Can You Survive on 2.9% of your Retirement Fund?
Many of my clients are nearing or are currently in some form of retirement. If you are at this stage of life, sustaining your targeted income stream is extremely important. The challenge is how you will do this in an unprecedented era of low interest rates and market volatility. The concept of “sustainable withdrawal rates” has never been more important.
This email is to offer a primer on the topic and invite you to meet with me to discuss how your own strategy should be adjusted to meet these challenging times.
The challenge, of course, is that interest rates are very low today. When we run a retirement
The concept of “sustainable withdrawal rates” has never been more important!
income projection, rather than use straight-line assumptions on interest rates (i.e. that they will stay at this level forever), we should be assuming that interest rates “mean-revert” to historical averages and the software should utilize a form of Monte-Carlo simulation to stress-test the different paths rates could take on their way back to average levels. The path they take can have a material impact on your retirement income – and therefore, your sustainable withdrawal rate.
Why? In part, it’s related to how bonds are priced. As rates rise, the current value of a bond decreases. (Very simply put, why would someone buy your bond with lower interest payments when they can get a new one with higher rates?) As such, we fully expect bond returns to be much lower in the future than they are today.
Lastly, the sequence of returns has a material impact on your capital balance when you are withdrawing money. It’s not as important in the accumulation phase, but believe me, it matters greatly when you are withdrawing. (If you’d like to see the numerical proof – the evidence – of this, please let me know. It’s quite fascinating. Honestly. In fact, stay tuned for a webinar on this topic.)
The 4% Rule
Everyone loves a good rule of thumb. The longstanding rule of thumb for taking an income from your investments is the so-called ““. It’s an investment-income strategy that says as long as you withdraw no more than 4 percent of your initial portfolio, adjusted for inflation, on an annual basis during your retirement years, you shouldn’t run out of money.
As I have noted above and also interestingly reported by CNBC last November, new research shows this rule doesn’t work for retirees in today’s low-rate environment. Why? Here is what they said:
When the formula was introduced in the early 1990s, it was designed to accomplish these goals of retirees:
- Provide a fixed rate of withdrawal, like an annuity.
- Rely on an easy-to-use withdrawal formula (unlike, say, required minimum distributions).
- Minimize retirees’ risk of running out of money.
But while, in the public’s imagination, the 4 percent figure remained fixed, the rates it relied on were anything but. Twenty years ago, when the rule appeared, the yield on a three-month Treasury bill was 6 percent.
So while the 4 percent model called for a 50/50 stock/bond allocation, even those with a more conservative asset allocation could still draw down 4 percent annually adjusted for inflation and reasonably expect to preserve their capital. Even in 2002, the five-year U.S. Treasury yield was still 4.5 percent.
There are many ways to estimate the sustainable withdrawal rate (that are outside the scope of this article – but see the references below for more research if you are interested) and this variance is okay. The main point is that future bond returns won’t be what past bond returns have been. So projecting these returns in one’s modelling is not appropriate and will lead to overly optimistic estimates of one’s sustainable income.
So times have changed… what are we to do now?
Given these challenges, it’s very important to run a sophisticated analysis that incorporates all of these factors to arrive at a sustainable withdrawal rate in your retirement years.
The bottom line adjustment to this rule of thumb, given the extreme zero-bound interest rate environment we find ourselves in, is to adjust the 4% rule down to… well, around 2.5% to 2.9% depending on how aggressive or conservative your portfolio is. While this may seem like a small percentage change, do the math on your portfolio to see what actual income this would generate for you.
The definitive voice (in my opinion) on this topic is Wade Pfau, Retirement Researcher. There are two sources for further information on this topic that I would commend to you. First, his Retirement Dashboard blog here:
and second, a recent white paper he co-authored on the topic here:
Now, what am I suggesting you do?
If you haven’t come in to see me and my team with the sole purpose of doing some longer-term financial and retirement planning, I would strongly encourage you to do so. Together let’s make sure the retirement investing you’ve been doing will allow you a comfortable rate of withdrawal when you need it. The offer is always on the table and my “rule of thumb” is that I plan to make it time well spent.