A sustainable withdrawal rate simply means the amount of money a retiree can withdraw from their investments each year without running out of funds before they die. This month, we’ll look at some important considerations when estimating a sustainable withdrawal rate. We’ll also introduce one way of doing this which is used by many financial planners – the 4% Rule.
Number of Years
Well, the first assumption we must make is how long will we live. That is, how many years must our portfolio support us? Naturally, we can’t know this for certain, but we must estimate it nonetheless. CDC statistics tell us that the average male will live to about 75 and the average female will live to about 80 years old. So, if we retire at 65 years of age and if we have average lifespans, men will need to have their portfolio last about 10 years and women about 15 years. But, are we comfortable running out of money at 80 years old? I know in Fort Collins, I see in the obituaries that people are frequently living into their 90s and some even over 100! So, it might be better to plan on living longer than the CDC stats predict. The financial planning industry has kind of settled on 30 years as a reasonable timeframe to plan for.
Portfolio Growth
Even if we neglect withdrawal rate considerations for the moment, a diversified portfolio is very important during retirement. It will help protect your assets from many sources of volatility. Many advisors recommend having a 50% equity and 50% fixed-income mix in retirement. (Some prefer a 60% equity and 40% fixed-income mix and some the reverse of this, but most are in this neighborhood.) In any case, the portfolio mix will be used to estimate portfolio growth and thus the available revenue. Considering future growth of each stock, bond and fund in your portfolio is a huge exercise. Often portfolio growth estimates are made by combining each individual investment into one of two categories –equity and fixed income. This makes estimating portfolio growth much more manageable.
Inflation
Portfolio growth determines the nominal growth of your funds. However, when it comes to paying for things, the real growth (inflation-adjusted growth) is what really matters. So an inflation assumption is required too. The Federal Reserve has a 2% inflation target, but it has varied significantly over time. For example, inflation was around 13.5% in 1980, but it was about 1.2% in 2020. Estimating inflation several decades into the future is uncertain, but many financial planners use 2% as their assumption.
Historical Versus Forward-Looking Modeling
Many people have analyzed sustainable withdrawal rates using historical data. Historical modeling has the advantage of using actual data so that models can be checked against reality. Forward-looking modeling has produced some interesting concepts, but being estimates of the future, they can’t be validated like the historical approach can.
The 4% Rule
One approach, based on historical data, that has worked pretty well over nearly three decades is a technique called the 4% Rule. The concept is really pretty straightforward. You withdraw 4% of your portfolio in the first year of retirement. Then you continue to withdraw that same amount adjusted for inflation in subsequent years. This is still the most popular guideline in use by financial planners. Of course, there are arguments to be made that you should take out less with today’s markets (most recently argued by Morningstar) and it is also argued that the 4% Rule is too conservative and that you should take out more (argued by many). The key notion here is that 4% is a guideline, not a hard and fast rule that works for everyone.
Is 4% Enough for My Lifestyle?
If you’re still working and you determine that you need more than the 4% Rule recommends, you may want to accelerate your savings so that 4% of a larger portfolio produces a higher retirement income. If you’re about to retire or are already retired, the question isn’t so much how much do you need as it is how much can you afford. It is important, of course, to see how much money the 4% Rule needs to produce. Suppose you need $100,000 in year one of retirement. First, we can reduce the required amount by your Social Security income. Social Security depends on several factors such as your income history and the age that you start taking your benefits. As an example, suppose you receive $35,000 per year in Social Security payments. That means you only need to withdraw $65,000 from your portfolio to make up the difference. You may have other sources of retirement income such as pensions, annuities, trusts and so forth. If one of these sources produces say $25,000 per year in retirement, you now only need the 4% Rule to produce $40,000 per year. A $1,000,000 portfolio could produce this. Naturally this is only one scenario, but it hopefully makes the point that you probably have one or more retirement income source outside of your investment portfolio.
You can see that the 4% Rule is a guideline. Many factors will determine whether it’s right for you. For example, do you wish to leave an estate or do you want your last dollar to go to the undertaker? How long have people in your family typically lived? What kinds of assumptions give you the peace of mind to relax and enjoy retirement? If you’d like to review the specifics of your retirement situation, or go over any other financial matter, we can discuss things in a no-charge, no-obligation initial meeting. Please visit our website or give us a call at 970.419.8212 to set up an in-person or virtual meeting.
This article is for informational purposes only. This website does not provide tax or investment advice, nor is it an offer or solicitation of any kind to buy or sell any investment products. Please consult your tax or investment advisor for specific advice.