Episode 155
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August 22, 2023
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00:21:41

In this episode of Finance For Physicians, hosted by financial advisor Daniel Wrenne, we demystify the often daunting question: "How do you know when you have enough to retire?" Tailored to physicians, this insightful discussion delves into the widely used 4% rule—a simple yet powerful tool for gauging retirement readiness.

Daniel expertly breaks down the mechanics of the 4% rule, providing practical examples and insights into its application. Beyond the calculations, he explores the real-world implications for physicians, considering factors like lifestyle changes, investment strategies, and future earnings growth. Discover how to personalize the rule to your unique circumstances.

Whether you're a seasoned medical professional approaching retirement or a young physician planning ahead, this episode offers actionable advice to align your financial goals with your aspirations. Tune in to Finance For Physicians to confidently navigate retirement planning, leverage the 4% rule, and pave the way for a secure financial future.

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Daniel Wrenne: What's up guys. Hope your day's going well. I'm going to be covering another common question that comes up today, and that is about retirement and how do you know when you have enough I think this is probably the most common question at least around like investing that people have, and there's a lot of different ways to it.
There's a lot of different rules of thumb and there's a lot of misconception. and so today I'm going to go through one of the most common rules of thumb. And if you've heard me for a while I'm not the biggest fan of a rule of thumb, but this is a pretty good one. It's good to understand the rules of thumb.
There is some benefit of using rule of thumb. And then when you understand it, you can start to. Apply it to your situation. And sometimes you'll skew one way or the other based on your circumstances. And that's where you can really, that's where we really are after is to personalize it to your situation.
So we're going to be talking about determining some ideas for how you might determine how much you need to retire. And so the. Rule of thumb, I think this is probably the most commonly used rule of thumb for a quick calculation to figure out if you have enough to retire. And so the rule of thumb is the 4% rule, and maybe you've heard it before.
So the 4% rule it's basically says that you can take whatever your total assets are earmarked for retirement, your total investment assets earmarked for retirement. And multiply it by... 4%, whatever that number is. So say it's a million dollars of investments for retirement and times 4%, that's 40, using the 4% rule, the 40, 000 that's based on this rule of thumb, a safe amount of money that you could assume is generated.
Per year for the rest of your lifetime. So in other words, like if your retirement lifestyle is 40, 000 a year, another way of looking at it is if you're using the 4% rule, that would say that. A million dollars is adequate to provide that 40, 000 a year lifestyle for your lifetime.
So that's the rule of thumb. I guess another way you can look at it is like, you can kind of go backwards with it. You can say, what is your retirement lifestyle that you need? And so say it's the 40, 000 we were just talking about and then divide it by 4%. And then that gets you the same million dollar number, that you would need to have, in today's dollars in order to retire.
So if you're not quite at the number, It's still helpful to kind of know how close you are. So it's assuming like today's dollars. This is not a future calculation. This is just a assumption of what you would need today if you were retiring today. like, let's say you have 700, 000, and.
The number that you need is a million. So you're like 70, 70% there. I'm not going to talk about the second part of the equation there. Like if you're short, you can do some additional calculations to figure out like what would be needed to be saved to get there. we can cover that in a future show.
Definitely. Let me know if you want us to get into that, but for today, I'm just going to focus on this 4% rule and like how it works and make sure. You know, you're applying it to your situation. So, 4% rule is based on the math of multiplying it by your total investment assets for retirement. The big, there's a big point.
I think that we should point out first especially for those of you that are like younger or earlier in your career this is all based on like retirement lifestyle. So I said, like. The 4% rule is used to determine if you're able to live in retirement. So your retirement lifestyle oftentimes is completely different than your current lifestyle.
So it's a, it's an important thing to think about, like, let's delineate between your current lifestyle and your retirement lifestyle. Do you know what your current lifestyle is first of all? And then do you know what your, you would. Estimate your retirement lifestyle to be. So I'll give you some examples of like common things that might make those numbers different, sometimes
substantially
different.
So maybe, maybe you're, you're having, you're making student loan payments now, or maybe you're about to start making student loan payments. Maybe you have childcare payments or nanny costs or charitable giving. Or insurance premiums for things like disability insurance that you would not typically pay in retirement.
Those are the sorts of things, maybe mortgages those sorts of things will typically be on schedule to be done by the time you retire. So the question is like, does that, is that part of your retirement lifestyle? it might be, it might not be, but I think what it comes down to is what are you likely to do with that money?
So, especially if you're going to pay it off. Or it's going to end way before retirement. So let's use like student loan payments. Say you're going to pay them off in five years. The big question there is like, where's that money going to go when you pay them off, if it's going to get most likely spent, or if you just want to play it safe, then assume that is also included in retirement lifestyle.
On the other hand, if it's like a mortgage and say, you're going to pay it off right when you retire that's not going to really give you any time to increase lifestyle. So. You know, maybe you don't include that in retirement lifestyle. So it's important to, first of all, understand what your current lifestyle is, and then second of all, start to have a pretty good idea of what retirement lifestyle might be.
Typically the numbers are different. The other thing is what about future pay increases from now until retirement? Sometimes that can skew. I mean, if your pay goes up. Cause retirement is all about lifestyle. Like your pay when you're working doesn't directly matter in retirement. What matters is like your lifestyle.
Cause you have to sustain it. So where pay does tie into your lifestyle is you typically like not always, but you typically increase lifestyle as pay increases. So sometimes people do this math on the 4% rule and they calculate their number and they're like, okay, 40, 000. I need a million. And then their pay goes up and they don't do the calculation again, or they're not adjusting it each year as pay goes up and they're going for a number.
That's now completely wrong because their pay has increased a lot and their lifestyle has gone way up with that. So if your number has gone from 40 to 80 to a hundred, that completely changes this calculation. So you got to think about like, how does that come into play? I'll circle back to that in a second.
So the other big thing, so, you know, how much do you have invested today? is the big factor. So understanding that tracking that over time I think you got to have, you know, a good idea of that. And I think we have some network trackers that we will link to those in the show notes. Also, we have a good handy, like expense tracking worksheet that will help with the retirement lifestyle versus the current lifestyle, where you can kind of do a.
It's already formatted. So you can do a percentage calculation to reduce things for retirement. But having this organized is really helpful. It can make this calculation, this analysis pretty simple and straightforward. So where does this come from? So the 4% rule is a rule of thumb. I think it's helpful to know where does that come from?
It comes from the Trinity study. So I'll link to that as well, but the Trinity study was a research. I guess it's ongoing. They keep, they've updated the timeline on it, but they've looked at how long you are, the probability, I guess, of your money lasting for various time periods based on how much you took out percentage wise each year.
and they also looked at it at varying like stock bond mixes. So for example, if you were a hundred percent. Stocks they looked at like, what is the probability of you being able to maintain a 2% withdrawal rate? What about a 3% withdrawal rate? What about a 4% withdrawal rate? Five, six, seven. I think they go from like two to 7% maybe.
But I'll link to that in the show notes. And then they look at it for, you know, 80% stocks, 20% bonds, 70% and then they go down the, the spectrum from more stocks to more bonds. So for example, on the 100% stocks, I'll just share a couple of like quick examples, so on the a hundred percent stocks analysis, if we're looking at 30 year timeframe and we use a 3% withdrawal rate.
The probability of success. So this probability is calculated on like historical, like varying periods of time. So it's probability is a safe way to do this because it looks at varying circumstances, but for the 30 year timeframe at a 3% withdrawal rate with a hundred percent stocks the latest result was that that's a hundred percent probability of success.
In other words, that's like a very, very solid 3% withdrawal rate is super solid. If you bump it to 4%, you're at 98% probability, which is still really solid. Especially if you're going to be doing this every couple of years. Now, if you bump it to 5%, it drops down to 80%. So that's kind of on the window of like, okay, if you go too much below that, I would say that's.
Concern. And so with a hundred percent stocks 4% is pretty safe. 5% is pushing it 3% is ultra safe. Now, if you go down to, and this is also assuming you increase that withdrawal amount by inflation as well. So just a side note. Now, if we reduce the stock, increase the bonds. So the next threshold they look at in this, this particular breakdown is 75% stocks, 25% bonds, and that break down the 30 year timeframe.
It's a hundred percent after at the 4% withdrawal rate. So it's a touch better than the a hundred percent stocks. And you can see, like, if you look at this chart, like the general consensus, I guess, if you're strictly looking at it from a probability of success standpoint like in most of these stock bond mixes 4% works well, it's very, very high, unless you have like a whole bunch of bonds, like 75% bonds.
Starts to become concerning. If you're a hundred percent bonds, it doesn't work for 30 years, but I don't know why you would have a hundred percent bonds for a 30 year timeframe. That doesn't make much sense. That's a separate conversation, but if you're having a decent amount of equities, 4% works very, very well.
That's where the rule of thumb comes from now. And you could actually, I mean, 5% is works most of the time, especially if you have at least 75% stocks. And if you have a hundred percent stocks, you can maybe, you know, depending on the outcome is like probably even go a touch higher, but like for, so rule of thumb wise, it's a safe rule of rule of thumb to say like, let's plan on 4%.
As you can see from these percentages, what's, what's important, a little side note on this too, is the study also looked at like the ending wealth at the end of the period for the varying scenarios. Like the average or the median, I guess the median ending wealth at the end. And what's interesting about that is the highest wealth numbers on the median are for the highest stock percentages.
In other words, if you're a hundred percent stocks, your median outcome is going to be a higher number than 75% stocks or 50% stocks. So you end up with more wealth at the end, the more stocks you have. So maybe you're looking at two scenarios, like you're looking at the 75% stock one and you're like, oh, that kinda looks like more or a better percentage outcome maybe.
I mean, it, it, you could interpret this if you're just looking at percentage outcome I think the percentage numbers are slightly higher in the 75% soc, 25% bond. Comparing them together but from a ending well standpoint, the numbers for the a hundred percent stocks are substantially higher than the 75% stocks.
And that makes sense to me. Basically the more risk you take, the more on average wealth you end up with. Now there is a slight effect on probability. Like it can be that it's so volatile in the a hundred percent stocks that it starts to affect your probability. Of success, but it's, it's a low, relatively small effect.
So that's the Trinity study. 4% is a very solid, I think, generally speaking rule of thumb to use. But we're going to talk about some of the limitations of this next. So biggest limitation. Well, you know, any of these rules of thumb or investment analysis, they tip. Typically have to rely on past data.
So there's always going to be that limitation we're using historical stuff. So nobody knows the future. There's uncertainty in the future and the future could look completely different. So the past is, you know, one of the best things we have, but there is uncertainty in going forward. It's also kind of going off this assumption that you do this calculation once And, you know, you don't really ever do it again because it's saying, okay, what's your probability of success?
You know, now for 30 years from now. And so I have seen, so it's, it's a, it's kind of this, it could be viewed as like a one time calculation you do, and then you're good. The problem with that is it's like, say you need a, you know, you're going for a hundred percent probability of success or 99% or whatever That's like another way of viewing it. That's like a hundred percent chance. You're going to have an inheritance and that calculation changes every year. So it's very, very, it's much more difficult to have a hundred percent probability of success for a 30 year timeframe than it would be to like, look at it each year.
And recalculate it make tweaks. So this assumption is that there's not any tweaks made and it's linear. And you're looking at a long time horizon, which is a limitation in itself, because in reality, in your life, real life, like you can look at it each year and make tweaks and it provides a ton more flexibility because if it's lower one year, you can make a tweak.
And if it's higher one year, you can kind of make a tweak or leave it the same. Also, it doesn't include taxes. Or fees or expenses. That's one of the reasons like our planning firm charges flat fees directly to the clients. We don't charge most financial planning firms charge asset based fees, like 1% of assets is a very common approach.
But the problem with that, like, as you start to build wealth, it's like, well, 4% is now 3% because 1% of the fee that 1% fee comes straight off the top. And so that's not, I don't think that's always the worst approach. It's not my favorite. That's that's, I don't feel like that's the best way to do it.
But if you are doing it that way, you just need to take that into consideration. Like don't use a 4% rule of thumb, use a 3%. If you're paying 1% fees, also taxes can have a big impact. I mean, I guess if you're a hundred percent Roth IRA for this investment balance, we're talking about, then that would actually translate to where it's going to work.
And you don't have to worry about taxes because it's all going to be tax free if you're keeping it till retirement. But in most cases you have some pre tax. Like that will get taxed. When you take it out, you have some Roth, you have some taxable, like stuff that gets taxed along the way. So there's all kinds of different tax treatments of your assets.
And so that almost always has an effect on this. And it will lower the net percentage that you get. So it's worth considering. That, in using, you know, in coming up with your specific. So the more you have in Roth, that's going to have less effect. The more you have in stuff, that's going to get taxed like pre tax money, like 401ks pre tax or traditional 401ks, the more effect it will have on that percentage.
It's also capped at a 30 year timeframe. So if you're like early financial independence type maybe you're going for financial independence at 50. It's like, there's a pretty good chance you live 40 more years or maybe more. So 30 years is not enough. And so you can either do your own calculations or you can scale that percentage down a little bit.
Like maybe you're going to use 4% and, but, but maybe you're retiring early. So you want to use 3% just because it's a longer time horizon. It also doesn't really incorporate. Lifestyle changes. Well, I mean, that's just the nature of life changing life changes in general are just not incorporated. Well, I'll circle back to that in a second.
But it's, it's important. We there's a quick, there's like an easy solution to that, but it's, it's, it's just one of the considerations to think about.
So the takeaways, I think based on all that a 4% rule. Is a, is a decent starting point to look at, like, what's your number. In fact, like for my own investments, I use it regularly. Like I actually track it monthly on our balance sheet, just like, I have an automatic quick calculation to show like how close we are to that number.
a great way to get a quick check on like how you're doing relative to. The retirement goal and have progress. So maybe you do it yearly. Like I do it monthly cause it's kind of like almost automated, but yearly I think is adequate. You need to make sure you're incorporating taxes and incorporate how you're investing.
So if you're all stocks versus all bonds, 4% is too much. And that's a separate thing. Like I said, you probably shouldn't be all bonds, but that's a separate conversation, but incorporating taxes, you know, if you're a hundred percent Roth, like I said, like it's not gonna have any effect versus if you're all pre tax it's have it'll have a pretty substantial effect.
And if you're able to look at this regularly over time, think you can be a little more aggressive with the percentage. So for example, for me, like I would be comfortable going for more like 80% probability of success because I know I'm going to look at it every year at minimum, and I know I can make tweaks.
So 80% probability to me is fantastic for that long of a timeframe. And by doing, by using 80%, I can get a little more aggressive, like with the, like it's going to happen sooner. I can use a higher withdrawal rate. Maybe I go to 5% withdrawal rate before taxes. So ideally, I think the biggest thing I would take away is like.
Understanding what this is incorporating it into your planning. Now, if you're working with us, we're already incorporating this. In fact, this is kind of like built into our planning, know, looking at this regularly, this probability of success based on your goal. So feel free to ask questions though on it.
But I think the big thing is that it's being tracked and it's being, it's something that you look at regularly. And the best way to do it is to make small tweaks along the way. That way you're staying within this like range of success and it is a great way to kind of get a quick check on how you're doing and that'll, that can kind of reinforce things are, are going well, give you, give you confidence in retirement.
So, that is the 4% withdrawal rule. I hope it's been helpful. As I mentioned at the beginning please reach out with questions that you would like us to cover. It can be. Questions related to this topic. We can, we can go into depth on like the way that you calculate if you're off on the number or, you know, how to look at the tax impact.
Or maybe you have other questions that are unrelated. Please email those to me. It's Daniel at finance for physicians. co. And I would love to cover those in future shows. All right. We'll see you next time.

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