Withdrawal Rate In Retirement? Focus On Your Return Rate Instead

It's one thing to plan for retirement by saving diligently year after year, but quite another to shift your focus to how much of those savings you will need to actually spend each year once you retire. Bills will always need to be paid no matter how much you are able to reduce expenses, and seeing your savings balance decline instead of increase can cause a bit of a shock. The immediate question then becomes, "How much can I withdraw each year and still not run out of money?". There's no shortage of articles offering advice about solving that riddle, but, unfortunately, each household's circumstances are unique, so there is no single right answer. My personal favorite is always the, "save more", answer, as if that's an easy option for everyone that they had just somehow failed to consider. The next most popular answer is to use the "4% rule" (quickly becoming the "3% rule" since the 4% amount has been debunked so may times). The problem is that this "rule" is not a rule at all (or even a rule-of-thumb) and was never intended to be one.

In 1994 William Bengen created what is now commonly referred to as the “4% rule” but it was only intended to be a guide to show what actions would result in a high likelihood of not outliving your savings. His research suggested that if you withdraw 4% of your retirement savings in the first year of retirement and then adjust your withdrawals for inflation in each consecutive year (4% plus the rate of inflation), your savings should last through retirement (or ~30 years). This theory works, but only if all of his assumptions are consistently applied:
• A portfolio of exactly 60% stocks and 40% bonds (which may not reflect your portfolio).
• Bonds will earn 5% or more annually. (Since 2011, they have returned ~ 2% or less annually.)
• The overall market's historical return rate (as of 1994) is applied to every year.
• Your spending never increases, or decreases, at more than the rate of inflation.
• There is no flexibility in withdrawal amounts, even if your returns don't match the assumption.

None of these assumptions are likely today, and certainly do not apply to most people's situation.

Most importantly, what good is any withdrawal rate "rule" if the specific percentage applied is not sufficient to pay your expenses? Remember that any withdrawal will incur tax liability (if it's not from a Roth account), reducing the spendable portion of the withdrawal. How much you withdraw is not nearly as important as how much of the withdrawal is actually spendable.

So how should you to proceed?

1) If you know that you have more than enough money to sustain you (lucky you, but you better be sure!), then the real question is, how much money would you like to leave to your heirs? Always consider taxes on withdrawals, and required minimum distributions starting at age 72, but after that, you have a choice. Either withdraw only what you need, or withdraw an amount that will be likely to leave you with a predefined amount (or as much as possible) at age 90 (a conservative life expectancy).

2) More common is the scenario where you need to be more careful about not overspending, because you will need all the money you have to pay your expenses through age 90 (or your own reasonable life expectancy). In this case, you will be withdrawing exactly what you really need (which includes "needs" and "wants"), and no more. The discussion about what % to withdraw is moot. You are withdrawing because you have to, not because it's a choice.

The real point is that a specific withdrawal rate doesn't matter, and shouldn't be a goal. Here's an example of why:

A couple retires at age 62 (they are both the same age), with $1M in savings, and no income (they will both wait to receive Social Security until they are 67). They expect to earn 5% on their money until age 70, and then 3% thereafter. Inflation is assumed to be 2.25%. Their combined Social Security income will be $25,000/year, but for the first 5 years they will rely only on retirement savings to pay expenses of $50,000 per year.

Their withdrawal rate will be ~ 6% - 7% for each of the first 5 years (enough to account for taxes on the withdrawals). At 67, their withdrawal rate will fall to ~ 4.0%, since Social Security income will begin. From then on, the withdrawal rate will increase slowly, year by year, because their expenses will increase with inflation, but their savings will decrease, requiring them to withdraw a larger percentage of the total each year (they're withdrawing more than the 3% they're making). At age 80, they will withdraw ~8.7% of their savings, and at age 85, they will need to withdraw ~15.0% of savings. Will their money last until they reach age 90 (a reasonable life expectancy)? Yes! Barely, but yes.

Rather than blindly following any generic rule (of thumb) about withdrawal rates, take a good look at your investment style, risk tolerance, and actual results to determine a conservative return rate for your retirement years. Your planned investment return rate is the single biggest factor in determining how long your savings may last! Take into account whether your current investing strategy will remain intact throughout retirement, or if it may change (become more conservative?) as you age. Also, don't assume a flat return rate for all years (unless it's very conservative). Neither the Dow Jones Industrial Average or the S&P 500 has ever had more than 9 years in a row of positive returns and even that has only happened once for each (stretches of 3-5 years of positive returns is more common). If the markets have never had 20-30 years of consecutive positive returns, you aren't likely to either. To get more realistic results, use varying return rates peppered with a few years of mildly negative returns (minus 2-3% every 4-5 years?). Using a single average return rate for all years does not produce the same results as using varying rates that amount to the same average! (See our blog post from 9/21 for a detailed explanation.)

The moral: your exact withdrawal rate doesn't matter, as long as you can afford to live your life. A far more important factor in how long your money will last is choosing the most realistic investment return rate possible. Overestimate that rate and you will be in for a big surprise when you can least afford it (literally). You can make choices that affect your expenses far more easily than you can influence your return rate. Be smart and cautious in your planning and your chances of a favorable outcome rise significantly. Above all, make sure that you understand the limitations of generic advice, and build your financial plan around the most realistic circumstances possible.


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