Determining Your Safe Withdrawal Rate

Sequence of return risk

What is it? | The risk that an investor’s portfolio returns will be low or negative early in a withdrawal period. Given the same starting principal and average return, individuals who incur low or negative returns early on during a particular withdrawal phase are at greater risk of exhausting their funds than individuals who experience low or negative returns later in that same period. This is because during periods of low or negative returns, investors must sell more shares in order to fund the same cash flow need because the price-per-share is lower. This in turn means that fewer shares are available to participate in future market returns, resulting in less portfolio appreciation (and, therefore, compounding returns).

Who is at risk? | Individuals who are retired or drawing income from their portfolios. Note that individuals in the accumulation phase are subject to their own sequence of return risk – negative returns in the years leading up to retirement can quickly minimize, and even negate, previous decades’ worth of positive returns.

Ways to protect your portfolio

Keep a portion in cash | Depending upon portfolio size, cash needs, market outlook, and other factors, some may choose to keep a couple years’ worth of their spending needs in money market funds or other conservative investments. This way, if the market drops, less shares of stock or mutual funds need to be sold to support cash flow because most (if not all) of the distribution can be taken from the conservative investment balance. The remaining shares of stock and mutual funds will then be able to benefit from a longer holding period, allowing for potential future recuperation and, hopefully, further appreciation.

Purchase an annuity or employ a laddered bond portfolio | In either instance, the income or bond proceeds are structured to meet cash flow obligations, leaving the investor’s stocks and mutual funds to be invested more aggressively. Oftentimes, advisors will recommend the popular “bucket” approach. This strategy segregates money into different buckets, each serving a different purpose. For example, one bucket may be for short-term expenditures and therefore invested in liquid assets, a second bucket could be for mid-range purchases with slightly more aggressive investments (i.e. bonds, conservative mutual funds), and a third “bucket” could have a long-term focus and take more risk. Another bucket option would be to fund basic living expenses with more stable income sources (i.e. Social Security, bonds, and/or a fixed annuity) and discretionary expenses with the remainder of their portfolio which can be invested more aggressively.

Maintain a personalized safe withdrawal rate | Another popular strategy is to calculate and maintain a personalized safe withdrawal rate. That being said, assuming an investor does not experience a similar scenario (or worse) than the 4% withdrawal rate was based on, this strategy may actually be too conservative and could result in lower spending than is necessary (see below for more information).

The 4% rule

Origins | In 1994, a financial advisor by the name of William Bengen conducted a survey to determine a “safe” withdrawal rate for retirees, or a rate that would be able to sustain an investor during the worst 30-year period in market history. Previously, the widely accepted rule of thumb was 5%, but Mr. Bengen wanted to dive deeper and focused his research on the most severe market downturns over a 50-year period beginning in 1926. He found that even during the absolute work sequence of returns during that time period, a 4% annual withdrawal rate would not have exhausted a balanced portfolio.   

The impact of inflation | Mr. Bengen’s 4% rule allows for retirees to increase their distributions to keep pace with inflation. This can either be accomplished by using a simple 2% annual increase (which is the Fed’s target inflation rate) or adjusting withdrawals to match actual inflation rates. Each have their pros and cons, but generally speaking, the simple 2% annual increase is obviously more predictable while the actual inflation adjustments ensure that distributions match cost-of-living increases, no more and no less.  

Accounting for the great recession | A study by three finance professors from Trinity University in Texas re-assessed the 4% rate in 2009 and found that a 75/25 portfolio (i.e. 75% equities, 25% bonds) produced a 100% success rate with inflation-adjusted monthly withdrawals.

Important caveats (supporting both higher and lower rates)

1) The 4% rate was calculated using a 30-year period and with longevity continuing to increase, may not hold up for today’s, and future, retirees.

2) Past data was used, which as we all know, is not necessarily an indicator or predictor of future performance. If future returns continue to be depressed for a protracted period of time, a 4% inflation-adjusted withdrawal rate may be too high.

3) In an overwhelming majority of historical scenarios, the 4% rule was too conservative and resulted in significant excess unspent wealth at the end; in fact, the average withdrawal rate that would have sustained a portfolio would have been closer to 6%.

Can it still hold up today? Likely, but…

1) You need to remain adequately diversified | If you plan to follow the safe withdrawal rate, your portfolio will need to employ a balance and diversified allocation; otherwise, drifting to any extreme in your portfolio would materially alter the mathematics underlying this rate.

2) Consistency is key | If using a straight 4% rule, you need to stick to it as best you can because a significant uptick in spending in one or two years can have potentially significant consequences down the road.

3) It depends on future yields | If we experience a continued and/or future period of low bond yields, 3 – 3.5% may be a safer bet considering bonds are oftentimes a sizeable component of a retiree’s investment portfolio.

4) What is your capacity (or willingness) to make other adjustments? | A few questions you might consider asking yourself before starting to hone in on an initial withdrawal rate:

-How is longevity in my/our family?
-How significant do I expect my healthcare expenses to be?
-Am I willing to return to work for a few years, even if only part-time?
-Would I be able to cut my spending by a significant portion in certain years to get back on track?
-Would I be willing to downsize and move into a less expensive home/apartment?
-Could I/we qualify for a reverse mortgage if need be?
-Is there a significant chance I’ll be receiving a moderate inheritance?

5) You may need to be flexible | While 4% will likely sustain you throughout retirement, it is impossible to say with certainty. Basically, if future returns turn out to be significantly different from historical returns, there is a chance you may need to course-correct later and adjust your spending to ensure your portfolio can last throughout your lifetime(s).

A “ratcheting” safe withdrawal rate may be the optimal strategy

What is it? | Developed by one of the foremost experts in the financial planning field, Michael Kitces, the ratcheting safe withdrawal rate posits a slight twist on the original. According to Mr. Kitces, the 4% rule may be too conservative and applying this strategy could feasibly result in retirees finishing with more wealth than they started retirement with. Under a ratcheting strategy, if a retiree’s portfolio gets “far enough ahead”, spending can be increased by a certain percentage but only at a certain frequency.

How does it work? | Per Mr. Kitces, using a ratchet-style approach, a retiree and his advisor may pre-determine that if the retiree’s portfolio rises more than 50% above its starting value (i.e. from $1 million to $1.5 million), they can increase their withdrawal rate by 10% (i.e. from 4% to 4.4%). Note that if this strategy is employed, spending should not be increased more than once during any 3-year time period even if the portfolio otherwise meets the criteria. In nearly all historical scenarios, this ratchet approach would have increased spending at least once, if not multiple times. Additionally, in none of those scenarios did the retiree run out of money or need to reduce their spending.

What should you do?

Considering the implications that poor planning can have on a portfolio and, by extension, your retirement, it is absolutely crucial to work with an experience wealth management team who can help monitor, invest, and adjust your assets properly. This is also where ongoing financial planning plays an extremely important role and why it is important for you and your advisor to keep an open dialogue as it pertains to your withdrawal rate.

Here at Aspen Wealth Strategies, we use sophisticated financial planning software that will stress-test your portfolio against a thousand randomized market conditions using Monte Carlo analysis. We also incorporate a conservative 2.5% inflation estimate into all of our plans to ensure a sustainable withdrawal rate so that you won’t have to worry about outliving your assets. Our software will even calculate your projected retirement withdrawal rate so that we can plan accordingly, make adjustments as needed, and ensure you remain on track for a successful and rewarding retirement.

 

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DISCLAIMER: Any opinions are those of the author and not necessarily those of RJFS or Raymond James. The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. There is no assurance any of the trends mentioned will continue or forecasts will occur. The information has been obtained from sources considered to be reliable, but Raymond James does not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Investing involves risk and you may incur a profit or loss regardless of strategy selected.

About the Author
Stephanie McElheny, CFP®, EA, ChSNC™

Stephanie McElheny, CFP®, EA, ChSNC™

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Stephanie is a Wealth Planner and Vice President at Aspen Wealth Strategies. A Certified Financial Planner™ professional with close to 10 years of industry experience, Stephanie is incredibly passionate about identifying opportunities and implementing comprehensive financial planning solutions for both individuals and businesses.As a Chartered Special Needs Consultant™ and an Enrolled Agent, Stephanie’s specific expertise includes special needs planning as well as individual and business taxation. Stephanie also holds Series 7, 66, and Life, Accident, and Health licenses.Prior to joining Aspen Wealth Strategies, Stephanie has acted as a Director of Financial Planning and a Registered Investment Advisor for both small and large investment management firms. A Pittsburgh native, Stephanie has served as President and Symposium Chair of the Pittsburgh chapter of the Financial Planning Association (FPA), among other roles. She also spent time on the pro-bono committee, offering financial literacy education to seniors, veterans, and underprivileged families.Outside of work, Stephanie enjoys spending time with her husband, Steve, and their corgi, Myron. She is an outdoor enthusiast who loves hiking, camping, cycling, and snowboarding. Stephanie also takes great pride in cheering on her hometown sports teams and alma mater – the Pittsburgh Steelers, Penguins, and Pirates and the Penn State Nittany Lions.

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