there is almost no chance of a decline of more than 1.5 percentage points. Presumably, almost anyone would be willing to accept the cost of this increased risk to get an additional half percentage point of funds. For the Pre 2008 Returns the 4% Rule is validated.
Lower Returns
For planning in the 2020s, however, the validation of the 4% Rule using the Pre 2008 Returns appears to be largely of historical interest, and of only limited consequence when looking forward. As discussed at the page, Model, from 2009 through 2021, the average annual real return on intermediates was close to zero, well below the .03 assumed in the Pre 2008 Returns. The possibility needs to be considered that the expected returns looking forward will be the Lower Returns, which assume the expected real return on intermediates is zero, instead of .03.
For the Lower Returns, Allocation finds that the best allocations for initial disbursements of 3.0% and 4.0% are respectively 40% and 70%. Assume an allocation of 70% for the 4.0% disbursement and split the difference and use 55% for the 3.5% disbursement. Using the Lower Returns and these allocations, the results are shown in Charts 5.3 and 5.4. A significant increase in sustainability risk is obvious. For instance, when starting at 4.0%, by year 24 there is now a .50 chance of a decline instead of a .15 chance. When starting at 4.0% by year 24 there is also a .10 chance that the disbursement will have lost half or more of its value. To get the same sustainability as a 4.0% initial disbursement for the Pre 2008 Returns, a significant reduction is required in the initial disbursement.
Sustainability with Lower Returns
Charts 5.5 and 5.6 show that to get the same sustainability with the Lower Returns that the initial disbursement must be reduced by one percentage point. When starting at 2.5% and 3.0% the curves are now virtually the same as those in Charts 5.1 and 5.2 except that they have been shifted to the left on the horizontal axis by one percentage point. With these lower initial disbursements, the best allocations are now 30% and 40%. Achieving this sustainability with the worst expected returns that seem reasonably possible in the 2020s, however, results in a significant loss of funds. Assuming the Pre 2008 returns in the 2020s does not seem realistic. To avoid retrenchment, however, many may be willing to accept more risk than the worst expected returns that seem reasonably possible.
Suppose instead of the Lower Returns that Mid Returns are assumed that are midway between the Lower Returns and the Pre 2008 Returns specified in Model. For the Mid Returns, the best allocations for initial disbursements of 3.0% and 3.5% are 30% and 40% with RDRs of .047 and .051. The results for the Mid Returns with initial disbursements of 3.0% and 3.5% are shown in Charts 5.7 and 5.8. As expected, the sustainability is the same as in Charts 5.1 and 5.2, but the curves are now shifted to the left by a half instead of one percentage point. By assuming more risk than using the Lower Returns, beneficiaries now have to give up only half as much funding.
Emergencies
As an option, the specification of the model considers the possibility that large extra disbursements may be necessary in the event of emergencies. Such losses might be covered by insurance, but there are limits on what can be covered by insurance, and some losses are not insurable, or even recognized as possible beforehand. Some problems that might require a large unexpected outlay include extensive damage to a residence caused by water or an earthquake and not covered by insurance, an urgent need for financial assistance by a child, or a personal medical problem for which insurance does not cover the best available solution. Such results are included in the model by assuming each year that there is an independent .05 chance that an extra disbursement will be required equal to 20% of the initial value of the portfolio. To avoid seriously depleting the funds needed for continuing activities in the future, however, the outlay is limited to 25% of the current value of the portfolio. With a .05 chance of an emergency each year, over a 20-year period the expected number of emergencies is one, which seems reasonable.
Earlier analysis showed that higher stock allocations are desirable when higher initial disbursements make the disbursement riskier. Planning on the possibility that extra disbursements may be needed to cover emergencies also makes the disbursements riskier, and also makes a higher stock allocation desirable. The best allocation is found by including the possible emergencies in the simulations and determining the best stock allocation as in Allocation. Doing so shows for the Pre 2008 Returns that the best stock allocations when extra disbursements for emergencies are possible are 40% for initial disbursements of 3.0% and 3.5%, and 50% for an initial disbursement of 4.0%. These allocations will be used under these conditions.
The results with the possibility of emergencies included, for the pre 2008 Returns when the initial disbursements are 3.5% and 4.0%, are shown in Charts 5.9 and 5.10. Sustainability risk increases by about half as much as when assuming the Lower Returns in Charts 5.3 and 5.4. When starting at 3.5% there is now almost a .10 chance of a decline by year 12 instead of no chance. At year 24, when starting at 3.5% the chances of a decline have increased from .05 to over .20. To offset this increased sustainability risk, suppose that the initial disbursements are reduced by half a percentage point from 3.5% and 4.0% to 3.0% and 3.5%. The results are shown in Charts 5.11 and 5.12. Almost all of the increased risk caused by the possible emergencies has been eliminated. The curves are now almost the same as those shown in Charts 5.1 and 5.2 except that they are shifted to the left by a little more than half a percentage point. Similar results are obtained when the possibility of emergencies is included in the simulations for lower returns. In particular, for the Lower Returns, when the possibility of emergencies is included, the initial disbursements have to be reduced to slightly less than 2.0% and 2.5% to get the same sustainability risk as for the Pre 2008 Returns in Charts 5.1 and 5.2.
A New 4% Rule
Viewed in the 2020s, a 4% disbursement no longer has little risk. A 2.5% disbursement does have little risk, but few will be able to fund their activities with a disbursement that small. To avoid retrenchment, they may be willing to assume that expected returns are not as low as seem reasonably possible in the 2020s, but instead are midway between the Pre 2008 and the Lower Returns that are assumed in Model. They may also accept that extra disbursements may have to be made for emergencies. They may not be willing to retrench, however, to allow for this possibility, and instead be willing to take their chances, and not plan on the possibility that such extra disbursements may be necessary. Accepting these risks, Charts 5.7 and 5.8 show that disbursements of 3.0% and 3.5% have about the same sustainability risk as shown for disbursements of 3.5% and 4.0% in Charts 5.1 and 5.2
Beneficiaries are willing to retrench initially to avoid serious retrenchnment in the future. They may not be willing to retrench initially, however, to avoid only small chances of future decllines and retrenchment like those shown in Charts 5.7 and 5.8. In such cases, they seem likely to be willing to accept more sustainability risk to avoid initial retrenchment by further increasing the initial disbursement to 4.0% as shown in Charts 5.13 and 5.14. Thus, Charts 5.13 and 5.14 provide a New 4% Rule for the 2020s that accepts risks that seem reasonable, but still provides the same amount of funding. Unlike the original 4% Rule, however, there is no chance of running out of funds, or even coming close.
Many may have long anticipated that significant downsizing will be required when they retire so that they can live on what they have accumulated. Sufficient sacrifice to live on a 2.5% disbursement with little risk, however, does not seem warranted. They may, however, be willing to accept the risks required in the 2020s to live on a 4.0% disbursement. In contrast, others will resist the need to curtail important habitual activities that they have long enjoyed to live on a 4% disbursement. By disbursing more, they would be able to defer any curtailment for many years. To cut back sufficiently to live on a 4% disbursement these beneficiaries need to see the risk of larger disbursements than 4.0% in terms of the lower disbursements that may then be necessary in the future.
More Than 4%
Those who have important activities that cannot be funded with a 4.0% disbursement have to decide whether it is worth the increase in sustainability risk to increase the disbursement to 5.0%. Charts 5.15 and 5.16 show the costs and benefits of increasing the disbursement from 4.0% to 5.0%. The benefit is that there are good chances that the increase to 5.0% can be sustained. The chances that the disbursement is sustained are given by one less the probability on the vertical axis when the plot for 5.0% begins to turn to the left. The chances the 5.0% disbursement will be sustained are .55 to year 12, and.40 to year 24. The cost of these benefits are the chances that the disbursements starting at 5.0% will be less than when starting at 4.0%. These chances are given by the probabilities on the vertical axis where the curves starting at 5.0% cross those starting at 4.0%. These chances are .23 at year 12, and .45 at year 24.
When the disbursement starting at 5.0% is less, the amount by which it is less as a percentage of initial portfolio value is shown by the difference between the curves on the horizontal axis for given probabilities on the vertical axis. The largest such difference is about .40 percentage points at a probability of .15 at year 12, and .75 percentage points for a probability of .30 at year 24. The average differences are about half of these maximums in each case. For beneficiaries the upside is a good chance that they will be able to continue important habitual activities for a very long time instead of immediately curtailing them. The major risk is at the back of the disbursement period where the chances are about a half that on average the disbursement will be about .4 percentage points less than its otherwise already diminished value. With limited life expectancy and other discounting for the future, however, it is questionable whether that risk, while appreciable, will be sufficient to curtail important activities that can be funded with a 5.0% disbursement.
Suppose now that it has been decided to disburse 5.0%, but there remain important habitual activities that will require a 6.0% disbursement. These activities are of somewhat lower priority than those funded with the 5.0% disbursement, but they are nevertheless difficult to curtail. The costs and benefits of increasing the disbursement from 5.0% to 6.0% are shown in Charts 5.17 and 5.18. The benefits of the increase have now been squeezed as the chances that the 6.0% disbursement will be sustained have declined to .35 at year 12, and .25 at year 24. Moreover, there have been significant increases in the chances that the higher initial disbursement will later be less than the lower initial disbursement. These chances are .47 at year 12, and .64 at year24. When the disbursement starting at 6.0% is less, it is less by about a third of a percentage point of initial portfolio value. These reductions may now be more serious because they can be from lower values of the 5.0% disbursement. With lower chances the increase will be sustained, and higher chances the increase will later be seriously lower, those who decided on an increase to 5.0% to continue important activities may not further increase to 6.0% to cover additional activities. Nevertheless, immediately curtailing important habitual activities is also a difficult decision. By clearly showing the costs and benefits, these charts are a significant help in making difficult decisions.
Conclusions
The first step in determining the Best Initial Disbursement, or BID, is to find the highest priority activities that can be funded with a highly sustainable initial disbursement from the portfolio, and any highly sustainable funds from other sources. Funding for important activities that cannot be included is obtained by accepting increasing sustainability risk to get additional funds from the portfolio for activities of decreasing priority. The BID has been found when the marginal cost in increased sustainability risk of more funds exceeds the marginal benefit of the additional activities being funded. After allowing for the possibility of lower expected returns, and the need to cover future emergencies, a disbursement of only about 2.5% is highly sustainable. Beneficiaries, however, seem unlikely to be willing to retrench to avoid sustainability risk from the lowest expected returns that seem reasonably possible in the 2020s, or from covering emergencies. Accepting these risks increases the initial disbursement from 2.5% to 3.5%. Accepting some risk of future declines to avoid initial retrenchment further increases the initial disbursement to 4.0%. Despite the risks many seem likely to accept this New 4% Rule to avoid retrenchment. Some may accept further risk by a further increase in the disbursement to 5.0% or 6.0% when necessary to cover important activities.
BID
Best Initial Disbursements
A well-known result about the largest sustainable real annual disbursement that can be made from a portfolio is the 4% Rule. In a study published in 1994, William Bengen reported that a 4% initial disbursement from a portfolio of stocks and intermediates could be sustained in real terms for 30 years without running out of funds. These results had serious reliability issues as the tests were based on a small number of consecutive series of historical returns. Nevertheless, the 4% Rule achieved considerable fame as it was simple, and met a need for retirees seeking guidance as to how much they could disburse from their investment portfolios to cover expenses.
Subsequently, the reliability of the tests has ceased to be a problem as such tests can be made using a very large number of series of investment returns generated by a Monte Carlo process on a computer, as is done at this site. Moreover, assuming disbursements will be made until a portfolio runs out of funds is unrealistic. Surely, the disbursements will be reduced well beforehand to stop that from happening. At this site that limit is provided by the Retrenchment Rule. The risk faced by beneficiaries is not running out of funds, but the sustainability risk posed by future declines in the disbursements of varying size. Also, finding the largest constant stream of disbursements that can be sustained in real terms ignores the possibility that large extra disbursements may be required to cover emergencies.
A critical issue in using simulations to run tests for sustainability risk is the historical period to use as a basis for the investment returns. Model provides two polar sets of returns based on the historic returns on intermediates before and after 2008: the Pre 2008 Returns, and the Lower Returns. In either set, the expected return on stocks over intermediates is .04 as observed in the returns prior to 2008. The very strong returns on stocks observed since 2009 are due in part to the decline in interest rates, and have little likelihood of being repeated. The Pre 2008 Returns and the Lower Returns are used as the basis for possible best and worst cases.
Suppose simulations are run using the Pre 2008 Returns. Over a 36-year period it turns out that a 4.0% initial disbursement has some small chances of declines, but in general has very good sustainability. The 4% Rule is validated. Now suppose that the simulations are rerun using the Lower Returns. The simulations now show that the sustainability risk of a 4.0% initial disbursement is very high. To get the same low sustainability risk as obtained when validating the 4% Rule, the initial disbursement must be reduced from 4.0% to 3.0%. Instead of using the Lower Returns, suppose now that the possibility of emergencies is included in the simulations as given as an option in Model. Doing so causes about half as much sustainability risk as using the Lower Returns. To get the same good sustainability as a 4.0% initial disbursement with the Pre 2008 Returns and no emergencies a further reduction in the initial disbursement is required from 3.0% to 2.5%.
The next step is to add to these funds any highly sustainable funds from other sources such as Social Security, and consider the highest priority activities that can be covered with this highly sustainable funding. For a few beneficiaries that funding may be sufficient, but for most living on highly sustainable funding will require significant painful retrenchment. These beneficiaries will want to consider accepting sustainability risk to obtain more funds from their portfolio. When doing so, the activities that cannot be covered with highly sustainable funding are arranged in descending order of priority, and risks considered that might be the most comfortable to accept to obtain more funds to cover these activities.
One risk that beneficiaries might be willing to accept to avoid retrenchment is using better investment returns in making the simulations than the worst that seem reasonably possible. Suppose, for instance, that the Mid Returns given in Model are used that are midway between the Pre 2008 returns and the Lower Returns. Doing so increases the initial disbursement from 2.5% to 3.0% without any increase in sustainability risk. To avoid initial retrenchment beneficiaries may also be willing to take their chances with respect to future emergencies. Excluding emergencies further increases the initial disbursement from 3.0% to 3.5%. Finally, it makes sense to retrench initially to avoid serious retrenchment in the future, but not to avoid any retrenchment. Beneficiaries will surely be willing to accept some future declines in disbursements and retrenchment to reduce initial retrenchment. Accepting some future declines and retrenchment further increases the disbursement to 4.0%.
Thus, a New 4% Rule has been developed. The original 4% Rule was a one size fits all. The New 4% Rule tailors an initial disbursement to the needs and risk preferences of individual beneficiaries. The New 4% Rule says that in the 2020s a 4% initial disbursement has risks. Many however, may be willing to accept these risks to avoid painful retrenchment. It is possible that some may be willing to further increase the initial disbursement to 5.0% or even 6.0%, when necessary to further reduce painful retrenchment. Simulations show the costs and benefits of these further increases so that a decision can be made when necessary. The general rule is that the initial disbursement should be increased until the marginal cost in terms of increased sustainability risk exceeds the marginal benefit of the activities that can be included with the additional funding.
Validating the 4% Rule
Charts 5.1 and 5.2 show the cumulative probability distributions of the disbursements at years 12 and 24 when starting at 3.5% and 4.0% with an initial horizon of 36 years. The results for year 12 indicate the sustainability risk at the front of the disbursement period, whereas year 24 indicates the risk at the back of the period. The Pre 2008 Returns are assumed. Allocation found for the Pre 2008 Returns that the best fixed stock allocation for a 4.0% initial disbursement is 30%. That is also the best fixed allocation for a 3.5% initial disbursement, and those allocations are assumed in these charts. Page, RDR, shows that the best RDR is at least .02 above the expected return of the portfolio. For an allocation of 30% the expected return is .042, which makes the RDR equal to .062.
The chances of a decline are shown by the probability on the vertical axis where a curve begins to turn to the left. For instance, when starting at 4.0%, Chart 5.1 shows that there is about a .05 chance of a decline by year 12. The chances of declines of varying size are shown by differences of probabilities on the vertical axis. For instance, when starting at 4.0%, Chart 5.1 shows that there is about a .01 chance of a decline of more than half a percentage point. There is about a .04 chance of a decline of up to half a percentage point. The charts themselves give a quick overall impression of sustainability risk without the need to look at specific probabilities. The charts show that there is almost no sustainability risk when starting at 3.5%. There is no risk of a decline by year 12, and only about a .05 chance by year 24. The marginal cost in increased sustainability risk of an increase from 3.5% to 4.0% is small. The chances of a decline by year 12 increase only to .05. At year 24, the increase is only from .05 to .15. Moreover, at year 24, there is almost no chance of a decline of more than 1.5 percentage points. Presumably, almost anyone would be willing to accept the cost of this increased risk to get an additional half percentage point of funds. For the Pre 2008 Returns the 4% Rule is validated.
Lower Returns
For planning in the 2020s, however, the validation of the 4% Rule using the Pre 2008 Returns appears to be largely of historical interest, and of only limited consequence when looking forward. As discussed at the page, Model, from 2009 through 2021, the average annual real return on intermediates was close to zero, well below the .03 assumed in the Pre 2008 Returns. The possibility needs to be considered that the expected returns looking forward will be the Lower Returns, which assume the expected real return on intermediates is zero, instead of .03.
For the Lower Returns, Allocation finds that the best allocations for initial disbursements of 3.0% and 4.0% are respectively 40% and 70%. Assume an allocation of 70% for the 4.0% disbursement and split the difference and use 55% for the 3.5% disbursement. Using the Lower Returns and these allocations, the results are shown in Charts 5.3 and 5.4. A significant increase in sustainability risk is obvious. For instance, when starting at 4.0%, by year 24 there is now a .50 chance of a decline instead of a .15 chance. When starting at 4.0% by year 24 there is also a .10 chance that the disbursement will have lost half or more of its value. To get the same sustainability as a 4.0% initial disbursement for the Pre 2008 Returns, a significant reduction is required in the initial disbursement.
Sustainability with Lower Returns
Charts 5.5 and 5.6 show that to get the same sustainability with the Lower Returns that the initial disbursement must be reduced by one percentage point. When starting at 2.5% and 3.0% the curves are now virtually the same as those in Charts 5.1 and 5.2 except that they have been shifted to the left on the horizontal axis by one percentage point. With these lower initial disbursements, the best allocations are now 30% and 40%. Achieving this sustainability with the worst expected returns that seem reasonably possible in the 2020s, however, results in a significant loss of funds. Assuming the Pre 2008 returns in the 2020s does not seem realistic. To avoid retrenchment, however, many may be willing to accept more risk than the worst expected returns that seem reasonably possible.
Suppose instead of the Lower Returns that Mid Returns are assumed that are midway between the Lower Returns and the Pre 2008 Returns specified in Model. For the Mid Returns, the best allocations for initial disbursements of 3.0% and 3.5% are 30% and 40% with RDRs of .047 and .051. The results for the Mid Returns with initial disbursements of 3.0% and 3.5% are shown in Charts 5.7 and 5.8. As expected, the sustainability is the same as in Charts 5.1 and 5.2, but the curves are now shifted to the left by a half instead of one percentage point. By assuming more risk than using the Lower Returns, beneficiaries now have to give up only half as much funding.
Emergencies
As an option, the specification of the model considers the possibility that large extra disbursements may be necessary in the event of emergencies. Such losses might be covered by insurance, but there are limits on what can be covered by insurance, and some losses are not insurable, or even recognized as possible beforehand. Some problems that might require a large unexpected outlay include extensive damage to a residence caused by water or an earthquake and not covered by insurance, an urgent need for financial assistance by a child, or a personal medical problem for which insurance does not cover the best available solution. Such results are included in the model by assuming each year that there is an independent .05 chance that an extra disbursement will be required equal to 20% of the initial value of the portfolio. To avoid seriously depleting the funds needed for continuing activities in the future, however, the outlay is limited to 25% of the current value of the portfolio. With a .05 chance of an emergency each year, over a 20-year period the expected number of emergencies is one, which seems reasonable.
Earlier analysis showed that higher stock allocations are desirable when higher initial disbursements make the disbursement riskier. Planning on the possibility that extra disbursements may be needed to cover emergencies also makes the disbursements riskier, and also makes a higher stock allocation desirable. The best allocation is found by including the possible emergencies in the simulations and determining the best stock allocation as in Allocation. Doing so shows for the Pre 2008 Returns that the best stock allocations when extra disbursements for emergencies are possible are 40% for initial disbursements of 3.0% and 3.5%, and 50% for an initial disbursement of 4.0%. These allocations will be used under these conditions.
The results with the possibility of emergencies included, for the pre 2008 Returns when the initial disbursements are 3.5% and 4.0%, are shown in Charts 5.9 and 5.10. Sustainability risk increases by about half as much as when assuming the Lower Returns in Charts 5.3 and 5.4. When starting at 3.5% there is now almost a .10 chance of a decline by year 12 instead of no chance. At year 24, when starting at 3.5% the chances of a decline have increased from .05 to over .20. To offset this increased sustainability risk, suppose that the initial disbursements are reduced by half a percentage point from 3.5% and 4.0% to 3.0% and 3.5%. The results are shown in Charts 5.11 and 5.12. Almost all of the increased risk caused by the possible emergencies has been eliminated. The curves are now almost the same as those shown in Charts 5.1 and 5.2 except that they are shifted to the left by a little more than half a percentage point. Similar results are obtained when the possibility of emergencies is included in the simulations for lower returns. In particular, for the Lower Returns, when the possibility of emergencies is included, the initial disbursements have to be reduced to slightly less than 2.0% and 2.5% to get the same sustainability risk as for the Pre 2008 Returns in Charts 5.1 and 5.2.
A New 4% Rule
Viewed in the 2020s, a 4% disbursement no longer has little risk. A 2.5% disbursement does have little risk, but few will be able to fund their activities with a disbursement that small. To avoid retrenchment, they may be willing to assume that expected returns are not as low as seem reasonably possible in the 2020s, but instead are midway between the Pre 2008 and the Lower Returns that are assumed in Model. They may also accept that extra disbursements may have to be made for emergencies. They may not be willing to retrench, however, to allow for this possibility, and instead be willing to take their chances, and not plan on the possibility that such extra disbursements may be necessary. Accepting these risks, Charts 5.7 and 5.8 show that disbursements of 3.0% and 3.5% have about the same sustainability risk as shown for disbursements of 3.5% and 4.0% in Charts 5.1 and 5.2
Beneficiaries are willing to retrench initially to avoid serious retrenchnment in the future. They may not be willing to retrench initially, however, to avoid only small chances of future decllines and retrenchment like those shown in Charts 5.7 and 5.8. In such cases, they seem likely to be willing to accept more sustainability risk to avoid initial retrenchment by further increasing the initial disbursement to 4.0% as shown in Charts 5.13 and 5.14. Thus, Charts 5.13 and 5.14 provide a New 4% Rule for the 2020s that accepts risks that seem reasonable, but still provides the same amount of funding. Unlike the original 4% Rule, however, there is no chance of running out of funds, or even coming close.
Many may have long anticipated that significant downsizing will be required when they retire so that they can live on what they have accumulated. Sufficient sacrifice to live on a 2.5% disbursement with little risk, however, does not seem warranted. They may, however, be willing to accept the risks required in the 2020s to live on a 4.0% disbursement. In contrast, others will resist the need to curtail important habitual activities that they have long enjoyed to live on a 4% disbursement. By disbursing more, they would be able to defer any curtailment for many years. To cut back sufficiently to live on a 4% disbursement these beneficiaries need to see the risk of larger disbursements than 4.0% in terms of the lower disbursements that may then be necessary in the future.
More Than 4%
Those who have important activities that cannot be funded with a 4.0% disbursement have to decide whether it is worth the increase in sustainability risk to increase the disbursement to 5.0%. Charts 5.15 and 5.16 show the costs and benefits of increasing the disbursement from 4.0% to 5.0%. The benefit is that there are good chances that the increase to 5.0% can be sustained. The chances that the disbursement is sustained are given by one less the probability on the vertical axis when the plot for 5.0% begins to turn to the left. The chances the 5.0% disbursement will be sustained are .55 to year 12, and.40 to year 24. The cost of these benefits are the chances that the disbursements starting at 5.0% will be less than when starting at 4.0%. These chances are given by the probabilities on the vertical axis where the curves starting at 5.0% cross those starting at 4.0%. These chances are .23 at year 12, and .45 at year 24.
When the disbursement starting at 5.0% is less, the amount by which it is less as a percentage of initial portfolio value is shown by the difference between the curves on the horizontal axis for given probabilities on the vertical axis. The largest such difference is about .40 percentage points at a probability of .15 at year 12, and .75 percentage points for a probability of .30 at year 24. The average differences are about half of these maximums in each case. For beneficiaries the upside is a good chance that they will be able to continue important habitual activities for a very long time instead of immediately curtailing them. The major risk is at the back of the disbursement period where the chances are about a half that on average the disbursement will be about .4 percentage points less than its otherwise already diminished value. With limited life expectancy and other discounting for the future, however, it is questionable whether that risk, while appreciable, will be sufficient to curtail important activities that can be funded with a 5.0% disbursement.
Suppose now that it has been decided to disburse 5.0%, but there remain important habitual activities that will require a 6.0% disbursement. These activities are of somewhat lower priority than those funded with the 5.0% disbursement, but they are nevertheless difficult to curtail. The costs and benefits of increasing the disbursement from 5.0% to 6.0% are shown in Charts 5.17 and 5.18. The benefits of the increase have now been squeezed as the chances that the 6.0% disbursement will be sustained have declined to .35 at year 12, and .25 at year 24. Moreover, there have been significant increases in the chances that the higher initial disbursement will later be less than the lower initial disbursement. These chances are .47 at year 12, and .64 at year24. When the disbursement starting at 6.0% is less, it is less by about a third of a percentage point of initial portfolio value. These reductions may now be more serious because they can be from lower values of the 5.0% disbursement. With lower chances the increase will be sustained, and higher chances the increase will later be seriously lower, those who decided on an increase to 5.0% to continue important activities may not further increase to 6.0% to cover additional activities. Nevertheless, immediately curtailing important habitual activities is also a difficult decision. By clearly showing the costs and benefits, these charts are a significant help in making difficult decisions.
Conclusions
The first step in determining the Best Initial Disbursement, or BID, is to find the highest priority activities that can be funded with a highly sustainable initial disbursement from the portfolio, and any highly sustainable funds from other sources. Funding for important activities that cannot be included is obtained by accepting increasing sustainability risk to get additional funds from the portfolio for activities of decreasing priority. The BID has been found when the marginal cost in increased sustainability risk of more funds exceeds the marginal benefit of the additional activities being funded. After allowing for the possibility of lower expected returns, and the need to cover future emergencies, a disbursement of only about 2.5% is highly sustainable. Beneficiaries, however, seem unlikely to be willing to retrench to avoid sustainability risk from the lowest expected returns that seem reasonably possible in the 2020s, or from covering emergencies. Accepting these risks increases the initial disbursement from 2.5% to 3.5%. Accepting some risk of future declines to avoid initial retrenchment further increases the initial disbursement to 4.0%. Despite the risks many seem likely to accept this New 4% Rule to avoid retrenchment. Some may accept further risk by a further increase in the disbursement to 5.0% or 6.0% when necessary to cover important activities.
Posted October 2024