Latest / The Financial Freedom Podcast with Fexingo: Quitting Your Job, Living Off Investments, Independence / How Safe Withdrawal Rates Change With a Rising Market
Transcript
- Lucas: So the S&P 500 has rallied roughly fifteen percent over the past twelve months. If you retired in early 2024 with a million-dollar portfolio and you've been taking out forty thousand a year, adjusted for inflation, your portfolio today is probably closer to one point one five million, maybe one point two. Luna: Which sounds like a great problem to have. Lucas: It is a great problem. But it's also a real decision point. Do you keep your withdrawal at forty thousand plus inflation, which is what the classic four percent rule says? Or do you reset to four percent of the new, larger portfolio, which would let you spend about forty-six thousand this year? Luna: And that's a pretty meaningful difference — six thousand dollars a year. That's a nice vacation, or a new car payment, or a year of groceries for some people. Lucas: Exactly. And the right answer isn't obvious. The original four percent rule, the Trinity study, assumed you take inflation-adjusted withdrawals from day one and never change the dollar amount. That approach is designed to survive the worst-case scenario — a 1966 retiree who faced high inflation and low returns. But it's not designed to optimize for good markets. Luna: So you're saying the rule is intentionally conservative, and if you follow it blindly during a bull market, you're essentially leaving money on the table? Lucas: Exactly. And there's a behavioral risk too. If you never increase spending even as your portfolio grows, you might end up dying with two or three times what you started with, which is inefficient if your goal was to enjoy the money. On the other hand, if you reset your withdrawal upward every time the market hits a new high, you risk overspending right before a downturn. Luna: That's the sequence of returns problem in reverse, right? If you increase spending after a run-up and then the market drops, you're effectively locking in a higher withdrawal rate just when the portfolio is most vulnerable. Lucas: Right. And that's why some researchers have proposed a middle ground called the ratcheting strategy. The idea is simple: you only increase your inflation-adjusted withdrawal when the portfolio has grown by a certain percentage — say, ten percent above its previous peak — and you never decrease it. So your spending can go up, but it can't go down. Luna: So it's like a one-way ratchet. That protects you from cutting your lifestyle in a downturn, but it also prevents you from overspending on every little market blip. Lucas: Exactly. Let me walk through a concrete example. Say you retired in January 2024 with $1.2 million. You take 4 percent — forty-eight thousand — and you plan to increase that by inflation each year. By May 2026, with inflation of maybe 6 percent total over those two years, your withdrawal would be about fifty-one thousand. But your portfolio has grown to roughly $1.5 million, a 25 percent gain. Luna: So under the inflation-adjusted approach, you're spending fifty-one thousand on a $1.5 million portfolio, which is a withdrawal rate of just 3.4 percent. That's extremely safe. Lucas: Very safe. And under a pure percentage of portfolio approach, you'd take 4 percent of $1.5 million, which is sixty thousand. That's a much bigger jump. The ratcheting approach would say: your portfolio is 25 percent above its starting value, so you've clearly cleared the 10 percent threshold. You could increase your withdrawal from forty-eight thousand not just for inflation, but to something closer to fifty-five thousand — a middle ground. Luna: Where does that number come from? Is it just an arbitrary midpoint? Lucas: There's a specific formula from a 2018 paper by Estrada, Kritzman, and Myrgren. They suggest increasing the withdrawal by 50 percent of the portfolio's real growth above a threshold. So if your portfolio grew 15 percent in real terms after inflation, you'd increase spending by 7.5 percent. In our example, that would take you from forty-eight thousand to about fifty-one thousand six hundred — very close to the inflation-adjusted path. But if the portfolio grew 25 percent real, you'd increase spending by 12.5 percent, taking you to fifty-four thousand. Luna: So the ratchet gives you a gradual increase, not a sudden jump. That seems more psychologically manageable too — you're not tempted to blow your whole gain at once. Lucas: Exactly. And the key is that you never cut spending. So in a downturn, you keep spending at the ratcheted level, even if the portfolio drops. That's a big behavioral advantage because cutting lifestyle during a bear market is painful and often leads people to make panic decisions. Luna: But doesn't that increase the risk of running out of money? If you ratchet up and then the market tanks, your withdrawal rate could spike. Lucas: It does increase risk slightly, but the research shows it's still very survivable. The ratcheting strategy had a success rate above 90 percent in historical simulations, compared to 95-plus percent for the fixed inflation-adjusted approach. And the trade-off is that you get to spend more over your lifetime. The median ending portfolio is lower, but the median lifetime spending is higher. Luna: So you're trading a bit of safety for more enjoyment while you're alive. That seems like a reasonable bet for a lot of early retirees. Lucas: Especially if your portfolio has grown significantly. And the great thing is you don't have to commit to one strategy forever. You could start with the inflation-adjusted approach, and if after five years your portfolio is up 30 percent, you could switch to a ratcheting approach from there. The key is having a framework, not a rule. Luna: Speaking of frameworks, this is the kind of conversation that really helps people think through their own numbers. And if these money conversations have helped you think about a decision differently, we should mention that listener support is what keeps this show ad-free. You can find us at buy me a coffee dot com slash fexingo. Lucas: Yeah, it's a small thing that makes a big difference for us. And we don't run sponsor spots, so that's the only way the show stays sustainable. Luna: Alright, back to the strategy. One thing I want to dig into — how do you actually implement the ratchet? Do you recalculate every month, every year? Lucas: Most people do it annually. Check your portfolio on the same date each year. Compare the real value — that is, adjusted for inflation — to the previous peak. If it's up more than 10 percent in real terms, you can increase your withdrawal by half the real gain. If it's not, you keep your spending flat in real terms. Luna: And if the portfolio is down in real terms, you just keep spending the same dollar amount? You don't cut? Lucas: That's the rule. No cuts. The ratchet only goes up. That's what makes it different from a pure percentage of portfolio approach, which would force you to cut spending when the market drops. And cutting spending during a downturn is exactly what most retirees want to avoid. Luna: But isn't there a risk that if you never cut, you'll eventually run out if the market has a prolonged downturn? Lucas: There is some risk, but the historical data shows it's manageable. The worst-case scenario for a ratcheting strategy is something like the 1970s: high inflation and flat markets. In that case, you'd never get a ratchet increase because real returns are negative, so you'd just be taking inflation-adjusted withdrawals, which is identical to the traditional approach. So the ratchet only adds spending in good times, which actually improves your lifestyle without dramatically increasing failure rates. Luna: So the ratchet is essentially a way to safely enjoy bull markets without overhauling your entire withdrawal plan. It's a middle path. Lucas: Exactly. And it's especially relevant right now because we've had a strong run. If you retired two or three years ago, your portfolio is likely significantly higher than when you started. The question is, are you adjusting your lifestyle to reflect that, or are you still living like it's 2024? Luna: And for someone who's still in the accumulation phase, does this have any implications? Lucas: Sure. The ratcheting concept can also apply to how you think about your savings goal. If your portfolio grows faster than expected, you might consider retiring earlier, or you might allow yourself to spend more now. It's the same logic: don't anchor to a fixed number from years ago. Reassess as the market moves. Luna: So the takeaway is: don't set your withdrawal in stone. Build in a mechanism to adjust upward when the market gives you a tailwind, but do it gradually and never cut. Lucas: That's the core. And it's not just for early retirees. Anyone living off investments — even a partial withdrawal — can benefit from thinking about how and when to adjust. The ratchet gives you a clear, rules-based way to do it without emotion. Luna: Alright, well I think I need to go check my own portfolio and see if I've been underspending. Thanks Lucas. Lucas: Happy to help. And remember, the goal isn't to die with the biggest number. It's to live the life you want.