The Safe Withdrawal Rate Revisited

The greatest retirement planning fear of most people is the possibility of outliving their money. One way to avoid that fate is to save a lot and invest well during the accumulation years. Those steps are widely discussed.

Less attention is devoted to the second part of the retirement plan, the withdrawal phase. Gone are the days when most retirees could move a portfolio into safe income investments such as CDs or treasury bonds and live off the interest. Rates are too low for most people to maintain their standards of living solely on the income. In addition, over today’s longer life expectancies inflation eats away at the purchasing power of a fixed income. A retiree’s income needs to increase over time, so a retiree needs to invest at least partly for growth and withdraw part of the portfolio each year.

The question then is how much the retiree can safely withdraw each year without depleting the portfolio early. Several studies indicate that the “safe withdrawal rate” in retirement is between 4% and 5% of a retiree’s portfolio the first year, and the closer to 4% the safer one is. After the first year, the withdrawal amount is increased for inflation each year. Even this withdrawal rate is not 100% safe. There still is only a 90% or so probability of not outliving one’s portfolio, meaning there is a probability of around 10% of running out of money.

A 4% withdrawal rate does not provide many people with a luxurious retirement. A $1 million portfolio generates a $40,000 distribution the first year at a 4% distribution rate. (After 15 years of 3% annual increases, the distribution is over $62,000.) A 5% rate equals $50,000 the first year.

Many people believe that the 4% withdrawal rate is too low to maintain the standard of living they desire and that their savings and investments warrant. Is the 4% rate too low? Instead of looking at the conclusions of the studies, let’s look at the assumptions that resulted in the conclusions. Then, consider if the assumptions should be adjusted in your situation. If you believe the assumptions do not apply to you or are willing to take some risks that are eliminated in the assumptions, a higher rate could be appropriate for you. Let’s discuss the assumptions.

The studies assume a traditional investment portfolio of stocks and bonds, or stocks, bonds, and cash. Then, the portfolio is run through different scenarios based on historic returns. After 500 or more scenarios, the probability of success is computed. Because historic returns are used, the portfolios experience extended bear markets of below average or negative returns which can last 20 years.

Investors are likely to achieve different degrees of success with different portfolios. The effects of extended bear markets in U.S. stocks and bonds are mitigated by adding international stocks, real estate, and other assets, as we have in our portfolios. In addition, the scenarios assume a fixed portfolio allocation over time. If the portfolio is adjusted to remove highly valued investments and those without margins of safety, as our Managed Portfolios are, they are less likely to experience long periods of modest or negative returns to which portfolios primarily of stocks and bonds are subject.

You also might retire at or near the end of a bear market. In that case, investment returns during the first half of your retirement are likely to be above average, allowing a higher withdrawal rate.

If one assumes a more diversified portfolio than those used in the models and perhaps some judicious changes in the portfolio over time, the portfolio is likely to sustain a higher withdrawal rate than 4%.

The annual increase for inflation is built into all models, but recent research calls into question automatically increasing spending with the Consumer Price Index. Retirees often do not increase their spending with inflation. As one ages spending on many items actually declines. The spending item that grows the most is medical care. If one has good medical expense coverage, even that budget item will not cause a significant boost in overall spending.

Instead of an automatic withdrawal increase equal to the CPI, a steady rate of increase between 2% to 4% can be used, as can a periodic increase. Many retirement spending models now assume percentage spending decreases after age 70 or 75. These assumptions also sustain a higher withdrawal rate than do the assumptions used in the safe withdrawal rate studies.

An alternative to consider after the first year is the formula used by the Yale Endowment. After the first year, multiply the prior year’s spending by the inflation rate. Multiply this by 70%. Then, multiply the current value of your retirement fund by the first year withdrawal rate. Multiply that by 30%. Add together the two products, and that is your spending for the year.

These three key assumptions do the most to determine the safe withdrawal rate. The most important factor, however, is the portfolio allocation. A more diversified portfolio avoids the worst effects of bear markets in U.S. stocks and bonds and can sustain a withdrawal rate of up to 7% rather than a 4% rate. Each change has its risks, of course. Adhering to a 4% rate comes closer to ensuring a steady income for life but risks reducing the standard of living below what it could have been. Increasing the rate closer to 7% takes the risk that the assumptions are too optimistic and spending reductions will be required later in life.