We all dream of the day when we’ve saved enough to retire. When we don’t need to work for money ever again. And we can simply live off our hard-earned savings.
You might think that represents a nice round number like $1 million, $3 million, or $5 million. How did you come up with that number? Did you use a rule of thumb like the 4% Rule? That’s where most people start.
The 4% Rule says that every $1 million produces $40k in income each year, plus inflation adjustments, for the rest of your life.
What if I told you there are ways to make your money do better than 4%? That you might need less money than you thought. That you could instead turn that same $1 million into $45k or $50k in life-long income.
Would you be interested?
Getting 4.5% or 5% out of your investments isn’t wishful thinking. It’s completely realistic, and history proves it. Let me show you how.
The Portfolio Behind the 4% Rule
The 4% Rule says that a conservative mix of stocks and bonds should last at least 30 years if you withdraw 4% of the starting balance the first year and adjust with inflation in following years.
It was developed in the 1990s, when historical data was only available for US large company stocks and treasury bonds. So the portfolio behind the 4% Rule only had those two asset classes to work with.
The original study by Bill Bengen found that 50% stocks and 50% bonds had the best chance of lasting at least 30 years. It also showed that portfolios with as much as 75% stocks and 25% bonds would do similarly well.
Four years later, a second study called the “Trinity Study” confirmed Bengen’s earlier research. It used a slightly longer dataset. And instead of intermediate-term treasuries, it used long-term treasury bonds.
So, to strictly follow the 4% Rule:
- Your portfolio would be somewhere between a 50/50 and 75/25 stock/bond allocation.
- Stocks would be in an index fund of large companies, such as the S&P 500.
- Bonds could be either intermediate-term or long-term treasuries.
- Your portfolio would stay the same throughout retirement.
Anything outside of those parameters would not be supported by the research.
Improving Your Portfolio’s Safe Withdrawal Rate
Three decades later, it would be foolish to assume that the 4% Rule portfolio has the highest Safe Withdrawal Rate (SWR) that we could achieve. We now have 30 more years of data. And there’s a long enough history on many more asset classes that we can use to build our portfolio.
So how could we make a higher SWR portfolio?
The answer is to use the same principle that makes bonds a good asset to combine with stocks: correlation.
Uncorrelated Assets Increase SWR
Stocks and bonds are uncorrelated—and sometimes inversely correlated—with each other. That means their prices don’t move together. And sometimes they move in opposite directions.
This is good for a retirement portfolio because it smooths the ride. When stocks are having a bad year, bonds may be having a much better year. You can then draw more income from bonds that year. And vice versa if stocks are doing better than bonds.
What we need to protect against the most in retirement is a bad sequence of returns in the first 5-10 years.
Think of 2001, when the Dotcom bubble burst, then just 6 years later the Great Recession hit. That was a bad decade. And a difficult year to retire. Stocks did badly. Bonds did much better.
If 2001 retirees only had stocks in their portfolio, it might not have recovered from 2001-2009 losses. Bonds saved the day.
Some Uncorrelated Assets to Consider
If stocks and bonds work together to improve SWR, what other asset classes might also work well in a high SWR portfolio?
The Construction and Analysis of the Pathway to FI Model Portfolios white paper goes into detail in section 5 about the correlation between 8 asset classes of interest. Bonds are the only inversely correlated asset with the S&P 500. But gold is almost completely uncorrelated. Utilities and Real Estate Investment Trusts (REITs) have relatively low correlation. Small-cap value and international stocks are also of interest.
If other asset classes are more correlated than bonds, why would they improve a portfolio beyond what bonds can do?
The answer is that they have higher average returns than bonds. Because they’re uncorrelated, each of them has beaten both large-cap stocks and bonds some years. And one asset class has far outperformed large-cap stocks over the last 53 years that we have data for.
Asset Class Performance
The white paper has a detailed table (Figure 17) that goes over 11 different performance parameters for the 8 asset classes.
The summary is that small-cap value has had the highest return with lower risk than large-cap stocks. Gold looks bad on its own, but has had bright spots in history that make it valuable as a small percentage of a portfolio. REITs and utilities are high return, low risk sectors to balance out a technology-heavy large-cap index. And international stocks have lower overall performance than the other types of stocks.
So if you’re only going to add one more asset class to your stock/bond portfolio, add some small-cap value! Adding two more assets? Include a small amount of gold.
Here’s a look at what these assets can do to increase SWR.
Portfolios with High Safe Withdrawal Rates
The following table shows what happens to SWR and PWR (Perpetual Withdrawal Rate) as additional uncorrelated asset classes are added to a stock/bond portfolio. SWR and PWR were calculated using PortfolioCharts, which has data going back to 1970 for every asset class that I mentioned except Utilities.
PWR is a more conservative version of SWR. SWR is the inflation-adjusted withdrawal rate that never ran out of money over any 30-year period since 1970. PWR is the inflation-adjusted withdrawal rate that is expected to last for retirements of 40+ years.
I like PWR because I personally wouldn’t be comfortable with a large drop in my initial portfolio balance. That might happen to those who take income using the SWR. It won’t drop as far if you use PWR.
As shown in the table, SWR starts close to 4% as the Trinity Study suggests. PWR is about 1% lower.
A 70/30 stock/bond portfolio is as good as it gets with those 2 asset classes. Moving down the table, replacing some of the large-cap with small-cap value increases SWR significantly. Replacing some of the bonds with gold causes an even bigger jump in SWR.
From there, we can replace some of the large-cap and small-cap with REITs to gain diversification. This doesn’t change SWR. But without REITs, the next step wouldn’t help since we’re reaching the limits of diversification. Finally, we can add some international stocks to get another small improvement.
Now we’ve assembled a portfolio that looks a lot like the Descent Model Portfolio. The only difference is an even split of the 20% REIT contribution with utilities!
Utilities are a great substitute for REITs in taxable accounts. So the Pathway to FI Model Portfolios have a 50/50 split between REITs and utilities.
A SWR higher than 6% seems too good to be true. And there’s no guarantee that what worked in the past will work in the future. But a portfolio that has done this well through the last 53 years of economic booms and busts gives a lot of confidence that more than 4% is safe!
If the future is 25% worse than the past, SWR would still be 4.9% and PWR would be 4.2%.
If it’s 35% worse, SWR would be 4.2% and PWR 3.6%. Still much better than a 50/50 or 70/30 portfolio!
Alternative Investment: Private Real Estate
There’s one more thought worth mentioning before wrapping up this article. An asset class that behaves very differently from the ones that are traded daily on stock and bond exchanges.
That asset is privately owned rental real estate.
Rentals are great because they produce steady, predictable cash flow when managed well. And cash flow naturally increases with inflation as leases are renewed each year.
Owning and managing a few rentals can be a great way to increase your SWR. You’ll rely less on stock and bond market performance and have another uncorrelated asset working for you.
For more on this topic, read How Does Real Estate Fit into a Stock/Bond Portfolio.
Summary
When you retire, you switch from saving for the future to spending down those savings. Instead of maximizing return, it becomes important to get as much income as you can from what you’ve saved.
This article showed you how to increase your expected Safe Withdrawal Rate beyond the mainstream thought that 4% is the best you can do. If you add even one or two uncorrelated assets to your portfolio, you’re likely to make more money from your retirement savings!
So instead of limiting your retirement portfolio to the S&P 500 and government bonds, think about diversifying with small-cap value and gold! If you don’t mind a little more complexity, go a step further with REITs, utilities, and international stocks. This level of diversification has done very well in the past. It includes at least one asset that does well in each type of economic situation.
For more about portfolio construction, read What Should My Asset Allocation Be for Building Wealth Versus Retirement next.
Read Getting the Big Things Right in Retirement Planning to gain perspective on your retirement plan.
And don’t forget to sign up for FREE to get much more value from PathwayToFI.
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