The New Safe Withdrawal Rate To Follow
If you have children or plan to donate to charities after you are gone, its important to plan financially beyond yourself.
Given the 4% Rule was established at a 20% discount to where the 10-year bond yield was at the time, we can also establish a similar 20% discount to todays 10-year bond yield to come up with a new safe withdrawal rate.
With the 10-year bond yield at ~1.1%, a safe withdrawal rate is actually closer to 0.88%. When the 10-year bond yield was at its low of 0.51%, the safe withdrawal rate was equivalent to 0.4%.
To make things simple, the new safe withdrawal rate equals the 10-year bond yield X 80%. Lets call this the Financial Samurai Safe Withdrawal Rate.
For reference, below is a table I created using the Financial Safe Withdrawal Rate formula.
Retirees Should Care More About Income Than Net Worth
As a retiree, your main focus is on generating enough income to live your life without having to work. Therefore, you like it when interest rates rise because it increases your risk-free and at-risk investment income.
Of course, you still care about your net worth. However, what you should care about more is how much income your net worth is generating.
Even if your net worth temporarily declines by 25% in a bear market, so long as your net worth is generating a similar amount of income, you are OK. But if your income declines by 25%, you may have to reduce your lifestyle. And living your best lifestyle is the end goal.
The risk to your investment income is during a protracted bear market. If a bear market lasts for much longer than a year, chances increase dividend payout ratios may be cut, property rental yields may decline, and bond yields may also decline. The double whammy of declining principal values and declining investment income hurt retirees the most.
In such a worst-case scenario, the recommendation is to be dynamic by lowering your safe withdrawal rate and/or generating some type of extra income. But the beauty of the FS Safe Withdrawal Rate formula is that it will automatically generate a lower recommended safe withdrawal rate in such a scenario!
Therefore, you dont have to overthink things. My dynamic safe withdrawal rate formula reflects economic conditions as they change.
What Is The Safe Withdrawal Rate In Early Retirement
So, given lower assumed future returns than historical averages, the Safe Withdrawal Rate depends on both your age and the initial asset allocation. You can see from the above examples that a 3.25% is ok regardless of the asset allocation. Compare that to a 4% Safe Withdrawal Rate that just barely squeaks by if you go aggressive90/10 asset allocation.
What is the downside of going aggressive with your asset allocation? Hello, Sequence of Returns Risk.
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Take Your Timeline Into Account
One of the biggest factors that affects how much you can withdraw is how many years of retirement you plan to fund from your retirement savings. Say you plan on a retirement of 30 years, you invest in a balanced portfolio, and want a high level of confidence that you won’t run out of money. Our research shows that a 4.5% withdrawal rate would have been sustainable 90% of the time .2
But if you work longersay you expect to retire at age 70or if you have health issues that compromise your life expectancy, you may want to plan on a shorter retirement periodsay, 25 years. The historical analysis shows that, over a 25-year retirement period, a 4.9% withdrawal rate has worked 90% of the time.
On the other hand, if you are retiring at age 60 or have a family history of longevity, you may want to plan for a 35-year retirement. In that case, 4.3% was the most you could withdraw for a plan that worked in 90% of the historical periods. These may sound like small differences, but they could equate to thousands of dollars in annual retirement income.
The good news is that even with the market’s historical ups and downs, these withdrawal amounts worked most of the timeassuming that investors stuck to this balanced investment plan. The takeaway from this analysis is that the longer your retirement lasts, the lower the sustainable withdrawal rate.
Past performance is no guarantee of future results.
Understanding The Safe Withdrawal Rate Method
Figuring out how to use your retirement savings isnt easy because there are so many unknowns, including how the market will perform, how high inflation will be, whether you will develop additional expenses , and your life expectancy. The longer you expect to live, the longer the time period you need to cover, which means you may experience more “unknowns” or factors that you can’t control. In addition, the worse the market performs, the more likely you are to run out of money.
The safe withdrawal rate method tries to prevent these worst-case scenarios from happening by instructing retirees to take out only a small percentage of their portfolio each year, typically 3% to 4%. Financial experts recommended safe withdrawal rates have changed over the years as experience has illustrated what really works and what doesnt work and why.
Knowing what safe withdrawal rate youd like to use in retirement also informs how much you need to save during your working years. If you want to withdraw more money per year, then clearly, you’ll need to have more money saved. However, the amount of money you might need to live on might change throughout your retirement. For example, you might want to travel in the early years and, therefore, would likely spend more money versus the later years. As a result, your safe withdrawal rate could be structured so that you would withdraw 4%, for example, in the early years and 3% in the later years.
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Will You Make Changes If Conditions Change
This is the most important issue, and one that trumps all of the issues above. The 4% rule, as we mentioned, is a rigid guideline, which assumes you won’t change spending, change your investments, or make adjustments as conditions change. You aren’t a math formula, and neither is your retirement spending. If you make simple changes during a down market, like lowering your spending on a vacation or reducing or cutting expenses you don’t need, you can increase the likelihood that your money will last.
A Better Idea Than A Fixed Safe Withdrawal Rate
Very few retirees follow any sort of strict fixed withdrawal rate, much less the 4% one. As you have read, the 4% rule is really just a 4% guideline. It’s a reasonable place to start. If Sequence of Returns Risk shows up early in your retirement, batten down the hatches and cut your spending. If it does not, bump up your spending. You could even spend 5%, 6%, or even more a year, especially if you can cut back when the market does poorly. The ability to be flexible in retirement is extremely valuable, and it will likely allow you to significantly exceed a 4% withdrawal rate.
What do you think is the true safe withdrawal rate? How do you plan to spend your assets down in retirement? Are you still worried about running out of money? Comment below!
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Be Dynamic In More Parts Of Your Life
Following a dynamic safe withdrawal rate will help you live a more peaceful retirement under ever-changing conditions. Its similar to my dynamic pay down debt or invest formula. The formulas help keep you in check when you may be sure what to do.
Blindly following a fixed withdrawal rate percentage, especially the 4% Rule from the 1990s is not the best choice in todays environment. Theres a reason why youre texting and no longer writing letters to friends and family.
In addition to retirement withdrawal strategies, you may also consider being more dynamic in other areas of your life. Here are some examples:
- Get good at a sport, musical instrument, or type of art
- Meet new friends outside of your socioeconomic level
- Meet new friends who are different in sex, race, culture, beliefs
- Learn another language
- Read all types of history
- Take up a new hobby
- Interview someone outside your circle
Personally, Im practicing Mandarin and strumming my old Martin acoustic guitar again. Further, I plan to get on podcasts with people outside of the personal-finance community this year. It would be nice to talk to people who dont all think index fund investing and budgeting are the best and only ways to get rich.
The Effect Of Supplemental Cash Flows On Safe Withdrawal Rates
This is one of the key reasons why Safe Withdrawal Rate Rules are really only Rules of Thumb! We each need a personalized financial analysis to determine our safe withdrawal rate. A 30-year-old early retiree with relatively modest expected Social Security benefits many decades in the future has a lower safe withdrawal rate than a 50-year-old early retiree expecting generous Social Security benefits in only a little bit over a decade. How much of a difference does that all make? Well, I studied this in great detail, once in a really early post, Part 4, and then again in Part 17.
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How To Calculate The Safe Withdrawal Rate
The safe withdrawal rate helps you determine a minimum amount to withdraw in retirement to cover your basic need expenses, such as rent, electricity, and food. As a rule of thumb, many retirees use 4% as their safe withdrawal ratecalled the 4% rule.
The 4% rule states that you withdraw no more than 4% of your starting balance each year in retirement. However, the 4% rule doesn’t guarantee you won’t run out of money, but it does help your portfolio withstand market downturns, by limiting how much is withdrawn. In this way, you have a much better chance of not running out of money in retirement.
Although there are a few ways to calculate your safest withdrawal rate, the formula below is a good start:
- Safe withdrawal rate= annual withdrawal amount ÷ total amount saved
Lets say as an example, you have $800,000 saved and you believe youll need to withdraw $35,000 per year in retirement. The safe withdrawal rate would be:
- $35,000 ÷ $800,000 = 0.043 or 4.3%
If you believe you’ll need a higher or lower amount of income in retirement, here are a few examples:
- $25,000 ÷ $800,000 = 0.031 or 3.0%
- $45,000 ÷ $800,000 = 0.056 or 5.6%
So, if you only needed $25,000 per year in withdrawals, you could safely withdraw it since it would only be 3% of your balance each year.
To calculate how much in retirement funds you’d need to satisfy the 4% rule and be able to safely withdraw $45,000 per year, we would rearrange the formula as follows:
Real Estate Investing And The Risk
With the risk-free rate currently at ~3%, you would not buy a property with an expected market return of 3% or less. Why? Because you could lose money. Further, it takes time to manage a physical rental property. Therefore, you look for the highest expected market return above the risk-free rate of return, which equals the equity risk premium.
Some real estate investors, especially in big coastal cities, will purchase real estate with cap rates at less than the risk-free rate of return. This usually means they are cash flow negative. They invest this way because they are banking on capital appreciation to more than compensate for their negative cash flow.
This strategy works great in a bull market, but puts the real estate investor at greater risk of foreclosure during a bear market compared to a cash flow positive investor.
As the risk-free rate goes higher real estate investors will refuse low cap rate properties, leading to market softness. Investors will look for higher cap rate properties and properties they think will return a higher percentage to maintain their equity risk premium. As a result, more capital should flow to the Sunbelt region where cap rates are higher.
The point of these formulas is to help you think more rationally as situations change.
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What If You Retire Early And Have Longer Than A 30
According to financial advisor and SWR researcher, Michael Kitces, it wouldnt impact how much you need to save.
Notably, it appears that the safe withdrawal rate does not decline further as the time horizon extends beyond 40-45 years the 3.5% effectively forms a safe withdrawal rate floor, at least given the data we have available.
In other words, if youve saved up enough for a 30 year retirement, your investment returns safely cover additional years of retirement . How cool is that?
What About A Longer Retirement
We can conclude that the 4% safe withdrawal rate is safe for retirement. You are probably here because you want to retire early. So, is the 4% rule safe for early retirement?
When you retire in your 30s or 40s, you hopefully need your retirement amounts for longer than the 30 years mentioned in the Trinity Study.
While retirement horizon is important for the safe withdrawal rate, its not as crucial as you may think.
Kitces mentions that an increasing time horizon from 30 to 45 years reduces the SWR from 4.1% to 3.5%. He also states that, given the available data, the SWR does not decline below this 3.5%. If your time horizon extends beyond 45 years, the 3.5% will hold.
So 3.5% SWR is the bottom, independent of how many years you expect to retire. He also mentions that there can be an early 1-2 decade of low returns and recovery of the portfolio for this SWR later on.
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When Should You Use The 4% Rule
The 4% rule assumes your investment portfolio contains about 60% stocks and 40% bonds. It also assumes you’ll keep your spending level throughout retirement. If both of these things are true for you and you want to follow the simplest possible retirement withdrawal strategy, the 4% rule may be right for you.
However, you should be aware that the 4% rule is an older rule. Following it no longer necessarily guarantees you won’t run short of funds. It may work depending on how your investments perform, but you can’t count on it being a sure thing, as it was developed when bond interest rates were much higher than they are now.
Putting It All Together
After you’ve answered the above questions, you have a few options.
The table below shows our calculations, to give you an estimate of a sustainable initial withdrawal rate. Note that the table shows what you’d withdraw from your portfolio thisyear only. You would increase the amount by inflation each year thereafteror ideally, re-review your spending plan based on the performance of your portfolio.
We assume that investors want the highest reasonable withdrawal rate, but not so high that your retirement savings will run short. In the table, we’ve highlighted the maximum and minimum suggested first-year sustainable withdrawal rates based on different time horizons. Then, we matched those time horizons with a general suggested asset allocation mix for that time period. For example, if you are planning on needing retirement withdrawals for 20 years, we suggest a moderately conservative asset allocation and a withdrawal rate between 4.9% and 5.4%.
The table is based on projections using future 10-year projected portfolio returns and volatility, updated annually by Charles Schwab Investment Advisor, Inc. . The same annually updated projected returns are used in retirement saving and spending planning tools and calculators at Schwab.
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A Look Back At History
Of course, your actual sustainable withdrawal rate will vary based on many things, including some you can’t controllike how long you live, inflation, and the long-term risk and return of the marketsand others over which you may have some controllike your retirement age and the investments you choose.
History suggests that the prevailing market environment at the time of your retirement may be particularly important, as a weak market early in retirement can significantly diminish your nest egg, especially if you don’t dial down your withdrawals with the declining markets. On the other hand, a strong stock market early in retirement can put the wind at your backfinancially speakingfor decades.
Consider the chart below, which illustrates a historical look at how much an investor could have withdrawn from savings without running out of money over a 28-year retirement, depending on the date of retirement. As you can see, actual sustainable withdrawal rates varied widely,1 from just under 10% if you retired in 1982, at the beginning of a roaring bull market, versus more than 4% if you retired in 1937, during the Great Depression.
Past performance is no guarantee of future results.
This analysis is based on a 90% chance that the portfolio would not run out of money within a given retirement horizon. The 90% confidence level reflects the “strong plan” framework used in Fidelity’s retirement planning tools.
Data Basis Of The Risky Part Of The Portfoliosequities
For the simulation of the annual return of the German market portfolio, the Frankfurt Top Segment Series by Stehle/Hartmond and Stehle/Schmidt was used. It represents a solid, historical database of the Prime Standard as the highest stock exchange segment of companies listed on the Frankfurt Stock Exchange. The series was compiled from various official sources after extensive review and verification for the years 1954 to 2013 . The developments of the New Market are not considered in the calculations of this series. In order to meet the requirement of determining the total return from the perspective of a German investor, this data series also takes into account the latter corporate income tax credits in the years 1977 to 2000 in the return calculation, in addition to normal and special dividends, capital increases, subscription right proceeds and par value conversions. However, as this series ended in 2013, whilst showing a median return difference of only 0.003% in the years 20042013 in comparison to the CDAX performance index, the CDAX performance index is used as the proxy for the German capital market. With currently 485 stocks, the CDAX is significantly broader based than the DAX.
Table 1 Deviations of geometric means of FTS and CDAX
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