Last week’s post, The Sequence of Returns – The Roulette Wheel of Retirement, showed how “luck of the rate-of-return draw” can have a dramatic affect on a retirement asset plan in determining whether you will outlive your investment portfolio. In two scenarios where the retirement age (65), portfolio beginning value ($500,000), average rate of return (7%), withdrawal rate (5%), and inflation factor applied to the withdrawal rate (3%) were identical, and the only variable was good vs. bad early years, there were quite different results. With the “Good Early Years” scenario, after 25 years, at age 90, distributions totaled $964,000, the portfolio earned $1.385 million, and the portfolio value was $921,000. Under the “Bad Early Years” scenario, the portfolio was depleted after 16 years at age 81 after taking distributions totaling $541,000 and the portfolio earning $41,000.
Many people would argue that 5% seems like a reasonable withdrawal rate, however, as we saw, under the “Bad Early Years” scenario, this proved to be too aggressive. The financial planning industry, after many years of debate, has settled on a rule of thumb of 4% as a “safe withdrawal rate.” That is to say, you can withdraw 4% of the value of your portfolio in your first year of retirement and then increase your withdrawal amount by an inflation factor in subsequent years without depleting your portfolio during your lifetime. As an example, assuming a portfolio value of $500,000 at retirement and a 3% inflation factor, you could withdraw $20,000 ($500,000 x 4%) in Year 1, $20,600 ($20,000 x 1.03) in Year 2, $21,218 ($20,600 x 1.03) in Year 3, etc.
Is a “safe withdrawal rate” something we should live by or is it simply a rule of thumb? While a 4% withdrawal rate during retirement can potentially enable you to sustain your retirement capital for the duration of your retirement, this is not always the case, particularly in “Bad Early Years” scenarios. In addition to the withdrawal rate, the interplay of the following ten variables will determine whether or not you will outlive your portfolio:
- Type of portfolio, i.e., nonretirement vs. retirement
- Income tax rates
- Source of income tax payments, e.g., checking account, nonretirement sales proceeds, IRA withdrawal, etc.
- Retirement duration
- Average rate of return
- Sequence of returns
- Timing of earning of income
- Inflation rate
- Frequency of withdrawals
- Timing of withdrawals
As an example of the interplay of several of these variables, let’s make the following assumptions:
- Retirement age: 65
- Beginning portfolio value: $500,000
- Average rate of return: 6%
- Sequence of returns: Bad early years
- Withdrawal rate: 4%
- Inflation rate: 3%
- Frequency of withdrawals: Annual
- Timing of withdrawals: Beginning of year
In this scenario, despite the fact that the withdrawal rate has been reduced from 5% per the “Bad Early Years” scenario in the last post to 4%, which is generally considered to be a “safe” withdrawal rate, by simply changing one other variable, i.e., reducing the average rate of return from 7% to 6%, per Bad Early Years Assuming 6% Average Rate of Return, the portfolio is depleted at age 85. While the frequency and timing of withdrawals in this example may not be typical, the “safe withdrawal rate” of 4% isn’t conservative enough.
There are other scenarios where the interplay of the various variables is such that a withdrawal rate of 4% can prove to be problematic. As is typically illustrated, the previous example assumed an inflation rate of 3% each and every year. What happens if inflation averages 3%, however, the sequence of inflation rates is such that it is much higher in the first five years, say 7%. This would result in larger withdrawals in years 2 through 6, and, depending upon the rate of return, sequence of returns, and duration of retirement, this could result in premature depletion of the portfolio.
Mathematics aside, there are several other issues to consider when planning to use a safe withdrawal rate. For starters, why should you base your withdrawals for the duration of your retirement on the value of your retirement portfolio on a single day, i.e., the day before you retire? Also, it does not consider the fact that a sizeable portion of your expenses may be for mortgage and/or other fixed payments that don’t increase each year, and, as such, don’t require an inflation factor to be applied to them. In addition, the safe withdrawal rate methodology doesn’t take into consideration the fact that we typically incur nonrecurring expenses, planned and unplanned, e.g., new car, home improvements, wedding, etc., in addition to our ongoing expenses.
Another factor not incorporated in safe rate withdrawal calculations is the affect of differences in sources and amounts of non-portfolio income, e.g., Social Security, pensions, part-time income, etc. on portfolio values. What about the impact of inheritances on the amount of subsequent withdrawals? Finally, who is going to be responsible for doing the accounting to ensure that the amount of withdrawals doesn’t exceed the targeted amount in a particular year?
While the amount of withdrawals calculated using safe withdrawal rate methodology may match your income needs in some years, this probably won’t be the case in most years. This is arguably its single biggest weakness. I don’t know about you, but I don’t want to live my life based on a simple calculation that doesn’t consider my changing financial needs. While a safe withdrawal rate is a nice starting point, or rule of thumb, for calculating retirement withdrawal amounts, its limitations need to be considered when applying it to one’s retirement plan.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.