Why the 4% withdrawal rate may not apply to you

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Like many retirees, you may be concerned about your retirement savings lasting for your entire retirement. You want to create an income stream to meet your retirement expenses, but how much can you safely withdraw each year without danger of outliving your savings? What’s a safe withdrawal rate?

The common answer is that you can withdraw 4% of your savings annually, inflation-adjusted. This figure is based on analysis of historical stock market returns by various financial researchers.

But it turns out that your asset allocation, i.e. which types of stocks you invest in, and what percentage are in other investments such as bonds, can make a significant difference in how much you can safely withdraw.

The 4% figure is based on stock research published in a 1994 article by financial advisor William Bengen and is sometimes called the “Bengen rule”. Examining market returns over 75 years, Bengen found that retirees who took out no more than 4.2 percent of their portfolio in the first year, and adjusted that amount for inflation each following year, had a great chance of having their money last throughout their lives. Bengen also found the optimal initial asset allocation was between 50% and 75% in stocks.

Later, the influential 1998 Trinity study, so called because its authors were professors at Trinity University in San Antonio, Texas, looked at various mixtures of stocks and bonds and found that a 4% withdrawal rate allowed a retiree to have a 95% chance of their savings last for at least 30 years. This 4% became known as a safe withdrawal rate (SWR).

However, subsequent studies found that the type of stock allocation made a big difference in safe withdrawal rate. Investing in large company stocks, small company stocks, and various types of international stocks greatly affects your personal SWR. A diversified portfolio that includes various types of investments may allow a retiree to have a SWR of 4.5% or even 5%. With a savings balance of $1 million or more this can be a significant difference – over 30 years, a difference of $300,000.

This is because the different stock markets are not highly correlated. A drop in the U.S. market doesn’t always coincide with a similar fall in overseas markets, especially over holding periods of more than one year. This is why many financial advisors recommend a diversified portfolio. James Tobin, who received the 1981 Nobel Prize in part for his work on the subject, summarized portfolio selection theory very simply: “don’t put all your eggs in one basket.”

If you want to see for yourself the effects of different asset allocations on SWR, portfoliocharts.com has an interactive calculator which includes a range of different asset classes and gives the corresponding SWR for 10 to 40 years out. Besides the safe withdrawal rate, which allows a retiree not to outlive their money, the calculator also gives the sustainable withdrawal rate, which guarantees that the original principal will be preserved, for those who wish to pass assets on to heirs.

The calculator uses the same methodology as Bergen’s original article but the data starts in 1972 instead of 1926, and includes more asset classes. The SWR that the calculator gives is the withdrawal rate that would have left the savings balance with exactly zero dollars at the end of the worst retirement period consisting of that number of years since 1972. You can see more details about the methodology here.

The default asset allocation is 60% in the total U.S. stock market, as recommended in Bergen’s paper, and 40% in the total U.S. bond market. As you can see, the SWR is somewhat less than 4%. Again, the calculator assumes the unlucky retiree is investing during the worst period of that number of years. A withdrawal rate of just under 3.5% would have sustained this unfortunate person during the worst 40 year period since 1972.

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Here are the results using a different allocation. The Swensen portfolio is recommended for individual investors by David Swensen, who manages the Yale University endowment fund. It consists of 30% Total US Stock Market, 15% International Developed, 5% Emerging Markets, 15% 5 Year US Treasuries, 15% US TIPS, and 20% US REIT.

As you can see, the SWR is at least 4% for time horizons of 25 years or longer.

 

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Here is yet another asset allocation. It is an approximation of The Oxford Club’s “Gone Fishin’” portfolio,  suggested for individual investors, that tries to maximize diversification. This one consists of 15% Total US Stock Market, 15% Small Cap Blend, 10% Europe, 10% Pacific, 10% Emerging Market, 10% Short-Term Treasury, 10% Total Bond Market, 10% Synthetic TIPS, 5% US REIT, and 5% Gold. Here the SWR is at or close to 5% for time horizons of 25 years or longer.

portfolio3

 

The point is that the asset allocation you choose has a significant effect on your safe withdrawal rate. Rules of thumb are useful but may not apply to every individual case. You will want to decide what asset allocation you are personally comfortable with.

 

 

 

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