The Safe Withdrawal Rate – Does the 4% Rule Still Apply?

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Safe Withdrawal Rate
The safe withdrawal rate was first calculated to answer a major concern when it comes to retirement: Will I outlive my money? Given the fact that people are living longer than ever, outliving your retirement nest egg is a valid worry. Even if you feel you have a lot of money saved for retirement, if…

The safe withdrawal rate was first calculated to answer a major concern when it comes to retirement: Will I outlive my money?

Given the fact that people are living longer than ever, outliving your retirement nest egg is a valid worry. Even if you feel you have a lot of money saved for retirement, if you live into your 90s or beyond, you could end up broke.

In theory, at least, the safe withdrawal rate will allow you to withdraw a consistent amount from your retirement savings each year without depleting your portfolio. It may even cover for inflation.

What Is the Safe Withdrawal Rate?

The safe withdrawal rate is based on the idea that you should limit your withdrawals from your retirement savings to a certain percentage. That way, you’ll be unlikely to ever outlive your money. It holds that — no matter how many years you withdraw money from your savings — you’ll never go broke.

The percentage withdrawal rate most commonly cited is 4%. This is why it’s often referred to as the 4% Rule.

In general, it’s assumed that a blended portfolio of both stocks and bonds will earn an annual return higher than 4%. This would allow you to make your annual withdrawals at that rate without seriously drawing down your savings.

In addition, any return on your retirement portfolio that exceeds 4% will enable your savings to continue growing — even as you make regular annual withdrawals.

That doesn’t necessarily mean your portfolio will continue to grow. The idea is that if you can earn more than 4%, you can cover your living expenses, as well as increase the size of your portfolio at least a little bit in a typical year.

Many people also use the safe withdrawal rate to determine when they have reached financial independence. In other words, you’re financially independent when withdrawing 4% of your portfolio will cover your annual spending needs. Another way to express this is having 25 times your annual spending requirements in your investment portfolio. (100% / 25 = 4%). So if your annual spending requirements are $60,000, you’d need an investment portfolio of $1.5 million to be financially independent. ($60,000*25 = $1,500,000) or ($1,500,000*.04 = $60,000).

Why Do You Need a Safe Withdrawal Rate?

There are at least two factors that make the safe withdrawal rate necessary. One is longevity, and the other is inflation.

Longevity

People are living longer than ever. While this is good news, it actually creates a problem from a retirement standpoint.

According to the Social Security Administration, a 65-year-old man can expect to live to be 84.3, while a 65-year-old woman can expect to live to be 86.6. This means the average person who retires at age 65 will need to provide for themselves financially for at least roughly two decades.

That’s just the rule of thumb. Many people continue living well past their mid-80s. If you’re 65 now and live to be 95, your retirement portfolio will have to provide for you for the next 30 years.

There’s no way to know with any certainty how long you can expect to live when you’re age 65. But as lifespans increase — and as medical breakthroughs arrive on the scene with impressive regularity — planning for a 30-year retirement has become a necessity. And if you retire significantly before you reach 65, you could be looking at 35 or 40 years in retirement, which will come very close to matching the number of years that you spent in the workforce.

This is a big reason why so many people are worried about outliving their money.

Inflation

Beating inflation should be every retirement saver’s goal. However, when you live on a fixed income, as retirees typically do, inflation is one of your biggest problems. It means that each year your investment portfolio is worth a little bit less. In order to avoid outliving your money, you have to make sure your portfolio value keeps up with inflation.

Statistically, inflation has averaged 3.05% per year between 1928 and 2016. And despite wide fluctuations in the inflation rate, even into double digits, statistics show that the 3% average rate has held remarkably steady over the past 25 years.

Even a relatively low level of inflation has a negative impact on retirement savings, particularly over several decades. For example, a 3% average rate of inflation can reduce the value of an investment portfolio by about 33% in just 10 years. That means the $300,000 portfolio you have at 65 may have a real value of just $200,000 by the time you reach age 75.

In order to withdraw 4% per year from your portfolio for the next 25 years — and keep pace with an average inflation rate of 3% — your portfolio would have to average a 7% annual return. And based on recent inflation performance, that’s probably a solid target for anyone who wants to retire right now.

Why 4%? Why Not 3%? Or 5%? Or 6%?

The 4% Rule is based on work by William Bengen, who wrote a paper in 1994 supporting the rule, and the Trinity study, which was written by three finance professors at Trinity University in 1998. They used past stock market performance to analyze portfolios based on various allocations of stocks and bonds to determine how many years the portfolio would last.

Making withdrawals of 4% of the portfolio was seen as the safest withdrawal level to ensure the portfolio would last at least 30 years. The Trinity study actually calls for withdrawing 4% of the portfolio balance the first year, then adding inflation to the previous year’s withdrawal (rather than withdrawing 4% of the account each year).

In summary, the 4% Rule is the withdrawal rate that has the highest likelihood of you never running out of money.

Is the 4% Rule a Hard & Fast Rule?

The 4% rate isn’t actually set in stone. There are various factors that can affect it, making it either lower or higher.

For example, if you retire at 55 or 60, you may need your portfolio to last longer. In that situation, you might want to set your safe withdrawal rate at 3% or 3.5% per year, in an effort to make sure your portfolio lasts as long as possible.

By contrast, if you’re 70, you might want to increase the rate to 5%, since your life expectancy is shorter. Along the same line, if you’re 75, you might be safe taking 6% per year.

Health is also a factor. If you have certain health conditions expected to reduce your lifespan, you might want to consider increasing your withdrawal rate. But just be careful in doing this, since new medical advances are coming online all the time.

Finally, there are times when you may have more flexibility. If you have fixed income that meets most of your financial needs, you can be much more flexible with the 4% Rule. After all, you can dial back your withdrawals to allow your money to cover your spending needs. This is most common for retirees who have income from a pension, Social Security, real estate income, or other sources.

In the End, the Safe Withdrawal Rate Is Just a Theory

There are no guarantees attached to the safe withdrawal rate. It’s a convention more than anything else. But it’s a much simpler way of calculating how much you can withdraw without going broke. There are other methods used to calculate withdrawals that are based primarily on some percentage of pre-retirement income, or a specific calculation of expected expenses. But the problem with those methods is that they focus more on covering living expenses than making sure your portfolio exists long enough to do that for the rest of your life.

But even at that, there are situations in which the safe withdrawal rate could fail.

For example, should inflation rise from an average of 3% to 4% during the first decade of your retirement, a 7% annual rate of return on your retirement portfolio would leave you in a weakened financial position at the end of that timeframe. You’d still be getting your annual withdrawal of 4%. But your 3% inflation cushion would fall short of the 4% that you’ll need. That means your portfolio will lose about 1% of its value in real terms each year. That’s a little bit more than 10% over a decade.

The other possibility is poor performance by the stock market. Should the market be flat for a decade, your portfolio would decline in value by roughly 50% if you continue to make 4% annual withdrawals. It would be worse still because of the effects of inflation during that same decade.

But once again, the safe withdrawal rate is really just a theory. That theory is based on the performance of the stock market over many decades. For example, statistically, at least, the S&P 500 has returned an average annual rate of 9.53% since 1928. However, within any one decade, the possibility is that the numbers simply won’t support the safe withdrawal rate.

How Would the Safe Withdrawal Rate Have Worked From 2007-2017?

Let’s take a look at how the safe withdrawal rate would have performed in a recent 10-year period.

From January 1, 2007, through December 31, 2016, the average rate of return of the S&P 500 was 8.76%, so let’s say 9%. Let’s also say that one-third of your money was invested in fixed-income assets, paying an average rate of 1.5%. That means you would’ve earned roughly 6.5% per year over 10 years.

If you withdrew 4% of your retirement portfolio each year during that decade, you would’ve had 2.50% left over to cover inflation. Did it work?

From the end of 2006 through the end of 2016, prices rose by 19.05%. That means inflation averaged just under 2% during that 10-year period.

This means, from 2007 until 2017, you could’ve withdrawn 4% from your retirement portfolio each year, had nearly 2% available to cover the rate of inflation, and about 0.5% per year to generate a little bit of real growth in your portfolio.

That means that the safe withdrawal rate — at least during these 10 years — worked reasonably well.

Will that be the case going forward? There’s no way to know for sure, but it’s better to have a reasonable retirement plan than no plan at all.

What’s your opinion? Do you think the safe withdrawal rate is a valid way to estimate how much money you should withdraw from your retirement savings, without running the risk of outliving your money?

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About Kevin Mercadante

Kevin Mercadante is professional personal finance blogger, and the owner of his own personal finance blog, OutOfYourRut.com. He has backgrounds in both accounting and the mortgage industry. He lives in Atlanta with his wife and two teenage kids and can be followed on Twitter at @OutOfYourRut.

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