How Much Can You Sustainably Withdraw from Your Investment Portfolio?
How Much Can You Sustainably Withdraw from Your Investment Portfolio?
A question that is often asked soon to be retirees, or even a young professional wrapping their head around saving for retirement is: “How much income can I withdraw from my portfolio without running out of money?”
The 4% Rule
A common answer to this question is that you can sustainably withdraw 4% from an investment portfolio that is moderately allocated to equities. In the first year, you withdraw 4% and continue withdrawing that amount each year, adjusting for inflation. For example, if you have a $1M portfolio, you would withdraw $40k in the first year.
Theoretically, the market will deliver average returns that will offset your withdrawals, and you will not run out of money over a 30-year retirement period. You may even be left with a sizable nest egg to hand down to your heirs, depending on market performance.
Studies have shown a high degree of success when utilizing a 4% withdrawal rate in varying market environments. Financial planner William Bengen published in 1994 that a 4% withdrawal rate was the highest sustainable rate that avoided running out of money over a 30-year retirement. Later analysis, which included small-cap stocks and proper international diversification, increased the sustainable withdrawal rate to about 4.5%.
History has demonstrated that a 4% withdrawal rate is typically conservative enough that you aren’t as worried about sequence of returns risk. This is the risk that you will have to liquidate a portion of your portfolio to cover living expenses in a heavily down year and permanently realize that loss, rather than waiting for the market to recover. Sequence of returns is very important, yet completely out of our control. Studies have shown that, in certain favorable starting years, retirees could have withdrawn close to 10% annually and not run out of funds over 30 years.
It’s important to remember, the 4% rule is just a rule of thumb. A proper financial plan should take many factors into account.
How to Increase your Withdrawal Rate
- Maintain a high equity allocation.
If history is any indication, maintaining an increased percentage of equities in your portfolio, even through retirement, can deliver higher average returns. You will need to stomach bear markets, and possibly declines of 30–50%, but if you can ride out temporary downturns, you will likely see higher returns and, therefore, have more money to withdraw. With higher exposure to equities, you may be able to withdraw closer to 5 or 6% per year. However, there are important considerations to make with this strategy, such as keeping a cash buffer to draw on the event of a market crash. Having a buffer can help to mitigate the sequence of returns risk previously mentioned.
- The “Guardrails” Method
The “guard rails” method is a dynamic withdrawal strategy that allows spending to be adjusted depending on market performance. The principle is that you start with an initial withdrawal rate of, for example, 5%. For a 1-million-dollar portfolio, this would equate to withdrawing $50k.
If the markets do well, and your portfolio increases by 20% to $1.2M, you can increase your withdrawal rate by 10% to $55k. You now withdraw $55k annually. Conversely, in a weak market where your portfolio declines 20%, you would decrease your withdrawals by 10% to preserve the portfolio.
Using the guardrails method allows you to start with an initial withdrawal rate that is higher than would be possible with a static approach. There are many variations of this method, so it’s important to select a dynamic withdrawal strategy that fits your specific situation.
Monte Carlo Simulations
Modern, sophisticated financial planning software tools has enabled advisors to model for dynamic withdrawals using Monte Carlo simulations. Put simply, Monte Carlo simulations run 1,000 different random projections that account for varying market performance and other factors. The variations are based on actual client data. This is a data driven process that can give important insight into the future by considering bull markets, bear markets, and black swan events.
The advisor aims for a success rate (for example: 80% success rate) and together with the client, adjust the withdrawal rate based on actual portfolio performance and life circumstances change with age.
Conclusion
The 4% rule is a useful starting point, but the proper withdrawal rate ultimately depends on your unique financial plan. Many factors such as tax rates, asset allocation, longevity, and social security impact the sustainability of retirement withdrawals and the likelihood of financial success.
It is highly recommended to discuss retirement planning with a trusted financial planner.
- Bill Rautiola RICP ®, AIF ®, PPC ®
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
All investing involves risk including loss of principal. No strategy assures success or protects against loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
