Retirement used to mean a gold watch and pension–times change. Today, an investment portfolio drives most people’s retirement. But building your nest egg is only one part of the equation. It comes down to one question when you’re ready to retire: how do you manage it?
We’re here to help you understand safe withdrawal rates and answer that all-important question. This article will analyze the factors that contribute to your withdrawals and assess different methods to achieve a safe and comfortable retirement.
What Is a Safe Withdrawal Rate?
A Safe Withdrawal Rate (SWR) is the amount of retirement income you can safely withdraw each year without depleting your portfolio. It’s a plan for annual retirement income to last for the rest of your life.
The perfect SWR maximizes income flow while maintaining a substantial balance to earn investment returns. It ensures your investments will grow large enough that your withdrawals won’t deplete your funds.
Determining the optimal safe withdrawal rate is the holy grail of retirement planning.
Financial planner William Bengen’s “4% Rule” gained popularity in the 1990s as the go-to safe withdrawal rate. Other financial planners over the years have revised the theory or proposed new ideas for improved SWRs.
It may help to first get a sense of your retirement picture to better understand how each strategy relates to your retirement.
What Will Your Retirement Look Like?
What’s too much? What’s too little? Take some time to assess your retirement picture and answer these questions.
Here are a few to guide your planning.
How Much Do You Have Saved?
Safe withdrawal rates often assume all portfolios are equal. That means it doesn’t consider the amount in your accounts.
An optimal SWR may not leave you with enough money to cover your expenses if your accounts are underfunded.
Saving for retirement should be one of every investor’s top priorities. Personal Capital offers helpful tools that can inform how your contributions affect your long term portfolio value.
Budget like a business and focus on your cash flow. In addition to their budgeting software, they have an awesome suite of tools to help you optimize your investments. Did we mention it's free?
Saving more now has a significant impact down the road. IRAs and 401(k)s each offer catch-up contribution options for people over 50 years old.
It allows you to increase your annual contributions beyond the respective limits and put a little extra away.
How Long Do You Expect to Live?
Apologies if this comes off as morbid, but life expectancy is a critical factor in determining your income needs. The first SWR theories intended to serve only 30 years.
But people now live longer, and many, including yourself, may live well beyond that timeframe.
Your health, habits, and family medical history are all factors in your retirement planning. Consider consulting with a doctor, insurance agent, or financial planner to set realistic expectations for an SWR.
What Age are You Planning to Retire?
The FIRE Movement has revolutionized the typical retirement age down to 30. But it also means your funds will need to last longer than the typical retirement portfolio.
Take these SWR’s with a grain of salt.
On the other hand, deferring retirement can buoy your income and increase your investment returns by reducing earlier draws. Deferring social security is another tool to increase your portfolio value.
While it’s understandable working more probably isn’t on most people’s bucket list, it’s a factor to consider related to your SWR.
What are Your Retirement Needs?
Are you planning on traveling? Downsizing out of your empty nest? What are taxes like in your state? Do you have a family to support, or that will support you?
The same way we budget for success in our day-to-day lives, you’ll need to consider all the factors that will affect your retirement savings over the short and long term.
Different spending and income needs may lead you to different SWRs.
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The 4% Rule
The Constant Dollar method popularized the 4% Rule. It’s one of the most well-known strategies for retirement withdrawals.
Use 4% of your portfolio value as an initial withdrawal rate. It establishes your base amount.
Every year after that, you take out the same base amount plus the cost of inflation.
The 4% Rule is a Constant Dollar strategy and based on withdrawing the same amount of money each year.
The rule includes an adjustment for the inflation rate to ensure your income’s purchasing power, but, overall, the dollar amount remains constant.
The 4% Rule assumes a 60/40 asset allocation between stocks and bonds. It’s also designed to serve a strict 30-year period.
William Bengan, the financial planner who created the 4% Rule, also grounded his analysis in Ibbotson Associates’ market data dating back to 1926.
Examining trends over time revealed 4% as the safest Constant Dollar amount to weather market extremes (e.g., the Great Depression or the 1970s high inflation period).
Challenges to the 4% Rule
Many financial and investment advisers challenge the 4% Rule and its assumptions. Retirement researcher Wade Pfau claims that risk-tolerant retirees might opt to withdraw as much as 7% for their Constant Dollar base.
Professors from Trinity University authored the influential Trinity Study, which called for the use of a bond portfolio grounded in corporate rather than government bonds.
These findings have challenged 4% as a strict rate, but the underlying principles of the rule still support it. The constant dollar method is more important than the exact percentage you decide suits your needs.
Constant Dollar in Practice
Let’s say you have $100,000 in a Roth IRA. We’ll use 4% to define our Constant Dollar amount.
In the first year of retirement, you’ll withdraw 4% of your account value. This amount equals $4,000.
That $4,000 is your Constant Dollar base. Your annual withdrawal will be $4,000 plus an adjustment for inflation (typically around 2%). That’s it.
The Constant Percentage method operates with a similar principle as the Constant Dollar. Your annual withdrawal is based on a fixed percentage of your portfolio’s value (rather than a fixed dollar amount).
The percentage remains constant, but your withdrawal amount will fluctuate with the value of your portfolio.
The Constant Percentage method does NOT account for inflation. It assumes the long term gains of the market will protect purchasing power over time.
Keep in mind that while the market points to growth over the long term, your year-to-year income will be up and down dependent on the market’s performance.
You should be financially secure enough to weather years when your portfolio value drops. This method is ideal for people with lower fixed expenses (e.g., no mortgage, rent, or large debt) that can manage greater income flexibility.
Prepare for Market Exposure
The Constant Percentage is arguably the simplest safe withdrawal rate to put into practice. Whatever your portfolio is in a given year, you draw the same percentage.
While the market changes don’t reveal a dramatic impact on our example, your income volatility will increase with your portfolio’s value.
Bond allocation becomes vital when using the Constant Percentage method. You should be transitioning your portfolio from stocks to bonds each year to mitigate market volatility with age.
Constant Percentage in Practice
Let’s look at how Constant Percentage effects our $100,000 Roth IRA. We’ll use 4% again as our Constant Percentage.
In the first year, we withdraw $4,000 or 4% of the total value. Your new portfolio value is $96,000.
In Year Two, your portfolio has grown 6% from $96,000 to $101,700. Your second annual withdrawal will be equal to $4,071.
Now let’s say there was a market correction in Year Three of your retirement. Your portfolio value has dipped 4% to about $93,700. Your withdrawal amount for this year is still 4% or $3,750.
Floor and Ceiling
William Bengen proposed his Floor and Ceiling method as a bridge between the Constant Dollar and Constant Percentage.
First, you establish a Constant Dollar Base amount. Instead of drawing the same amount, your withdrawal will fluctuate with market performance similar to Constant Percentage.
Your withdrawals are limited to a hard 15% floor and 20% ceiling from your base amount.
This method intends to smooth market fluctuations having a dramatic impact on portfolios using Constant Percentage.
The ceiling allows you to leverage market gains for additional income during good times, while still preserving enough money to compound and preserve your portfolio’s longevity.
The floor means you’ll reduce spending during poor market performance compared to the more strict Constant Dollar method. It does increase the possibility of depleting your portfolio but this becomes less risky over time.
Floor and Ceiling in Practice
We have our $100,000 Roth IRA with a 4% initial withdrawal rate. It gives us a $4,000 base. Your floor and ceiling are set according to your base amount.
So, we have a 20% ceiling or 20% of the $4,000. That’s $4,800. Conversely, our floor is set at 15% of the $4,000 or $3,400.
Your annual withdrawal will reflect the market. If your portfolio grows, you can spend up to your ceiling, instead of the Constant Percentage of all growth.
If the markets dip drastically and your portfolio loses significant value, you can use your floor to maintain a baseline of income.
Financial adviser Michael Kitces’ “Rachet” method challenges the Constant Dollar method’s risk-averse underpinnings. Kitces dug deep into the same historical data used to establish the 4% Rule.
He notes that while a 4% rate survives the worst possible scenarios, 6% was the average successful safe withdrawal rate and up to 10% can be reasonable for lots of portfolios.
His analysis shows that 4% leaves so much principle to compound that two-thirds of retirees finish with more than double their initial principal balance.
That’s a serious success rate.
While 4% withdrawal remains a safe starting point, it’s reasonable to increase your withdrawal amount if you’re watching your wealth outpace your retirement.
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The Rachet method keeps the safe floor established by a 4% withdrawal and ratchets it up once your portfolio returns grow large enough to withstand a higher withdrawal.
You keep drawing 4% annually until your portfolio increases 50% above it’s starting value.
Once you cross that threshold, you’ll ratchet up your withdrawal rate to 10% and capture this increased value.
Too Much, Too Soon?
The Rachet method still keeps the longevity of your portfolio in mind. You don’t want to remove so much money you’ll be forced to make spending cuts to prevent portfolio depletion.
The point is to maximize your nest egg, not diminish it.
Keep in mind the 10% increase does NOT establish a new annual standard. You should never give yourself a spending bump more than once in any three years.
This will ensure you don’t spend too much, too quickly.
Even with this safety net in place, Kitces notes that when your portfolio reaches 50% growth, it’s so far ahead it will likely be able to withstand any future market dips.
The Ratchet in Practice
Let’s take a look at our Roth IRA with $100,000. You’ve remained steadfast with removing your annual 4% base.
Your market returns have compounded and your portfolio has grown to $150,000 (i.e., 50% of its starting value).
You can now ratchet up your withdrawal $10,000, or 10% of your original $100,000 balance.
Even if your portfolio continues to grow, wait at least three years before giving yourself another spending bump to provide a buffer.
The Rachet Rule is a more hands-on, reactive approach to managing your retirement spending.
Which Safe Withdrawal Rate Is Right for You?
You can’t predict the future. Your retirement accounts will likely bounce between bear markets, high returns, and who knows what else.
Being able to weather market volatility and support your goals starts with sound planning.
Choosing a proper safe withdrawal rate should reflect your income, wealth, and risk tolerance. The key is to stay consistent and committed to your method.
Financing your retirement should be a well-rounded approach, and the right safe withdrawal rate can provide you with a reliable plan to make it last for the long haul.