The Safe Withdrawal Rate (SWR) Strategy

The SWR method involves finding the highest ‘safe’ withdrawal rate that would have survived a significant number of historical scenarios.

Here’s how you use an SWR to calculate your FIRE portfolio target: Calculate your expected annual expenses in FIRE. Divide this by your chosen Safe Withdrawal Rate (SWR), say 3% (more on WR below). Then:

FIRE portfolio amount needed = Expected Annual FIRE Expenses / Withdrawal Rate

An example: Your annual FIRE expenses (including taxes) is 12 lakhs. Assuming a WR of 3%, you will need a FIRE portfolio of (12/0.03) = 400 lakhs or 4 crores.

The Trinity Study

In the 1990s a paper that is now famous as the Trinity Study indicated that a portfolio of 50% stocks (the S&P500 index) and 50% bonds would last at least 30 years if the person withdrew 4% of it in year 1 and then each year increased that amount to account for inflation. This is now popular as the 4% rule (of thumb). ‘Success’ here is defined as having at least $1 in the portfolio at the end of the 30 year period.

Note that the 4% rule applies for the USA only and that too only for a retirement period of 30 years. Why 30 years? Because that’s the maximum traditional retirement length assumed for someone retiring at the regular retirement age of around 65. Recently it was shown that the 4% rule remains valid even for India as of the date of the posts Part 1, Part 2.

A withdrawal rate (WR) of 4% is also commonly expressed as a corpus of 25x. 4% of Rs 100 is Rs. 4, and if Rs. 4 is your annual expenses, then your corpus ie, Rs. 100 is 25x of your annual expenses. Similarly a withdrawal rate of 3% (which is safer than 4%) means that you need a corpus of 33x of your annual expenses.

Contrary to many people’s beliefs, this 4% rule is not really a mathematical rule.

Rather it's just a rule of thumb, an observation that's true based on past data (US equities and bonds). The future may or may not be the same as the past. But most people believe that the past is a reasonable proxy for the future given that we have seen two world wars, a cold war and everything in between - the argument being that if the 4% withdrawal rate stood the tests of the 20th century, then it's already been tested well enough.

The 4% rule also does not include any option for flexibility in expenses. It assumes you will forever continue withdrawing 4% of the starting portfolio, adjusted only for inflation in subsequent years. Any flexibility in reducing expenses and therefore the WR would increase the chances of success, as would any additional income earned from a temporary part-time job or gig.

So if your retirement duration is expected to be 30 years, then you need at least 25x to retire. To be honest, you probably should have a little more than that, just to be on the safer side - ie settle for SWR of less than 4% even for a retirement duration of 30 years. This multiplier-over-yearly expenses based technique is known as the Safe Withdrawal Rate (SWR) strategy.

If you are looking at early retirement, then your retirement duration is going to be longer than 30 years and you certainly need more than 25x to be retirement ready.

What SWR should you use?

To minimize the ‘sequence of returns risk’ (more on that later) and thus avoid running out of money before you die, many early retirees keep a 1-2 year cash ‘cushion’. In case of a downturn shortly after firing, this helps avoid having to withdraw from the already beaten down equities portion of the FIRE portfolio.

Okay so what SWR should you use? Using your chosen asset allocation ratio, you can back-test how well your portfolio would have fared historically. This can be done using websites like cfiresim, firecalc, Portfolio Visualizer, or Engaging Data calculators using historical returns and Monte Carlo simulations. However note that these only work for US and global markets (not an Indian assets-only portfolio). The only such exercise conducted for Indian markets can be seen over on /r/IndiaInvestments.

Using this approach you can settle on an SWR that has a success rate that you are comfortable with for your chosen asset allocation ratio. While back-testing doesn’t assure future success of your portfolio, it goes some way in giving peace of mind that nothing in the past (recessions, wars, high inflation periods, black swans etc.) would have derailed your plan. For further peace of mind, you can lower your maximum withdrawal rate during FIRE to below your SWR and/or increase your cash allocation. Being flexible on FIRE spending and willingness to earn some income if your portfolio goes below a critical level will go a long way in saving your retirement.

While you should use a single SWR for calculating your target FIRE portfolio, you shouldn’t use a fixed SWR for withdrawals after you FIRE. If the market drops 50% and we enter a multi-year depression during FIRE, continuing to withdraw at a fixed % doesn’t make sense. Most of us should be able to tighten our belts a bit in such a scenario and this will reduce the chances of running out of money. So there are many different withdrawal strategies that don't involve a fixed SWR, but the popular ones are:

• Variable Spending (with a max and min.) % of portfolio (withdrawal amount calculated as a % of portfolio at the beginning of each year)

• Variable CAPE

• Variable Percentage Withdrawal (VPW)

We strongly encourage you to explore the withdrawal strategies above - a good place to start is the Safe Withdrawal series by Big Ern at the Early Retirement Now blog.