The 7 FIRE Metrics That Matter: Part 2 - Withdrawal Rate (or Replacement Rate) and Return On Investments
Yesterday, I covered Net Worth, both total and liquid, and Savings Rate. They are very important metrics.
These next two are also important, but a bit more nuanced in how you want to think about them.
Your Withdrawal Rate becomes way more important post-FIRE, but you want to be thinking about it beforehand.
You want to have a general approach figured out for what you will allow yourself to spend from your portfolio each year.
That amount should be lower than your total returns, and ideally, lower than your total returns minus inflation. This is why Return on Investments is one of the 7 FIRE metrics That matter, too.
In my post-FIRE experience:
I have been getting an annual Return On Investment of about 11–12%.
I have been “withdrawing” between 3–4%.
Inflation has eaten up about 4% of the returns.
Thus, my portfolio (liquid net worth) is generally doing what I need it to do.
All good so far. We’ll see what happens.
Withdrawal Rate
As I was working towards FIRE, the way I thought about withdrawal rate was in relation to two things:
As a percentage of my net worth
As a proxy for “replacement rate”
What do I mean by this?
To keep it simple, assume I thought I would have a $1,000,000 liquid net worth at the time of leaving paid employment.
If I keep it static, Personally I believe i can safely set my withdrawal rate at 5%.
Thus, my annual “salary” post-FIRE would be $50,000 for the first year.
If it goes up to $1.2 million, then I have $60,000 to spend the next year.
Yay! Daily lattes!
If it goes down to $800,000, then I have $40,000 to spend the next year.
Beans and rice, rice and beans!
I have written about this in earlier articles. I started off using what Dave Ramsey was talking about in 2008 or so.
He was suggesting an 8% withdrawal rate. He was assuming that if you invest in good growth mutual funds, you will get a 12% return each year, over time.
You spend 8%, and your portfolio keeps up with inflation.
If that works out …
A lot of personal finance geeks Have gnashed their teeth over Ramsey’s view on this.
And wrung their hands over what is the right “safe” withdrawal rate.
They’ve fretted,
they’ve said keep it as low as possible,
and that if you never want to run out of money, keep it at 3% or less.
Look, ideally, I sort of agree.
ideally you do want to be able to live off the cash flow your assets put off and never spend or sell the principal/capital invested to fund your lifestyle.
That’s where the 3% idea comes from.
That’s an easy yield to get from your assets each year without touching principal/capital.
However, I like and am basically recommending what I heard Paul Merriman describe as his approach.
He keeps it simple.
He sets his spending budget at 5% each year, based on whatever his total portfolio is at the end of the previous year.
If it was $2,000,000, then he allows himself to spend $100,000.
If it ended way up, say to $2,500,000, then he can spend $125,000.
(Pack the bags, honey, we’re going on that overseas exotic vacation!)
If it’s been a terrible year and it drops to $1,500,000, they spend $75,000.
(Dig out the tent and the Igloo cooler, we’re going camping this year.)
You need to understand your Bare Necessities metric to be able to do his approach, but I think it is a really good way to go.
(That will be covered in the next article.)
Whichever rate you use, you want to make sure to dynamically adjust it each year.
Don’t set it, forget it, and assume everything will work out okay.
Think of a plane that has to constantly course-correct as it flies from LA to NYC.
Replacement Rate
Before I reached FIRE, I also thought about a withdrawal rate in terms of what something actually cost.
I think I first learned this from a couple of Robert Kiyosaki books I read in the early 2000s.
His whole approach is kind of saying try to never work, invest in businesses that cash-flow.
Instead of selling your time for money, buy assets that pay for what you want.
You want a $10,000 vacation each year?
Well, go buy an asset that puts off $10,000+ in cash flow each year.
I used a similar approach but with a 4% withdrawal rate.
If I want to spend $10,000 per year on vacations, then what amount of capital do I need to invest to withdraw $10,000 at 4% each year?
This is the 25-times-annual-spending math you’ll read about in lots of personal finance stuff.
$10,000 × 25 = $250,000
Gosh, camping on Padre Island for $1,000 total sounds fun, doesn’t it, Honey?
$1,000 × 25 = $25,000
You can do that for all your ongoing, regular expenses.
Instead of a withdrawal rate, you are talking about a “replacement rate.”
Once you have all your regular and necessary expenses covered like this, you’ve reached FIRE.
you’ve hit a cross-over point.
It’s that simple.
Return On Investments
Oh man, this is a can of worms. Do I really want to open it?
Okay, I will, but only briefly.
Here’s the deal with Return On Investment (ROI): It is both predictable and unpredictable.
Anytime you invest your money beyond an FDIC-insured deposit account, you have introduced risk into whether or not you will ever see that money again.
And even the FDIC is not completely risk-free.
Remember runs on banks? We just had one not too long ago.
That’s the bad news.
The good news is that there are less risky assets and there are very risky assets. And you can decide where to put that money.
Your goal is to be able to cover your living expenses with the returns from the investments.
Back when Joe Dominguez was teaching his Transforming Your Relationship With Money seminars, he was advising you to put your money in the absolute safest and highest-returning assets you could.
Back then, in the early 1980s, he was advocating U.S. Treasury Bonds.
They were returning about 12% per year.
(Note: You think 7% mortgage rates are bad now? Try the 15–18% ones back then!)
He continued to adhere to that, I believe, up until he passed away in 1997.
In the revised version of Your Money or Your Life, Vicki Robin, his co-author, introduces other ways of investing that are “generally” safe.
There are other people, like Dave Ramsey, who advocate putting the majority of your capital in good growth stock mutual funds.
He recommends choosing funds that have been around for 10 or more years with good historical returns.
He believes you can count on 11–12% per year returns.
I think I heard Charlie Munger, or someone like that, say that going forward we might expect an 8% return on index funds.
That is typically the rate of return that is mentioned by personal finance writers when they talk about a 60/40 portfolio (60% in stocks, 40% in bonds).
There are other economist types who say that all you can really expect for returns is what the Gross National Product generates in the long term.
I’ve heard various people claim That amount might be 4% per year or less.
Look, I am not advising or advocating for any type of investments or approach. \
You need to educate and decide for yourself.
That said, I track my actual results each year.
I stay on top of what my investments are returning.
I know the cash flow they are putting off.
I know how much they have grown on a per-annual basis since I left paid employment.
I have contingency plans in place if things go haywire.
My ultimate goal is to only live off the cash flow put off by my investments.
And, with the right cuts to my spending, I can do that if need be.
I am currently spending more than that, but I keep a close eye on it.
Thus, I recommend you use Financial Mentor’s Ultimate Retirement Calculator to play around with your own numbers.
It’s free. No strings attached. Here’s the link:
https://www.financialmentor.com/calculator/best-retirement-calculator
I used this calculator all the time when I was working towards FIRE.
it kept me motivated and helped me think through my plans and strategies.
I now use it every year or so just to see what has changed.
Heck, I am probably due to use it again, given the wild inflation environment we have found ourselves in these past six years!
It’s straightforward.
Don’t be intimidated.
And it is a lot of fun to play with the numbers and look at different scenarios.