Withdrawal Rates During Retirement: Are We Being Too Conservative?

by: Mark Hebner

Summary

1. Retirement Planning.

2. Withdrawal Rates.

3. Passive Investing.

How much can one afford in retirement? It is the Holy Grail of retirement planning and has been through multiple evolutions over the last few decades. Why? In short, we are trying to give a solution today based on uncertainty about the future. What are returns going to be like in the future, or the rate of inflation, or an investor's life span? All of these variables affect the solution that we advise on in the present.

Because we cannot accurately predict the future with a high degree of confidence, we must estimate what we "expect" to happen in the future and advise accordingly. The alternative would be to provide a conditional solution that can be adapted depending on how the future actually plays out. For example, if market returns happen to be lower than expected or inflation ends up being higher than expected, then the solution changes.

The problem with a conditional strategy is that it doesn't necessarily lend itself well in practice. How many investors like to have their annual budget change from year to year? Most investors, especially during retirement, like consistency, and therefore, we must be able to provide a solution that fits this behavioral trait even though it might not be "optimal" in terms of maximizing outcomes.

One of the best known rules in retirement planning is the 4% rule, originally developed by William P. Bengen. It states that a retiree can withdraw 4% of their wealth at retirement every year (adjusted for inflation) and be highly confident that they will not run out of money over a 30-year period. It is based on an analysis that included historical returns of the S&P 500 spanning over eight decades as well as historical inflation rates.

Recently, Mr. Bengen has updated his previous 4% rule up to 4.5% given his introduction of small-cap stocks into his analysis. Small-cap stocks have outperformed large-cap stocks over long time horizons and definitely have their place in everyone's asset allocation.

But is 4.5% still too conservative of an estimate?

It is an important question since any non-utilized funds in retirement will be bequeathed to beneficiaries. While bequeathing money to loved ones is never a terrible thing, most people didn't work hard their entire lives to just pass their wealth along. They also want to enjoy the life they have built for themselves.

Our own analysis begins by tapping into our over 50 years of historical performance data across multiple asset classes around the world. The benefit of having a large data set is not only the accuracy that accompanies a large sample size, but also the many trials and tribulations the markets have already faced. Multiple wars, economic booms and busts, high bouts of inflation, presidential assassinations, etc. Through all of these trials, markets have prevailed, although those trials were very unnerving at many times. It is hard to say what is going to happen in the future, but we have a pretty robust data set that has been time-tested through many types of extreme events, so the conclusions we draw from the data are definitely not meaningless.

Based on over five decades of data, we looked at the worst 10, 20, and 30-year periods in terms of returns across 10 of our IFA Index Portfolios and tried to find the maximum withdrawal rate where investors didn't lose 1 cent of their principal. For example, if an investor has $500,000 at retirement, what would be the withdrawal rate that would allow her to have $500,000 at the end of her life?

The table below shows the start dates for the worst 10, 20, and 30-year periods for 10 of our IFA Index Portfolios as well as the maximum withdrawals rates that left investors with the same amount of principal at retirement and at the end of their life. Periods are based off of monthly rolling data.

Start Date of the Worst Period

IFA Index
Portfolio
Worst Rolling
Period Return
10 Year
Worst Rolling
Period Return
20 Year
Worst Rolling
Period Return
30 Year
P 10 6-Mar Sep-96 Sep-86
P 20 6-Mar Sep-96 Sep-86
P 30 6-Feb Jun-96 Sep-86
P 40 6-Feb Mar-96 Jul-86
P 50 6-Feb Mar-96 Jul-86
P 60 6-Feb Mar-96 Jul-86
P 70 Mar-99 Mar-89 Jul-86
P 80 Mar-99 Mar-89 Jul-86
P 90 Mar-99 Mar-89 Jul-86
P 100 Mar-99 Mar-89 Jul-86
Click to enlarge

Max Withdraw Rate w/o losing Principal

IFA Index
Portfolio
Worst Rolling
Period Return
10 Year
Worst Rolling
Period Return
20 Year
Worst Rolling
Period Return
30 Year
P 10 2.35% 3.90% 5.31%
P 20 2.90% 5.80% 6.13%
P 30 3.35% 6.25% 6.91%
P 40 3.72% 7.35% 7.70%
P 50 4.05% 8.00% 8.39%
P 60 4.27% 8.65% 9.05%
P 70 6.60% 10.30% 9.67%
P 80 6.80% 10.80% 10.27%
P 90 7.00% 11.23% 10.84%
P 100 7.10% 11.65% 11.39%
Click to enlarge

Sources and Disclosures: IFA, ifabt.com

For example, the worst 20-year period for IFA Index Portfolio 50 was from March 1996 to February 2016, which was a 6.16% annualized return. The maximum withdrawal rate a particular investor in IFA Index Portfolio 50 could afford was 8.00%, which is almost double what Mr. Bergen originally advised on. Remember, the investor is still left with the same amount they had at the beginning of retirement. Also, this is the WORST 20-year period we are looking at. Results could have been slightly better if we analyzed the median outcomes.

As you can see, maximum withdrawal rates ranged from 2.35% to 11.65% depending on the time horizon and IFA Index Portfolio. Now in reality, most investors wouldn't find themselves in an IFA Index Portfolio 50, 60, or even 100 throughout retirement. We advise our clients to follow a simple Glide Path risk-reduction strategy throughout their life to ensure that their risk exposure properly matches their risk capacity, which diminishes over time. As a reminder, our Glide Path strategy reduces our investor's equity allocation by 1% per year.

Let's assume that someone enters the workforce right after they graduate college and they invest in our IFA Index Portfolio 100 and follow our recommended Glide Path risk-reduction strategy. At a normal retirement age (66 years of age) they would find themselves roughly in IFA Index Portfolio 55. Now, we don't know how long they are going to live for, but let's see what the results look like across multiple time horizons (10, 20, and 30-year periods). If they continued with our recommended Glide Path strategy, they would find themselves in IFA Index Portfolio 45, 35, and 25 at the end of their life, respectively.

The table below shows their "average" IFA Index Portfolio exposure throughout their retirement years.

Time Horizon Average Portfolio
10 Years Portfolio 50
20 Years Portfolio 45
30 Years Portfolio 40
Click to enlarge

For example, someone who retired at 66 in IFA Index Portfolio 55 and lived for 30 additional years would, on average, have experienced an IFA Index Portfolio 40 throughout their retirement years [55-(30/2)].

The table below shows the maximum withdrawal rate for each of the 10, 20, and 30-year time horizons based on the worst period for each IFA Index Portfolio that corresponds with their average exposure over that time horizon.

10 Years 20 Years 30 Years
Average Portfolio Portfolio 50 Portfolio 45 Portfolio 40
Worst Period 02/06 - 03/16 03/96 - 02/16 07/86 - 06/16
Annualized Return 3.84% 5.88% 6.89%
Maximum Withdrawal Rate 4.05% 5.70% 7.70%
Click to enlarge

Sources and Disclosures: IFA, ifabt.com

Depending on the investor's time horizon, they could afford a withdrawal rate of 4.05-7.70% throughout retirement.

This analysis was simple but leaves a very powerful message for investors. While many prognosticators may be saying "death to the 4% rule" based on their prediction of future returns, most investors are going to be JUST FINE. We analyzed withdrawal rates looking at the worst rolling period returns that we have ever experienced and we are getting results that are right on track and even better than what has been recommended in the past.

Remember, this leaves the investor with the same amount of principal they started with at retirement. If we were trying to liquidate all retirement assets, these withdrawal rates would be even higher. As a general rule, we have been advising our clients for years that a withdrawal rate of 5-6% is a safe bet throughout retirement and also allows for consistency in cash flows from year to year. This accommodates possible events or return scenarios that we have never experienced before (like 2008) as well as the multiple risk capacities that our investors have in retirement.

Although Mr. Bergen was a pioneer in answering the Holy Grail of retirement planning questions, he is a little late to the party on his revision.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.