Financial independence has arrived. Retirement is opening its doors. Capital has been accumulated from savings and investments. The time has arrived for this “nest egg” to meet its final purpose: producing income.
Money may need to be withdrawn monthly, quarterly or annually to contribute to our budget and cover living costs. It is inevitable that with this, questions arise:
- What percentage can I ‘safely’ withdraw?
- Should I withdraw the same % each year or use a more tactical approach that considers factors such as age and market conditions?
- What asset allocation (stocks-bonds) is advisable?
This article covers the first of these questions; the remaining two questions will be addressed in my next article.
What percentage can I ‘safely’ withdraw?
Clearly most people would like to be able to comfortably draw from their retirement capital throughout their entire lifetime. So, perhaps it is no surprise that an American financial planner by the name of Bill Bengen in the early 90s asked himself the following question (1):
“How much of my savings can I spend each year without outliving my money or losing buying power to inflation?”
Bengen was a businessman who, on retirement, became a financial planner. He was a numbers guy as well. He went to work and analyzed historical data of the financial markets. And he came up with a figure to answer his question: 4.2%. So was born the concept of a safe withdrawal rate, later referred to as SAFEMAX.
Note 1: Bengen assumes an asset allocation of 50% equities and 50% fixed interest.
Note 2: In practice, to account for inflation, you spend 4.2% of the assets in your first year of retirement and increase that annual dollar amount each year by the inflation rate.
This safe withdrawal rate is one of the most discussed and researched topics among US financial planners and 4% (or 4.2% ) became “the magic number”. One of the discussions has in fact been whether this exact percentage is correct. Bengen himself adjusted his 4.2%, in 2006, to 4.5%. Naturally one wonders how ‘safe’ these withdrawal rates actually are, when equity markets crash like they did in the credit crisis (2008). Recent research (2) addressed exactly this question and concluded that for covering “emergencies” the safe withdrawal rate should be lowered to 3%!
Another way to tackle this ‘safety’ question is to work with probabilities. What likelihood is there that a portfolio will run out of money, using withdrawal rate x, y or z? A recent study (3), using market data that included 2008 and 2009, shows that in all conditions at least 96% of the capital was preserved using a 4% rate (for the same 50% equities 50% fixed interest allocation Bengen used in his study).
So, when it comes to the US Dollar spending in the US, history seems supportive of a number close to 4%. Of course, it remains to be seen whether this kind of rate can be used when spending in Euros, GBP, Aus$ or one of the Asian currencies (I will address this in my next article). But at least there is a starting point for forming opinions and expectations.
Some readers who have thought about withdrawal rates on retirement may have expected a higher rate. In fact, often in retirement illustrations, higher rates are used. Other readers may find a target rate of 4% (tracking inflation) too high. The argument may be that, although US market historical data have accounted for the recent credit crisis and the ‘lost decade for equities’( 2000- 2010), they still present too rosy a picture.
In any case, by now, all of us should be prepared for the reality that ‘safe’ does not fully exist when it comes to investments and returns. The best we can do is to familiarize ourselves with various scenarios- and always include a ‘worst case’ scenario in this process! With this in mind, at least for Americans retiring in the US, 4% seems a reasonable reference point for expectations.
1. “The Retirement Spending Solution” by William P. Barrett, Forbes.com 5 May 2011;
2. “ Effect of Emergencies on Retirement Savings and Withdrawals”
by Gordon B. Pye, Ph.D., Journal for Financial Planning, November 2010
3. “Portfolio Success Rates: Where to draw the Line” by Philip L. Cooley, Ph.D., Carl M. Hubbard, Ph.D. and Daniel T.Walz.,
Journal for Financial Planning, April 2011