I Don’t Understand the Safe Withdrawal Rate Discussion

It isn’t hard to find an article that discusses Safe Withdrawal rates, but I am not exactly sure why it is such a hot topic in retirement planning.  Investopedia provides a pretty succinct definition of the Safe Withdrawal Rate (which they refer to as the 4% rule),

What Does Four Percent Rule Mean?

A rule of thumb used to determine the amount of funds to withdraw from a retirement account each year. The four percent rule seeks to provide a steady stream of funds to the retiree, while also keeping an account balance that will allow funds to be withdrawn for a number of years. The 4% rate is considered to be a “safe” rate, with the withdrawals consisting primarily of interest and dividends. The withdraw rate is kept constant, though it can be increased to keep pace with inflation.

Investopedia explains Four Percent Rule

The four percent rule helps financial planners and retirees set a portfolio’s withdrawal rate. Life expectancy plays and important role in determining if this rate is going to be sustainable, as retirees who live longer will need their portfolios to last a longer period of time and medical costs and other expenses can increase as the retiree ages.

I believe that for the most part safe withdrawal rates are simply academic at best and misleading at worst.

The “rule” comes from a set of studies that were performed in the late 90’s commonly referred to as the Trinity Study.  It was hypothesized that with a proper allocation of bonds and stocks that a portfolio can withstand a 4% withdrawal rate (with increasing withdrawals for inflation) without crashing the portfolio.

Since that time additional back tests have provided different but similar results…so why do I think they are all worthless? Because it isn’t real life!

Retirement Income is What You Need

Lets says we have the normal American “dream” of retiring at 65 and saving up so your investable assets are $1,000,000.  You spend a normal $50,000 or $60,000 a year are you all of sudden only going to spend $40,000 because that is what some paper said is possible? Retirement is not a switch on your living expenses.

Granted this example is purposefully simplistic; maybe there will be be Social Security or a pension to cover the short fall.  But it is more likely than not you won’t have that $1,000,000 in investable assets, because comparatively speaking a $1,000,000 is still a lot of money.  My back of the napkin math in the linked article says about 92% of people do not have that kind of net worth…so that 4% withdrawal rate becomes much more “real” when we are talking about investable assets of $500,000 or $250,000 which only allows for a yearly withdrawal of $20,000 and $10,000, respectively.

If I had $500,000 in investable assets and I am retiring it is likely that I will do a mix of drawing down principal and cutting living expenses which is why I believe safe withdrawal rates are nothing but academic.  They allow near retirees, not actual retirees, and financial planners sleep better at night.

Am I all gloom and doom? No Way! There are millions of Americans who are retired who figure it all out.  Humans in general usually figure out a way how to survive.  In fact this type of discussion actually provides me hope that not everyone has to attain such a huge goal to be able to live.

25 Responses to I Don’t Understand the Safe Withdrawal Rate Discussion

  1. Andy Hough says:

    It is a useful rule of thumb for some people. As a rule of thumb people shouldn’t worry about getting too exact with the number.

    I agree that it won’t even apply to most people. My parents will be relying on pension and Social Security for practically all their income. Their savings will just be used for occasional large purchases.

    • Andy,
      Thus, even your parents still need SOME guidance about what safe cash flow can be drawn from the savings that they do have, if they wish to use it that way.

      The safe withdrawal rates research is about sustainable cash flows from a portfolio asset base. How you integrate THOSE cash flows with the rest of an individual’s available income sources (e.g., pensions or Social Security) is a completely separate question, and depends on the retiree’s goals.

      Respectfully,
      - Michael

      The 4% withdrawal rate is, by the research itself, designed for a 30-year time horizon. The research shows an array of safe withdrawal rates for varying time horizons. The 4% number is simply the most common cited because 30 years is the “default” time horizon used in most retirement examples.

      In other words, the safe withdrawal rate research itself already says you should pick the withdrawal rate associated with the appropriate time horizon for your situation.

      In regards to Krant’s comment, the safe withdrawal rate research is already assumed to blend a combination of interest, dividends, capital gains, and principal liquidations over time.

      Respectfully,
      - Michael

  2. The 4% rule is just a guideline… but it’s a useful one. It’s useful to talk about the safe withdrawal rates because people have trouble deciding how much they can take out of their retirement accounts. On the one hand, you don’t want to jeopardize your future, on the other hand, you don’t want to keep scrimping and then be too sick to enjoy what you’ve accumulated.

  3. krantcents says:

    Four percent (to me) means you want you savings to last roughly 25 years. Since it is generally a mix of dividends and capital gains it may last longer. Most of us willnot spend 25 years in retirement, but everything depends on how long you will live.

    • I agree. Well said Krant. I think it all depends on when you retire too. If you retire sooner rather than later than you will need more money to support yourself for a longer period of time.

      • The 4% withdrawal rate is, by the research itself, designed for a 30-year time horizon. The research shows an array of safe withdrawal rates for varying time horizons. The 4% number is simply the most common cited because 30 years is the “default” time horizon used in most retirement examples.

        In other words, the safe withdrawal rate research itself already says you should pick the withdrawal rate associated with the appropriate time horizon for your situation.

        In regards to Krant’s comment, the safe withdrawal rate research is already assumed to blend a combination of interest, dividends, capital gains, and principal liquidations over time.

        Respectfully,
        - Michael

  4. With all due respect, I think you’re utterly and completely missing the point of the entire body of research.

    Let’s start with your example: “If I had $500,000 in investable assets and I am retiring it is likely that I will do a mix of drawing down principal and cutting living expenses …”

    First of all, the safe withdrawal rate research ALREADY assumes your goal is to spend down your principal over your time horizon, so that’s actually redundant.

    Second, yes if the individual doesn’t have $1,000,000 but only $500,000, of course they’ll have to cut expenses. THAT’S THE POINT. What the research tells you is that if you want to do spending of $40,000+ on $500,000 of assets, it’s not going to be sustainable. The research says: Find a new spending goal (or retire later, or save more before retirement, or make some other adjustment), because your current goal is not economically viable.

    Your suggestion is to reduce spending. That would be the financial planner’s recommendation. The question then becomes “ok, well, by HOW MUCH should you reduce your withdrawals, so that it will be safe and sustainable when added to Social Security and any other income sources?” To answer that question… you end out right back at the safe withdrawal rate research!

    Granted, there are some issues and flaws with the safe withdrawal rate body of research, but your discussion here is in some ways a mischaracterization of how it is applied, and in other ways leads you right back to looking for SOME research to still tell you what IS sustainable given a certain portfolio (or what someone should be trying to save towards to have a sustainable retirement at the specified spending goal).

    Respectfully,
    - Michael

    • Evan says:

      Michael,

      I understand the topic and what it is based on, and I think I agree we probably agree that more people should work with financial advisors to figure it out.

      That being said I think most financial advisors or investment advisors put way too much faith it.

      Why not use either a monte carlo analysis or a more comprehensive budget review?

      I think there is a huge gap in income planning for the upcoming retirees and blind faith in a 4% withdrawal is not the answer in it of itself.

      • Evan,
        But if you run a Monte Carlo on a client with a spending pattern that matches a 4% withdrawal rate, it will be successful. If you run a Monte Carlo with spending higher than the equivalent of a 4% withdrawal rate, it will show a weak percentage. If you run a Monte Carlo with spending lower than a 4% withdrawal rate equivalent, it will be not only be successful but show a large terminal sum. That’s the point – the safe withdrawal rate research gives you a shortcut to know where the breakeven is.

        That being said, virtually no clients actually have a real world spending goal that happens to perfectly align with the research assumptions in the 4% withdrawal rate. I’ve literally never met a bona fide financial planner that doesn’t ultimately do a more client-specific analysis of the situation, for the simple reason that most people have more uneven goals.

        Nonetheless, the safe withdrawal rate research still provides a descriptive framework for understanding what is sustainable spending. A client who has an uneven spending pattern of specific goals that turns out badly on Monte Carlo has a spending pattern that exceeds the 4% withdrawal rate equivalent. In practice, such comparisons prove incredibly helpful to ground people in what are and are not realistic spending expectations, as most of us otherwise have no natural tools to understand what is and is not a safe sustainable spending pattern – or worse, use poor mental shortcut frameworks like “just” trying to spend dividends, or capital gains, or interest, despite the incredibly painful spending volatility that entails.

        Respectfully,
        - Michael

  5. I think the numbers are driven by CFPs who need to qualify their “advice”.

    • Actually, CFPs use the number because that’s what the research says IS the appropriate advice (at least when applied properly, although it seems widely misunderstood in this blog post and the associated comments).

      Are you suggesting that financial planners would better serve their clients by deliberately ignore research and just “winging it” instead?

      There are flaws with the research that deserve to be addressed in further research or competing theories, but in point of fact the original research was highly controversial because it devastated the typical financial planner (and consumer press’) spending recommendations for retirement. Bengen’s original 4% withdrawal research (which actually preceded the “Trinity study” cited by this blog by many years) was published at a time when most magazines regularly recommended 7%-8%+ withdrawal rates, in light of the higher bond and stock returns available in the 1980s and 1990s. The safe withdrawal rate research at the time was highly criticized for being so LOW compared to the “standard” advice!

      Respectfully,
      - Michael

      • Evan says:

        Considering I was born in ’81 I don’t have much experience but I have heard stories that in the early 80′s you could get a CD for 13 or 15%! If that was the case then 7 to 9% even after tax seems very reasonable lol

        • Evan,
          Except rates fell like a rock and it wasn’t nearly as sustainable as believed at the time… which was part of the point of the research, to show that the key is what’s sustainable in a broad range of environments, not just what was a then-currently-bullish one. :)

          Respectfully,
          - Michael

  6. Monevator says:

    Hi Evan,

    Quick heads up that your first link (the CBS link under ‘safe’) is broken.

    Keep up the good work! :)

  7. 101 Centavos says:

    I suspect that drawing down on principal could get a little scary in retirement. The retired folks that I know keep buys and try to live on interest, SS, pension, dividends, part-time work and other sources of income, and not touch the principal nest egg.

    • Evan says:

      A fantastic goal that I don’t think is very realistic for most people out there!

      • Indeed, it works for a while, until inflation slowly makes it impossible to maintain a standard of living on coupon clipping alone.

        In point of fact, what we see from the safe withdrawal rate research is that you should actually be withdrawing LESS than your income/growth for the first half of retirement, or the compounded inflation (even at modest rates) will be destructive in the second half of retirement.

        Even in the classic retirement projection (8% compounding portfolio on 3% inflation-adjusting withdrawals) you don’t even spend all your growth/return/income until your mid-to-late 70s, allowing your principal to grow up until that point so it can handle inflation-adjusted spending in your 80s.

        Respectfully,
        - Michael

  8. Good discussion. It all comes down to the rate of inflation, rate of return on retirement assets, and your balance as to what withdrawal rate will be possible. If you have only saved 50K by the time you retire the withdrawal rate has no meaning.

    • The withdrawal rate is a rate; a percentage of assets. It has just as much meaning with a $50k balance as a $500k or $5M balance.

      The caveat, of course, is that presumably the sustainable distributions a retiree will take from $50k of savings will probably only constitute a small portion of his/her overall retirement income, which will presumably be supported predominantly by other sources.

      Respectfully,
      - Michael

      • Steve says:

        With assets that low, you’d have to keep them all just for unexpected expenses. Probably even add to them out of your social security income.

  9. Evan,

    I spent two weeks researching and writing an extensive post on Safe Withdrawal Rates shortly before you published this one.

    It was favorably reviewed by many of the experts and researchers in the field.

    I normally wouldn’t link in a comment (self-promotion) but it is highly relevant to this discussion…

    http://financialmentor.com/free-articles/retirement-planning/how-much-to-retire/are-safe-withdrawal-rates-really-safe

    Hope you find it useful…

    • Evan says:

      Fantastic Article – Allow me to be so crude to sum it up in a sentence or two and tell me if I am right:

      Retirement Income Planning is Complicated, as such, it is recommended to meeting with a professional to discuss your asset allocation and budget.

      • First off, I’m glad you liked the article. Thanks.

        However, I’m surprised by your one line summary. Either you’re intentionally “rebel rousing” for fun or you missed the conclusion of the article.

        My belief is just the opposite. This topic is widely misunderstood. I was attempting to right that wrong through education and give people the tools they needed to work through the issues.

        Telling people to hand it over to an adviser is DEFINITELY NOT my message…

        • Evan says:

          I didn’t mean turn the other way…I mean closely work with a professional that understands your budget, and asset allocation (and of course subscribes that a blind 4% is just a terrible idea)

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