Your Sustainable Withdrawal Rate

It's no secret that most American workers are not saving enough for retirement. But how much should you save by the time you retire? One way to answer this question is to estimate your "sustainable rate of withdrawal." This represents the percentage of retirement savings you can withdraw each year without running out of money before you die. Ideally, your sustainable withdrawal rate should provide for a comfortable lifestyle while mitigating the risk of exhausting your savings

An overly simplistic approach is to equate your annual withdrawal rate with your portfolio's expected rate of return. In other words, an assumed average annual return of 7% would lead to a 7% withdrawal rate during retirement. However, this ignores the variability of returns in the real world. Extensive testing of this approach using computer models and various return and volatility assumptions, reveals a poor rate of nest egg survival. For this reason, virtually all knowledgeable financial planners agree that your withdrawal rate should be lower than your expected rate of return.

The most commonly quoted study on this topic suggests a 4% annual withdrawal rate. However, there is no magic number that works for everyone. A 4% withdrawal rate is reasonable for most individuals who retire between the ages of 50 and 65. If you retire at a younger age, a more conservative withdrawal rate (3-4%) may be needed to ensure a reliable income stream throughout a lengthy retirement. If you retire later in life, a higher withdrawal rate (5-6%) may be appropriate. A 7-8% withdrawal rate may be fine for someone in his eighties who doesn't mind some invasion of principal. If you plan to bequeath a large estate to your heirs or favorite charity, a more conservative withdrawal rate should be considered.

Three variables can undermine the best laid retirement plans: volatility of returns, inflation and taxes. Higher volatility of returns increases the likelihood of account depletion. Your portfolio should therefore be well-balanced and globally diversified to reduce volatility. You can also lower volatility by increasing the fixed income portion of your portfolio. However, fixed income securities are unlikely to meet your long-term cash flow needs and therefore a combination of stocks and bonds is advisable.

Inflation has an insidious effect on your wealth. If you withdraw a constant dollar amount every year in retirement, your buying power will diminish at the rate of inflation. The old rule of thumb about living on 70% of your pre-retirement income is misleading. Many retirees today spend 100% or more of their pre-retirement income during the first few years of retirement. However, the appetite for travel and other costly pursuits tends to wane within a few years. The spending rate typically continues to decline until late in life at which time it may spike upwards due to healthcare and assisted living expenses. The declining spending rate that prevails throughout most of retirement can help offset the effects of mild to moderate inflation.

Your mix of taxable and tax-deferred assets is also important. Most assets in tax-deferred retirement plans will be taxed at your marginal income tax rate upon withdrawal. This can have a huge impact on the amount of money that actually reaches your hands, particularly if you are in one of the higher tax brackets. Furthermore, with rising US budget deficits, it is easy to imagine higher tax rates in the future.

To help illustrate the above concepts, please perform the following exercise:

1. Estimate your desired annual income during retirement.
2. Multiply that number times 25.

The result is the amount of money you should have saved by the time you retire to allow a 4% annual withdrawal rate that should be sustainable throughout the rest of your life.

Please do not hesitate to contact me if you have any questions or comments.

Jeffrey J. Brown, MD MBA CFA
Shearwater Capital

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