We all look forward to and approach retirement in different ways. In order to retire comfortably, individuals must accumulate adequate savings over time. If you withdraw too much from your portfolio too early, you may run the risk of depleting your savings prematurely. Conversely, if you withdraw too little, you may lower your standard of living needlessly. How much can you withdraw annually from your retirement account while still making sure you have enough money to fund your remaining years of retirement? This is a question often asked by retirees and those approaching retirement. The issue then becomes finding the right balance of withdrawals to fund your years of retirement, i.e. determining a sustainable withdrawal rate.
A withdrawal rate is the percentage that is withdrawn each year from an investment portfolio for living expenses. If you take $30,000 from a $1 million portfolio, your withdrawal rate is 3%. However, in retirement income planning, what’s important is not just your withdrawal rate, but your sustainable withdrawal rate. Sustainable withdrawal rate can be defined as “the rate that represents the maximum percentage that can be withdrawn from an investment portfolio each year to provide income, with reasonable certainty, that the income provided can be sustained for your lifetime”. In order to be sustainable, the percentage must be based on assumptions about the future, such as life expectancy, inflation, taxes, as well as rate of return and market volatility.
When determining a withdrawal rate, not every investor is going to be able to retire with a portfolio that can provide sufficient income to meet their current and future needs. When this happens, they will likely need to draw upon principal from their investment portfolio in addition to using the income it generates to meet their expenses. A common misconception in the past among investors was that an annual withdrawal could be made from a retirement portfolio that was equal to the compound annual net rate of return that the portfolio was expected to generate. In this regard, a portfolio that is expected to generate an annual compound net return of 7% over the long term should be able to withstand an annual withdrawal of 7% without any capital erosion. If the portfolio had no volatility and produced that 7% each and every year, this reasoning would hold true. But, we know this is not the case with average annual market returns of near 0% for the past 5 years. The fatal problem with the traditional assumption is that it does not account for the variability of returns each year. The more dramatic a portfolio’s fluctuations, the greater the odds that the portfolio will last as long as needed. If it becomes necessary during market downturns to sell some assets in order to continue to meet a fixed withdrawal rate, selling at an inopportune time could affect the portfolio’s ability to generate future income.
Three business professors from Trinity University in Texas broke new ground several years ago with their paper, “Retirement Savings: Choosing a Withdrawal Rate That is Sustainable”. They employed historical back testing to demonstrate the relationship between withdrawal rates, time horizon, and asset allocation. The Trinity Study results revealed that portfolio failure rates are directly related to time horizon, and withdrawal rates, and influenced by asset allocation. Using the S&P 500 and bonds in various combinations over varying time periods all the way back to 1926, the study tracked failure rates against withdrawal amounts. The study highlights the need for conservative withdrawal rates, and the need to accumulate a significant amount of capital to fund a comfortable retirement. Although historical back testing can be helpful, it does come with limitations as we are provided with one series of data, and that the past results will re-occur in exactly the same sequence, the findings will not be as accurate as anticipated. New and more powerful modeling tools add confirmation to these principles and add additional insight, but do not replace the need for very conservative assumptions to have a sustainable withdrawal rate.
At Smith Anglin, as a part of our financial planning program, we incorporate Monte Carlo simulations. A Monte Carlo simulation is a computerized mathematical technique that utilizes random draws of numbers from pools constructed with specified rates of return and volatility. We build a pool of numbers and pull them out at random to construct a single test, and then calculate and repeat the results 10,000 times, each time using a different set of random values from the probability functions, and then summarize the results. By varying the construction of the pools of numbers (varying rates of return, risk, time horizon and distribution rate), we can examine different strategies to see which ones provide a higher probability of success. The simulation reveals a clear link between volatility and survival of the portfolio at any given time horizon.
Distribution planning is not a one size fits all exercise. Each client and retiree will have different needs that are going to influence the sustainable withdrawal rate decision. There is no magic rate to ensure that a retiree doesn’t outlive their assets. The most commonly cited study of this topic (The Trinity Study) has led many retirement planners to say, with confidence, that a withdrawal rate of 4% or less is likely to withstand any 30 year payout period, with an asset mix that at least has some moderate stock exposure. That rate can go as high as 6% for those taking on a more aggressive withdrawal approach. Always remember to be flexible with your plan. Depending on current economic conditions, you may want to start your initial withdrawal rate at a conservative percentage, such as 3% when times are tough. When investments perform well again, you may be able to increase your rate slightly to a more normal level. If you are already in distribution mode, calculate your rate, and determine that it is suitable. You may need to examine your budget and look for items to eliminate or reduce. This is a good exercise to do periodically anyway; you might be surprised where your money is going every month.
It is a good idea to conduct a “check up” of your portfolio and review your plans and goals, your withdrawal rates, and certainly any lifestyle change, i.e. retirement or inheritance, etc. If you would like to take advantage of this opportunity contact your advisor.
