Retirement is a relatively new idea. In 1880, four-fifths of men over 65 were still working.
The world we live in today is very different. The life expectancy of 65-and-up Americans has risen by several years, yet their labor force participation rate is under 25%. We rely on other sources of income to provide for us in our latter years. Because of all this, we need to think carefully about how much money we pull from our savings each year in retirement.
Enter the "safe withdrawal rate" -- the percentage of your savings that you can, in theory, withdraw every year without running out of money while you're alive. Let's go over how to figure out what your safe withdrawal rate may be and how this number can help you plan your retirement.
What does safe withdrawal rate mean?
The idea behind a safe withdrawal rate is simple: It tells you how much money you can pull from your savings in year one of retirement. After that, you can adjust that rate every year to account for inflation. As we get into the nitty gritty of figuring out your safe withdrawal rate, keep in mind that there's no universally appropriate rate. Everyone's life and financial circumstances are unique.
Having said that, the most popular rule of thumb is the 4% rule. This means that if you have a nest egg of $600,000, you should take out $24,000 in your first year (4% of $600,000), and then increase that amount in year two based on inflation. This is a key distinction: You do not take out 4% of your nest egg every year. You only do so in the first year, and then you make cost-of-living adjustments every year after that based on the rate of inflation. You can find recent inflation rates on websites such as USInflationCalculator.com, which shows you in a chart what the inflation rate has been for each of the past 10 years.
If, for instance, inflation after year one stood at 3%, then it would be "safe" to withdraw $24,720 in year two ($24,000 X 1.03). That extra $720 would help make up for the rise in the prices of everyday goods like food and gasoline.
You may think $24,000 isn't much to live on. But as we'll cover below, your nest egg is just one of (hopefully) many sources of income you can draw on in retirement.
Where did these estimates come from?
The 4% rule has an interesting origin story. For a long time, financial advisors believed it safe to withdraw up to 5% of your retirement portfolio in year one of retirement and make the same adjustments.
But in 1994, financial advisor William Bengen released a landmark paper that shifted the debate markedly. According to his research, 4% should be the new standard-bearer. Bengen ran models showing how different portfolios, made up of varying blends of stocks and bonds, would have performed in the past. The two variables he looked for were 1) the initial withdrawal rate and 2) the mix between stocks and bonds. His calculations included the biggest market downturns, such as the Great Depression and the bear market of the early 1970s.
Using the 4% rule, Bengen claimed, would help retirees avoid insolvency:
Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe. In no past case has it caused a portfolio to be exhausted before 33 years, and in most cases it will lead to portfolio lives of 50 years or longer.
In other words, it's highly likely -- based on past data -- that the 4% rule will allow your nest egg to last at least 30 years (until your 90s) and perhaps 50 years or more. That's great news for those who plan to live to 120!
Just as important, Bengen found that keeping between 50% to 75% of your nest egg in stocks was important. While stocks are more volatile in the short term, they provide higher returns than bonds in the long run. Because retirement can last anywhere from one to 40 years, long-term results matter.
What assumptions are built into the 4% rule?
It's vitally important to understand the parameters of Bengen's research. Here are some key assumptions the 4% rule makes:
- Between 50% and 75% of your nest egg is invested in stocks, perhaps via low-fee exchange-traded funds.
- The remaining portion -- between 25% and 50% -- is invested in intermediate-term Treasury notes or some other sort of bond.
- Every year, these allocations are rebalanced to maintain your "ideal" allocation.
Perhaps the most important assumption is that you do not become overly conservative if there are stock market declines. Lowering your withdrawal rate when the market dives is perfectly acceptable, but selling out of stocks and buying more bonds after market downturns can be disastrous.
As Bengen points out:
The client who retired in 1929 with $500,000 in a retirement fund saw that fund dwindle to less than $200,000 by the end of 1932. ... In this situation, with stocks having performed so dismally so early in retirement, it may be tempting to switch all investments to bonds in order to salvage what is left of the original capital. But that would be precisely the wrong thing to do!
He goes on to explain how such a client would be committing the cardinal investing sin: buying high and then selling low, thereby locking in tremendous losses.
Bengen goes on to demonstrate how this approach would lead to said client running out of money in less than 20 years. Had they left their allocation alone, the nest egg would have recovered nicely and lasted the duration of retirement.
That's because every time the stock market has experienced a significant downturn, it has eventually bounced back even stronger. After falling 57% during the Great Recession, the S&P 500 has since advanced over 280%!
The real killer: sequence risk!
By far the biggest risk that retirees face -- especially if they choose to withdraw more than 4% from their nest egg -- is a huge drop in stocks, bonds, or (gasp) both in the first five years of retirement. In general, you will likely be safe if you are following the 4% rule. But if there's a stock market drop of over 60% in the first five years of your retirement, you should consider reducing the amount you pull out. The reason for this is twofold:
- The portion of the nest egg you withdraw will increase markedly above the 4% threshold. For example, say you have a $1 million nest egg. In year one, you'd withdraw 4%, or $40,000. But if the market drops 60% over the following year while inflation is flat, then according to the 4% rule, you'll need to withdraw $40,000 from the remaining balance of $384,000 the next year -- that's 10.4% of your nest egg!
- All of the money taken out does not get the chance to compound over the next 25 to 35 years. In other words, the extra 6% that you withdrew in the example would lose the growth it might have otherwise experienced.
Here's an even better example of what I'm talking about. In this scenario, three different portfolios each earn 6% returns after inflation during normal years but suffer a 25% decline for two consecutive years at varying stages of retirement.
The colored lines represent your retirement savings after the corresponding number of years of retirement.
In all three scenarios, these retirees experience 33 years of 6% returns and just two consecutive years in which their portfolios drop 25% (for reference, the market lost a little over 50% in the financial crisis of 2008 and 2009). But as you can see, the timing of those drops makes an enormous difference.
Real-life returns are never this regular, but the point is clearly illustrated: One of the greatest risks to your portfolio is a huge drop in your nest egg's returns during the first five years of retirement. If that fall comes later, the danger is mitigated because your portfolio has had plenty of time to grow. The dent isn't nearly as harmful.
From this, there are two clear takeaways:
- If you experience a huge loss in your portfolio in your first five years of retirement, strongly consider taking out less money until your portfolio recovers.
- Retiring after a particularly bad year or two in the stock market can actually be a good thing. The once-in-a-decade market drop -- a 30% drop, for instance, occurs every 10 years -- has already occurred, and the chances are higher that you'll experience better-than-expected gains moving forward. This assumes that the market swoon didn't deplete your nest egg to the point where you need to withdraw more than 4% in year one.
How else can the withdrawal rate change over time?
As I pointed out above, if you endure a serious market swoon in the first couple of years of retirement, it would be wise to lower your withdrawals -- but not reduce your stock allocation -- until the market recovers.
There are other factors that may tempt you to change your withdrawal rates over time. For instance, if you're lucky enough to retire at a time when returns are above normal, your nest egg may continue to grow at a fast clip, regardless of your withdrawals. That may tempt you to start withdrawing more.
While a modest increase in your withdrawals is acceptable -- and occasionally necessary for expenses such as medical procedures -- Bengen again cautions against dramatic changes.
[Such retirees] must understand that excess returns earned today will probably be needed to offset losses in the future. They have enjoyed good luck, and nothing more. Good luck is too rare and precious to be squandered.
As Bengen shows, increasing your withdrawals by even a few percentage points -- say, from 4% to 7% -- could prove disastrous if low returns and high inflation are just around the corner.
How does this fit with Social Security, pensions, and other retirement income?
As promised, we can now get to the part that covers all of your sources of income in retirement. Looking at your safe withdrawal rate is nice, but it doesn't tell the whole story. If you have a $500,000 nest egg, you might balk at spending just $20,000 per year. Chances are, however, you'll have more sources of income than this.
Apart from your your nest egg, these may include:
- Social Security benefits
- Pension payouts
- Rental property
- Part-time work
In 2017, the average American household with residents over 65 spent about $50,000 annually. Because this is the "mean," and we know that high spenders can pull this figure up, let's assume the "median" -- a number that better represents ordinary retirees -- is somewhere around $42,000 per year.
Our hypothetical couple has a nest egg of $250,000. That may sound like a lot, but using the 4% rule, this comes out to just $10,000 per year that can be safely withdrawn. Luckily, there are other sources to consider.
For instance, the average monthly Social Security retirement benefit paid in November 2018 was $1,374. Over the course of a year, assuming there are two beneficiaries in the household, that amounts to $33,000. Add in a $10,000 savings withdrawal, and this couple would cross our $42,000-per-year threshold.
Of course, not all couples will fit this scenario. Some will have income from rental properties, and others will have pensions. And while some people scoff at the idea of working part-time in retirement, there are a few big side benefits to such work:
- It helps you maintain social contacts in your community. This is vitally important, as loneliness is the silent killer of American retirees.
- It keeps you active in your old age, helping you maintain your health.
- It likely won't require major obligations. If you need an extra $10,000 per year, that means finding a job that pays $15 an hour and doing it for just 13 hours per week.
You need to consider all of these moving pieces to determine what the appropriate withdrawal rate will be for you.
What role do taxes play?
Taxes: They're a central part of retirement planning calculations. And they are ever-changing. Back when Bengen did his original analysis, Roth IRAs didn't even exist yet. It would be foolish to assume there will be no major changes in the tax code between now and when you pass away.
So we need to come to terms with the fact that taxes will affect our investments, and we can't predict exactly how. That said, here's what we do know when it comes to withdrawing money from our nest egg:
- Cash that is taken out of Roth IRAs and Roth 401(k)s will not be taxed. If you take out 4% in year one, you get to spend all 4%.
- Cash that is taken out of traditional IRAs, 401(k)s, or 403(b)s will be taxed based on your income bracket. That means you'll end up paying somewhere between 10% and 20% of whatever you pull out of these accounts in taxes. That's vitally important to remember, as it essentially lowers the amount of your savings you can actually spend in a given year from 4% to around 3.2%-3.6%. That's a big difference.
There's an endless number of ways in which your tax situation can affect your safe withdrawal rate. There's no way we could cover every situation in one article. That's why its important for you to consult a tax professional and map out how much you'll pay in taxes and how you'll cover that expense.
Drawbacks of taking too much
Withdrawing too much money from your nest egg increases your chances of running out of money while you're still alive. This can put a financial strain not only on you, but also on your family and friends, who may feel obligated to step in and help fund the gap.
If you do decide to start withdrawing more money than the 4% rule dictates, it's much better to raise your distributions by modest amounts, and after you've been retired for five to 10 years. Of course, major life events like unexpected illness can change the calculus -- but you can only focus on the factors that you control.
And if you're really worried about running out of money, you might consider lowering your initial withdrawals to 3.5%.
Drawbacks of taking too little
Because we humans are risk-averse, the thought of running out of money gets a lot of attention. The flip side of the coin rarely gets noticed, but it's worth mentioning: If you withdraw too little, you run the risk of never enjoying retirement.
I'll be the first to argue that, beyond fulfilling your basic needs, money doesn't buy all that much sustainable happiness. That being said, if you keep putting off retirement, working in a job you don't love so that your nest egg, your ideal retirement budget, and the 4% rule line up just right, you might have a problem. And if you spend retirement living like a monk solely because you fear going broke, you may someday pass on with a lot of leftover money -- and a lot of missed opportunities to enjoy yourself.
Step back from the situation and look at it from 30,000 feet. Money need not be an end unto itself; it is a tool to help you get the experiences you want from life. Only three things can really make you happy, according to Martin Seligman and Sonja Lyubomirsky, two leaders in the field of positive psychology:
- Purpose and meaning
- Healthy relationships
- Control over your own time
Those last two items require flexibility in your schedule. Because of this, taking out a slightly higher amount -- say 4.5% -- might be a worthwhile decision if it means it will give you more time to focus on such things.
Everyone's circumstances will be different. Running out of money is obviously a fate we all want to avoid. By carefully considering all these factors -- especially the 4% rule -- combining them with where you and your spouse are right now, and planning out what you'd like your Golden Years to look like, you should get a better idea for exactly what your own safe withdrawal rates will look like.
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