You’re doubtlessly familiar with the many retirement strategies that say something like this: If you invest X dollars per year for the next Y years, at Z percent, you’ll have N dollars by the time you’re ready to retire. That’s certainly true in theory (though most people won’t even get close). But what about once you retire? The financial industry loves formulas, and the answer to this one is the safe withdrawal rate. Today let’s dare to consider why the safe withdrawal rate won’t work for most retirees.
Now the safe withdrawal rate is widely admitted to be a theory in most circles. It holds that if you withdraw no more than 4% of your retirement portfolio in any given year, you’ll never outlive your money.
It goes something like this…You have $1 million in your retirement portfolio, and you withdraw 4% per year, or $40,000. Your portfolio never runs dry, because it continues to earn 7% or 8% each year in a mix of stocks and bonds. If your return is 7%, you can withdraw 4%, and leave the remaining 3% in the portfolio to cover inflation Voila, you’ll never run out of money.
Now let’s look at the reasons why the safe withdrawal rate won’t work for most retirees.
There are No Safe Investments Paying 4% Right Now
The only way to truly guarantee a 4% safe withdrawal rate is by investing in interest-bearing securities that pay at least that amount. But there hasn’t been a safe investment with that kind of interest rate yield in years.
Assuming you wanted to tie up your money for that many years, the current yield on a 10 year US Treasury Note is 2.96% (as of June 12, 2018). Shorter term securities are paying even less.
If you’re withdrawing 4% each year, and earning less than 3%, your portfolio will shrink by 1% per year. That doesn’t include the effects of inflation. What that means is you’ll be withdrawing 4% on a slightly smaller balance each year. Eventually, that won’t provide enough income.
There’s No Guarantee You’ll get 7% or 8% on Your Money for the Rest of Your Life
Based on the S&P 500, the stock market has produced an average annual rate of return of about 10% going all the way back to 1928.
If you have 50% of your money in an S&P 500 index fund, earning an average of 10% per ear, and 50% in 10-year US Treasury notes at 3%, your average annual rate of return would be 6.5%. As long as inflation goes no higher than 2.5%, the 4% safe withdrawal rate will work just fine.
But the problem is the 10% annual return in stocks. It’s an average over the past 90 years – but it’s not a guaranteed annual rate. Should the stock market fall by just 10% over the next three years, your 4% annual safe withdrawal rate will begin depleting your portfolio.
Your treasury notes at 3% per year, will produce a 9% gain. But against the 10% loss in stocks, you’ll have a net loss of 1%. And because you’ll withdraw 4% per year for living expenses – 12% total, your portfolio will drop by 13% in three years.
You’ll then be withdrawing 4% of 87% of your original portfolio each year. And once again, that’s not factoring inflation into the mix. For that matter, it’s not even a dramatic outcome for the stock market.
You Probably Won’t Be Invested in Stocks as You Get Older
This is another basic problem with the safe withdrawal rate. While you might have a healthy chunk of your portfolio in stocks in your 60s, you’ll probably whittle that down as you move into your 70s. Eventually, you might be 100% invested in fixed income securities.
While it’s easy enough to assume you’ll be heavily invested in the stock market throughout your life, your risk tolerance will almost certainly decline as you get older. As a practical matter, as you get older, you simply don’t have time to “wait out” a market decline, with the expectation of recovering your losses in the future. Since the future becomes increasingly limited, there’s no certainty of recovery. That alone will force you to move out of stocks.
Unless interest rates rise substantially in the future – which is not at all certain given the levels of debt in the country – it’s unlikely you’ll get returns of greater than 4% in fixed income investments. And even if you do, it’s probably because inflation has gotten higher.
One Stock Market Crash Changes the Whole Game
This is the part of retirement planning that financial planners and financial bloggers prefer to tiptoe around. But the reality is that we have had three stock market crashes, going back to 1987. Would you bet against one or two more in the next 30 years?
Here’s the problem…It will only take one stock market crash to completely derail the safe withdrawal rate. If 50% of your portfolio is invested in stocks, and the market takes a 50% loss, then 25% of your portfolio will be wiped out in short order.
Now you’re down to taking 4% of 75% of your portfolio. If you had $1 million to begin with, and it’s now down to $750,000, your annual withdrawals will drop from $40,000 to $30,000.
If you continue withdrawing $40,000 per year, you’ll draw down you savings even faster.
I suspect most people are aware of this possibility by the time they reach 70, and that’s why they prefer to avoid a large position in stocks.
You May Take More than 4% – And That Has Long-term Consequences
This is the emotional factor. It takes a certain amount of discipline to take only a very small slice out of a very large portfolio each year. If income from other sources proves to be less than expected, you might make up the difference by taking larger withdrawals. You might reason that you need 5%, 6%, 7%, or even 10%.
That might make sense if you’re 80 years old, but what happens if you’re only 70?
If you have a need to withdraw more than 4%, you’ll deplete the portfolio earlier than expected. This raises the very real possibility of outliving your money.
When I was doing income taxes a few years ago, I noticed a disturbing trend that retirees were withdrawing principal – not investment income – from their retirement savings.
Once again, people over 70 are less likely to invest in stocks. For that matter, they’re not entirely likely to invest in 10-year treasury notes either. Most were investing in CDs paying somewhere between 1% and 2%. That makes a necessity of drawing down principle. Interest is simply insufficient to provide the necessary level of living expenses.
In many cases, it was completely obvious that the draw down was taking place fast enough that the retiree was in real danger of depleting his or her savings.
I should also note that the majority of these retirees were on the higher end of the wealth pyramid (which also means higher financial requirements). But a large retirement portfolio doesn’t eliminate either financial conditions or decisions based on emotion or necessity.
Why the Safe Withdrawal Rate Won’t Work – And a Better Alternative
OK, let’s get unconventional here. It’s a common recommendation in the financial universe to tout accumulating a very large retirement portfolio, then relying on the safe withdrawal rate. It’s even used to advance early-retirement.
That’s actually quite doable for wealthy individuals who have well over $1 million in investment assets. But for the 90+% of the population who are not millionaires – and won’t be – it may not work. (Statistical fact: Less than 10% of US households are worth $1 million or more.)
What’s the alternative, especially if you have more modest retirement savings?
Nothing scientific or empirical here, but over the years I’ve seen a lot of people continue to work in some capacity well into their retirement years, while collecting Social Security and maybe a pension. They work as long as they’re able, and only begin tapping their retirement savings when they reach an advanced age, and can no longer work.
It may be that you’ll have to rely on Social Security and some level of earned income until you’re, say, 75. If you have retirement savings of, say $200,000, you might begin taking a percentage based on your remaining life expectancy.
For example, if you expect to live to be 85, you might begin taking 10%, or $20,000 per year. It would be better if you can take less, but that’ll depend on how much money you need. If you expect to live to 95, you might take 5%, or $10,000 per year.
It’s not a strategy any financial planner would ever recommend. But it might be the best choice for those with only moderate retirement savings. Which is most of the population.
Final Thoughts on Why the Safe Withdrawal Rate Won’t Work for Most Retirees
The bottom line is, the longer you can go without tapping your retirement savings, the less likely you’ll be to outlive your money.
Any other suggestions on how much retirement savings to tap – particularly for those who won’t be millionaires?