Good Morning, Income Investors!
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In February, Buffett released his annual letter to shareholders, which is available here. I read it every year because Buffett's wisdom is a level I aspire to reach someday. Today, I want to highlight some of the comments Buffett made that spoke to me and my thoughts on them.
When all of us got sent home during the COVID epidemic within the United States or even just around the world, the number of scam calls or online scams perpetuated rose astronomically. To put it into perspective, from 2021 to 2022, there was a reported 82.35% increase in losses related to scams reported by the FBI. This amounted to about $3.1 billion worth of losses for people 60 years and older. Scammers became more sophisticated but also more prevalent simply because they had nothing better to do and it is easy for them to try and perpetuate a scam. What if I told you that there was a bigger scam, in my opinion, that I see perpetuated over and over again within the financial sector by people who believe that they're doing well, but they have also been duped?
When it comes to retirement planning, being duped into falling for a potential scam or using something that no longer is true, but we still believe it is, can cause you to have financial calamity. The last thing I want for any investor or person I've ever met is for them to live in complete financial disparity or to live in the bare bones of our society because they, while betting everything they have into it, fell victim to something that may have been true previously, or was built upon a number of assumptions that turned out to be no longer valid. Today, I want to take a look at the world-famous 4% withdrawal rule that many will vehemently defend till they are blue in the face and recognize that the assumptions of when it was built no longer apply today. The cards have changed. Things have shifted. We now live in an environment that you need to adapt and change.
Let's dive in.
The Magic Bullet of 4%
The financial investment advisory world was rocked in 1994 when William Bengen published his now-famous paper titled "Determining Withdrawal Rates Using Historical Data." What he did was he took historical data going all the way back from 1926 forward to determine what the safe with Max withdrawal rate would be so that our portfolio would survive at least 30 years, sustaining the same level of income. When he did this, he found that the 4% rate allowed a portfolio to survive 30 years with a 0% chance of failure. For many of these assumptions, they were able to see that it could last up to 50 years and still be surviving. This was based on the assumption that a portfolio would be on a 60/40 split between equities and bonds and that they'd only withdraw 4% adjusted for inflation every single year, meaning if you had $1,000,000, you would take $40,000 out every year and adjust it from year two forward for whatever the inflation was at the time.
I will commend him for the fact that he used actual market returns from 1926 through 1992 to build his model and his estimations. He then projected future expected market returns going forward because he can't see the future, and my crystal ball is still broken. He assumed a safe withdrawal rate of about 4%, assuming that the market provided 7% returns every single year and inflation was no higher than 3%.
Modern Developments
In recent years, with higher levels of inflation and lower levels of interest rates, some places like Morningstar have recommended that the safe withdrawal rate be dropped down to the 3% range, which reduces the amount someone takes out and thus reduces failure rates. 3.3% withdrawal rates gave an acceptable 10% failure rate. It was determined that for many investors in the current environment and the style of portfolios they have, failure rates could be up to 80%, meaning that investors and retirees would burn out of their entire portfolio savings before the 30-year mark was hit if using the 4% withdrawal rule.
Even more alarming was that if you started to shift this portfolio to be more focused on bonds and less focused on equities to adjust for a retiree's potential risk tolerance or desire for long-term capital preservation versus potential risks found in common equities, the failure rate approached 100 percent.
"If you measure success rates of the 4% rule using the traditional 30-year sustainability yardstick, safe investments have a zero percent chance of success." – Michael Finke, Frank M. Engle Chair of Economic Security at the American College of Financial Services
That's a pretty stark outlook.
Inflation's Drip Of Poison
For many of us, thinking about living on $40,000 doesn't sound that tangible, and you'd be correct. Life is expensive and only getting more expensive as time goes on. When his report was written in 1992, he recommended a $40,000 (4%) withdrawal rate compared to a million dollars. To put that into perspective, factoring inflation from 1992 until now. The difference in the value of $40,000 in 1992 comes out to about $88,000 to $92,000 today, depending on which inflation metric you use. This means that if you want to have the equivalent amount of money to withdraw each year, you would need a portfolio worth about $2 million using the 4% withdrawal rule, even though we're recognizing that it creates a statistically unacceptably high level of failure rate.
Rapid inflation impacts, low-interest rates or higher interest rates, and the shifting around of the market have rapidly shown that the 4% withdrawal rule, which has become the golden marker, is more of a risk to your portfolio than it being a benefit. At this juncture, so many retirees build their lives on the thought that they could stack up this wonderfully massive pile of money and only take 4% of it away at a time and that it would sustain them for the 30 years of their retirement and they're discovering it's all a sham when the money dries up.
It's no wonder that I talk to retirees daily who are new members of my private community who literally tremble with fear over the fact that they are worried about running out of money before they run out of breath. The tools that modern retirement and investment advisors are using are outdated.
Stop Selling, Start Collecting
My personal recommendation is to stop. Take a moment to evaluate realistically what you want from your retirement and ask yourself if this wasn't some magical investment advice that you received and if you understood the market entirely, does it make sense to build up a pile just to sell it off?
Let's move it to a totally different situation.
Let's say you're a landowner, and you own a million acres. Would you sell off for 40,000 acres every single year, hoping that the value of those other acres will rise to allow you to sell fewer acres the next year? The assumption is that the value of land is going to rise to offset the previously sold-off acres, meaning that when you sell the next swath of acres, you should arguably have to sell less to unlock the same value, but that's not always the case. The market goes up, and the market goes down for land values just like it does in the actual market. So, every year, the amount of land that you own reduces because you're selling it off to pay your bills.
For many, they simply hold shares that do nothing more than hopefully rise in value - fingers crossed! - but provide no other tangible benefits. Like a farmer who owns land but doesn't use it for anything other than to sell it off.
If you've spent your entire life building up this land around your home, I highly doubt you would take the last 30 years of your life to utterly dismantle your life's work. I've known many farmers in my life – my grandparents on both sides of the family were farmers. Neither one of them actively sold off chunks of their farm to pay for their retirement years. They did with so many farmers do – they rented their land. Someone else worked it and did all the efforts of planting and sowing, or grazing cattle on it, and taking care of it. They simply received a rent check. They didn't have to sell their acreage to be able to pay for their retirement. The acreage proved to be fertile ground from which they could generate an income. So why is it that when we approach the stock market and retirement planning, our entire idea is to build up something just to break it down?
The 4% withdrawal rule is simply an orderly dismantling of your entire life's work wrapped up in prettier language. If you have to sell a share, you reduce your ownership of something. If you own 100 shares of a company and you sell me one of them every single year, I, by the end of 100 years, will own the company, and you're out. It doesn't matter if the company's value continues to rise, or if you're shrinking ownership percentage is the same value. You still lose ownership value. Everything you've built will be mine.
My recommendation is to entirely forgo the mindset of selling shares to be able to pay for your retirement instead. Start collecting. I'm a net buyer of the market in almost every situation because I am provided a relentlessly powerful stream of dividends into my portfolio from my shareholdings. When you start income investing, you may only get a few dividends trickling in, but over time, that trickle will become a raging Amazon River that others will be vastly jealous of.
For some of you, you have a lot of capital to start with and you can put that to work right away and see a torrential rainfall of dividends into your account that you can use to combat the fires of your expenses. Instead of having to throw your life's work into the fire to try and put out the expenses, you can use the precious rainfall of dividends to do that and still own everything you have. If your expenses are like a raging forest fire that consumes everything you have because the only plan you have is to let it all burn to survive, I feel absolutely sorry for you. So many homeowners, when it comes to an area where there are forest fires, will actively spray water over their homes and dig fire trenches to prevent that forest fire from burning down their possessions. They have a plan in place.
Your retirement expenses are a fire, and they will consume every single dollar you have unless you have a plan to offset them and put them out. Tap into the massive supply of dividends that are paid out into the market every single year and stop letting the scam belief that you have to let your entire life's work burn up to expenses throughout your lifespan and unlock something truly revolutionary.
That's the beauty of my income method. That's the beauty of income investing.
That can be your dream retirement outcome.
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