Determining a Safe Retirement Withdrawal Rate

Sometimes a statement like, “You lose 80 percent of your body heat if you don’t wear a hat,” gets repeated often enough that, regardless of its accuracy, it becomes accepted as common knowledge. Plenty of statistics and formulas in the investment planning arena fall into this category of accepted wisdom. For example, you have probably heard of the “4-percent solution” as the answer to the question: How much can I afford to withdraw from my portfolio each year during retirement without exhausting my money prematurely? However, what does 4 percent mean? And, more importantly, can you trust that calculation, especially in a recession?

To clear up a common misconception, the 4-percent solution does not advocate withdrawing 4 percent of your portfolio every year in retirement. If that was your plan, your income would rise or fall depending on your portfolio’s performance. Rather, to establish a reliable income stream, research supports withdrawing 4 percent of your portfolio in year one of retirement and adjusting that amount in future years to reflect increases or decreases in inflation. In other words, if you are retiring this year and have a $1million investment portfolio, research suggests that you can “safely” withdraw $40,000 in 2009, followed by $40,000 indexed for inflation in 2010. In 2011, you would adjust your 2010 withdrawal for inflation, and so on. (Of course, the primary calculation pre-retirees must make is to determine their annual income needs in retirement, as well as how large a nest egg they need to accumulate in order to support their retirement.)

The 4-percent solution has its roots in research by Dr. William Bernstein, author of The Intelligent Asset Allocator.  In a series of articles, he established the ability of a broadly diversified portfolio—60 percent in equities and 40 percent in bonds generating an estimated average annual return of 7.5 percent (with annual inflation running at 3 percent)—to support a 30-year retirement. Dr. Bernstein’s research was later expanded upon by William P. Bengen in a series of articles he wrote for the Journal of Financial Planning titled “Determining Withdrawal Rates Using Historical Data.”

Bengen experimented to determine how portfolios with stock allocations ranging from 50 to 75 percent would survive the safe initial withdrawal rate of 4 percent. Significantly, he found that a portfolio made up of three asset classes—with 20 percent invested in small-company stocks, 45 percent invested in large-company stocks, and 35 percent in 5-year Treasury notes—would increase the optimal withdrawal rate from 4 percent to nearly 4.4 percent. This finding underscores how broad-based diversification to exploit low correlations between multiple asset classes enhances returns.

Today, however, pre-retirees and retirees alike worry about higher equity exposure in a recessionary period. After all, while it is inevitable that a retiree’s portfolio will experience both positive and negative returns over the years, a sustainable withdrawal amount is more severely threatened when those down years occur early in retirement. In an article published last summer, “Withdrawal Rules: Squeezing More From Your Retirement Portfolio,” Jonathan Guyton presents some reassuring data.  He tested several balanced, diversified portfolio mixes along with what he referred to as “systematic decision rules” governing portfolios in years with market losses or high inflation. Rather than use historical data, Guyton focused his analysis of withdrawal rates on the extreme period from 1973 through 2003, which consisted of two severe bear markets and a prolonged early period of abnormally high inflation.

Guyton found that forgoing an inflationary adjustment to your withdrawal following a particularly difficult year, with no make-up of that adjustment in the future, produced a safe withdrawal rate significantly higher than 4 percent. In fact, in the 65-percent stock portfolio, it rose to 5.4 percent, which was sustainable for 40 years. Not surprisingly, forgoing abnormally high inflation adjustments and, instead, placing a cap on inflation adjustments also increased the safe withdrawal rate, especially if high inflation occurred early in retirement.

Of course, “safe” and “sustainable” are subjective terms. Some investors are perfectly comfortable with a 90-percent chance that they won’t outlive their money. Others want more of a guarantee. And, of course, none of us knows exactly how long our portfolio will need to support us. However, in the midst of these uncertainties, there is comfort in the 4-percent solution, because it gives us a reasonable, research-based place to start in planning for a sustainable retirement income stream.

Whereas the rule of thumb is based on broad generalizations and averages, we will develop a solution for you based on a careful analysis of your individual risk tolerance, your goals, and your investment horizon. First and foremost, the withdrawal rate we will identify will seek to avoid extremes—the possibility that you could run through your assets too quickly and have to substantially lower your future standard of living, or that your decision to live spartanly could strip your retirement of fulfillment and meaning.  And, finally, because markets and your goals are not static, we will continue to monitor your withdrawals throughout retirement to ensure that your income remains secure.

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