Chapter 29
Withdrawal rates: How much can I
spend anyway?
4%. Maybe more.
So, you’ve followed the simple path big three:
You’ve avoided debt
You’ve spent less than you’ve earned You’ve invested the surplus
Now you’re sitting on your assets and wondering just how much you can spend each year and not run out. This could be stressful, but it really should be fun. You might even be cheeky enough to ask, “What percent of his own assets does Jim spend?” We’ll get to that.
You don’t have to have read far in the retirement literature to have come across the “4% rule.” Unlike most common advice, this one holds up to our beady-eyed scrutiny pretty well, even though it is really very little understood.
Back in 1998, three professors from Trinity University sat down and ran a bunch of numbers. Basically they asked what would happen at various withdrawal percentage rates to various portfolios, each with a different mix of stocks and bonds, over 30 year periods depending on what year the withdrawals were started. They ran their scenarios both adjusting withdrawal levels for inflation and not adjusting the withdrawal. Whew.
Then they updated it in 2009.
Out of the scores of options in the study, the financial media seized on just one of these models: The 4% withdrawal rate, 50/50 stock/bond portfolio, adjusted for inflation. Turns out, 96% of the time, at the end of 30 years such a portfolio remained intact. Put another way, there was just a 4% chance of this strategy failing and leaving you destitute in your old age. In fact, it failed in only two of the 55 starting years measured: 1965 and 1966.
Other than those two years, not only did it work, many times the remaining money in the portfolio had grown to spectacular levels.
Think about that for a moment.
What that last line means is that in most cases the people owning these portfolios could have taken out 5, 6, 7% per year and done just fine. In fact, if you gave up the inflationary increases and took 7% each year you would have done just fine 85% of the time. Most of the time taking only 4% meant at the end of your days you left buckets of money on the table for your (all too often ungrateful) heirs. Great news, were that your goal. Also great news if you anticipate living on your portfolio for longer than 30 years.
But the financial media believes that most people don’t like to think too hard. By reporting the results at 4% they could report on just about a sure thing. Roll it down to 3% and we have as sure a thing as we’ll ever see short of death and taxes. And that’s giving yourself annual inflation increases.
While 1965 and 1966 were the last and only two years where 4% failed, remember that more recent start years have not yet had their own 30 year measurable runs. My guess is that if you began your own withdrawals in 2007 and the early part of 2008 just prior to the collapse, you will have hit upon two more years in which the 4% plan is destined to fail. You’ll want to scale back. On the other hand, if you started with 4% of your portfolio’s value as of the March 2009 bottom, you’re very likely golden.
If you are curious, here’s an overview of the Trinity Study you can read for yourself: http://www.onefpa.org/journal/Pages/Portfolio%20Success%20Rates%20W here%20to%20Draw%20the%20Line.aspx
In summary:
Withdrawing 3% or less annually is as near a sure bet as anything in this life can be.
Stray much further out than 7% and your future will include dining on dog food.
Stocks are critical to a portfolio’s survival rate.
If you absolutely, positively want a sure thing and your yearly inflation raises, keep your withdrawal rate under 4%. And hold 75% stocks/25% bonds.
Give up those yearly inflation raises and you can push up towards 6% with a 50% stock/50% bond mix.
In fact, the authors of the study suggest you can withdraw up to 7% as long as you remain alert and flexible. That is, if the market takes a huge dive, cut back on your withdrawals and spending until it recovers.
If you review the study you’ll see it has four tables. Tables 1 and 2 look at how various portfolios performed over time and at various withdrawal rates. Tables 3 and 4 tell us how much money remains in the portfolios after the 30 years have passed. The difference between them is that tables 2 and 4 assume the dollar withdrawal amount is adjusted each year to account for inflation. Let’s take a look.
So if you look at Table 1 and at the 50/50 mix with a 4% withdrawal rate, you see you have a 100% chance of your portfolio surviving 30 years.
Table 2 tells you that if you take those same parameters but give yourself inflation raises, your portfolio’s chance of survival drops to 96%. Makes sense, no?
Tables 3 and 4 tell us how much money remains in the portfolios after the 30 years have passed and this, to me, is really compelling stuff. Again, Table 3 assumes a straight percentage withdrawal and Table 4 assumes giving yourself inflation raises. Let’s take a look at some examples.
Assuming a 4% withdrawal rate on a portfolio with an initial value of $1,000,000, here’s what you’d have left (median ending value) after 30 years: From Table 3 (without inflation adjusted withdrawals)
100% stocks = $15,610,000
75% stocks/25% bonds = $10,743,000 50% stocks/50% bonds= $7,100,000
From Table 4 (with inflation adjusted withdrawals)
100% stocks = $10,075,000
75% stocks/25% bonds = $5,968,000 50% stocks/50% bonds = $2,971,000
This is very powerful stuff and it should give you a lot to feel warm and fuzzy about as you follow The Simple Path to Wealth.
As you look over these tables, one thing that should become very clear is just how powerful and necessary stocks are in building and preserving your wealth. This is why they hold center stage in The Simple Path to Wealth.
What is likely less obvious—but every bit as important—is the critical importance of using low-cost index funds to build your portfolio. When you start paying 1-2% fees to active mutual fund managers and/or investment advisors all these cheerful assumptions wind up in the trash heap. Wade Pfau, Professor of Retirement Income at the American College for Financial Services and one of the most respected observers of the Trinity Study, says it best:
“For an example of this, the 50-50 portfolio over 30 years with 4% inflation-adjusted withdrawals had a 96% success rate without fees, 84% success rate with 1% fees, and 65% success rate with 2% fees.”
In other words, using the Trinity Study projections with portfolios built from anything other than low-cost index funds is invalid.
So, now to answer that question we alluded to earlier: What withdrawal percentage do I personally use in my retirement? I confess I pay so little attention it took a few moments to figure it out and even once I did, it wasn’t exact. But my best guess is for the last few years it has run somewhere north of 5%. This casual approach may surprise you. But there are mitigating circumstances:
I had a kid in college. That is a huge annual expense, but as of the Spring of 2014, it has gone away. During her college years, the money for it was figured into my net worth, but it was also earmarked as “spent.”
Since my retirement, my wife and I have accelerated our travels and the related spending has spiked sharply. Not to be morbid, but at my age I am more worried about running out of time than money. If the market were to tank in a major way, this is an easy expense to adjust.
Sometime in the next few years we will have two nice new income streams coming online in the form of Social Security.
Most importantly, I know I’m well under the 6-7% level that requires close attention.
Given the above, going forward my guess is it will drop to under 4%.
Within that 3-7% range, the key to choosing your own rate has less to do with the numbers than with your personal flexibility. If as needed you can readily adjust your living expenses, find work to supplement your passive income and/or are willing and able to comfortably relocate to less expensive places, you will have a far more secure retirement no matter what rate you choose. Happier too I’d guess.
If you are locked into certain income needs, unwilling or unable to ever work again and your roots go too deep to ever seek out greener pastures, you’ll need to be much more careful. Personally, I’d work on adjusting those attitudes. But that’s just me.
4% is only a guide. Sensible flexibility is what provides security.