Will A 4% Withdrawal Rate Last You Through Retirement?

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Includes: VWELX, VWINX
by: Dave Dierking, CFA
Summary

The 4% withdrawal rule is one of the most often repeated retirement planning ideas.

In many cases, a 4% annual withdrawal from your retirement will last you through retirement but it requires careful planning and dogged persistence.

In this article, I run several simulations around the 4% rule modifying rates of return, number of years, etc. to assess the chances that your retirement balances will last.

An article I recently published on Seeking Alpha regarding the Vanguard Wellesley Income Fund (MUTF:VWINX) generated a lot of conversation. One of the common themes in the comment thread is how the fund would fit into a retirement portfolio.

One individual commented on how he had recently rolled his workplace retirement plan into a 50/50 combination of Wellesley and Vanguard Wellington (MUTF:VWELX) and that led into the following broader retirement-related question…

Question: Just curious, I am close to retirement and was thinking of doing exactly the same thing. I think I could withdraw 4% a year without diminishing the principal, do you do anything like that? I have about 300k to invest with, so looking to withdraw 1K a month.

Answer: The "do I have enough for retirement" question is as old as time. Everybody wants to make sure they don't outlive their savings, but given so many factors such as medical costs, housing expenses and return on investment, there's just no way to say yes with 100% certainty.

The 4% annual withdrawal rate on retirement savings accounts is commonly used figure recommended for retirees, so it's appropriate to look at an a fairly straightforward example using that number.

There are a lot of moving parts in a scenario analysis like this, but to start I'll make a few assumptions…

  1. As mentioned, the starting portfolio balance is $300,000.

  2. We invest in a 50-50 combination of Vanguard Wellesley and Vanguard Wellington.

  3. A $1000/month withdrawal is made and is indexed annually for a 2% inflation rate (i.e. in year 2, $1020 is withdrawn, in year 3, $1040.40 is withdrawn and so on).

  4. No consideration is given to Social Security, pensions, etc. since the person asking is looking to generate a specific income from a specific account.

The biggest challenge here is estimating what the 50-50 combination will earn going forward. Wellington has returned between 8-9% annually over its 88-year life while Wellesley has done almost 10% per year. It's probably unreasonable to expect those kind of returns going forward since 1) the stock market is on pace for its 9th consecutive year of gains, 2) we're at the tail end of the biggest bull market in history for bonds and 3) the markets are continuing to look expensive. It's unclear from the example how long the money will need to last other than the reader says they are "close to retirement". Let's assume that we should aim to have the money last for 30 years. As for future return estimates, let's go with 5% for Wellesley and 6% for Wellington. I don't think any of these numbers is overly optimistic and it's always better to be too conservative than too aggressive.

For the record, I like to use Portfolio Visualizer to run any simulations. It's got some nifty tools that allow you to both forecast and backtest scenarios with a number of variables involved.

To provide a baseline, I plugged the numbers above into the simulation, except I used historical returns as an expectation for future returns. We get the following results.

The fact that there's a 99% chance you'll have enough money to last shouldn't be a surprise. If you're earning 8-10% but only withdrawing 4%, you'll probably do pretty well. In this example, your $300,000 starting balance grows to over $1.5 million in the median simulation even considering the $1000/month withdrawals.

But, again, those returns aren't likely to be realistic. Let's run the simulation again using the expectation of 5-6% returns going forward.

With lower expected returns on the portfolio, the odds of success drop to 81%. The overall picture is still encouraging as a 4-in-5 chance of not going broke is still good, but there's a lot less certainty involved. At an 81% success rate, there's a much greater risk of any single factor coming in worse than expected (lower actual returns, longer life expectancy, significant drawdown at the wrong time) drastically increasing the chances you'll outlive your money. In this simulation, the median maximum drawdown was around 40%. That would be a severe blow to your portfolio if that were to come at the wrong time.

How do the odds change if we adjust some of these factors just a little bit? Let's run a few more scenarios.

Suppose you live five years longer than expected (35 years instead of 30 years in this example).

The chances of having your money last drop to 69%. This scenario may not be as far-fetched as it seems since more and more people are living to be 100.

What if we raise the expected returns on the portfolio by a single percent to the 6-7% range?

Return expectations make a big difference in these simulations. Adding just 1% additional return annually bumps the odds of success up to a relatively safe 92%. In most cases, your portfolio is actually gaining value instead of being depleted over time. A word of warning: this expectation goes the other way too. Reducing your expected return by just a single percent puts you back in the danger zone.

You'd end up having enough money just ⅔ of the time.

Here's another scenario that has a higher likelihood of happening - withdrawing more money than you planned. Suppose that $1000/month withdrawal creeps up just a little bit to $1050. What happens then?

Not a huge difference but your 81% success rate drops to 76%. It's easy to see how spending more than you have budgeted to quickly lead to trouble.

We could run these scenarios all day, but the overall point here is that the 4% withdrawal rate can work just fine as long as you have proper expectations in place. If you expect the good times to continue rolling at the rate of a 10% annual return and you only get half of that, you might be forced to make some major changes. In this scenario, I tried to set expectations relatively low as far as what type of return the portfolio would experience and how long we'd need the money. Even then, there was a roughly 1-in-5 chance we wouldn't make it. Start spending beyond your means in retirement or run into unexpected medical issues, the whole game changes.

Conclusion

The 4% withdrawal rule is one of the most commonly repeated retirement directives there is. Unfortunately, it's not a simple "set it and forget it" strategy. Whether or not the 4% target will work depends on risk tolerance, spending plans, time horizon and other factors. Always be honest with yourself and set reasonable expectations. It might be the only way of knowing for sure if your retirement nest egg will last as long as you need it to.

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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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.