How much can you safely withdraw from your portfolio in retirement? This is one of the most important questions in planning your retirement. You don’t want to take out too much or too little. Your strategy will ultimately depend on several factors such as your tolerance for risk, asset allocation, expenditure flexibility, and desire to leave assets to heirs.
One of the main elements of retirement planning is calculating how much money is needed to be financially independent. Sometimes referred to as “The Number,” this is the amount of money you need to accumulate so that you can safely withdraw income and have the freedom to do whatever you want for the rest of your life.
Many calculations are necessary to determine this amount. Perhaps the most important is figuring the amount of money you can safely withdraw from your portfolio each year. You will need to accumulate an asset base large enough to generate the income you need for the rest of your life, while minimizing the risk of depleting your nest egg later when you might need it most and may be the most financially vulnerable.
Like everything in economics, there is a trade off involved. If you withdraw too much you might prematurely exhaust your portfolio. If you withdraw too little, you will have unnecessarily lowered your standard of living during your lifetime. Accordingly, there is no right answer for everyone. Your strategy depends on several factors such as your tolerance for risk, asset allocation, expenditure flexibility, and desire to leave assets to heirs.
The issue of a safe withdrawal rate has been studied for a long time by academic and professional researchers. Institutional investors, such as pension plans and endowment funds, did much of the early work on this subject, but in the last ten or so years several studies have focused on the specific needs of individual investors. The results of these studies are generally consistent with each other, but have subtle differences that yield important lessons.
Some early studies that were done in the mid-1990s used rolling-period historical returns to calculate safe withdrawal rates. Retirement time horizons were assumed to be 30 years, withdrawals were generally assumed to increase each year to account for inflation, and portfolios were often simple combinations of traditional stock and bond indexes.
Researchers simulated the returns of various investment portfolios and withdrawal rates to find the probability of a portfolio surviving 30 years given their assumptions. The presumption was that what worked in the past will likely work in the future and that past market returns are good estimates of future returns.
The attraction of using this methodology is that it reflects actual market conditions. One can calculate with certainty the maximum withdrawal rate that would have worked through the exact the time period studied. For example, the adverse economic and market conditions that faced a new retiree in 1973 were the worst on record due to the high inflation and low real asset returns that, with hindsight, we know occurred during the 1970s. It can be comforting to know that you have a plan in place that would have survived such a period of extreme and unmatched difficulty.
The results of these early studies were fairly consistent and generally concluded that the maximum safe initial withdrawal rate is somewhere between 4% and 4.5% per year of a portfolio’s value. This rate would allow income to be fully adjusted for inflation every year thereafter and still maintain a positive balance at the end of every 30-year period.
There were two surprises that came from this early work: (1) safe withdrawal rates were lower than many expected, and (2) portfolios with higher percentages of stocks had greater rates of success. Prior to this work, even most professionals thought withdrawal rates of 6% or more were reasonable and that portfolios with higher stock allocations were more risky for retirees.
More recent studies have made improvements in methodologies and assumptions over previous work. For example, rather than using historical year-to-year returns, researchers now often use stochastic modeling, or Monte Carlo analysis, to allow for a more robust simulation of potential future outcomes. Stochastic modeling has the ability to simulate thousands of multi-year retirement outcomes and can more accurately predict probabilities of success.
Further, more realistic withdrawal rules more accurately reflect the flexibility of income needs, which is the case for most retirees with moderate to significant wealth. Simulations have been done that restrain withdrawals during poor market conditions. This essentially eliminates the risk of running out of money while simultaneously allows for higher initial withdrawal rates and the maintenance of long-term purchasing power. Some studies show that flexible withdrawal rates allow a retiree to start off withdrawing 5.5% or more of their portfolio’s value, which is about 1% higher than earlier studies that assume steadily increasing withdrawals.
Current market conditions may call for adjusting the withdrawal rate down. Today’s low interest rate environment and the lower expected returns many economists forecast suggest that an initial withdrawal rate of 3-4% is more appropriate now.
Regardless of the method used to determine your withdrawal rate, being conservative is important because the worst outcome would be to run out of money in old age. Lower and more flexible withdrawal rates are proven to be safer and should provide investors with increased peace of mind to help them weather the occasional difficult market conditions that will be a part of every investor’s retirement years.