As a rule of thumb, financial planners generally say that you can safely withdraw about 4% of the value of your nest egg as income in retirement and increase it by inflation each year. That number was based on the “Trinity study” that looked at the outcomes of various withdrawal rates from 1926-2009 as well as additional research by financial planner and author William Bengen. However, I recently came across this interesting blog post that points out a few shortcomings of the study:
1) It was based on indexes and thus does not account for the effect of mutual fund fees and trading costs, which can eat into your returns by as much as 3% a year. For example, 4% inflation-adjusted withdrawals from a portfolio divided equally between stocks and bonds had a 96% success rate without fees, an 84% rate with 1% in fees, and a 65% success rate with 2% in fees.
2) It was based on 30-yr periods. However, for a 65-yr old couple, there’s a 25% chance that either the husband or the wife will past the age of 97. The success rate of the above portfolio falls to 88% over 35 years and 82% over 40 years. Add a 1% fee and the 40-year success rate is only 60%.
3) It was based solely on the United States. Sustainable withdrawal rates have been much lower in other developed countries.
4) It was based on a time period that may not be representative of the future. Current high stock valuations and low interest rates have been associated with low success rates in the past. In addition, many experts are concerned that our growing national debt could lead to higher inflation rates in the future.
5) It assumes that retirees do not care about leaving an estate for their heirs.
However, the post also points out some good news:
1) Retirees can improve their chances of sustaining a 4% withdrawal rate by diversifying their portfolio with international assets and TIPS.
2) There’s also evidence that the average retiree spends less money in their later years since higher health care costs are outweighed by less money spent on travel and entertainment as they age.
So what does all this mean for us in retirement?
1) Diversify your portfolio internationally and with TIPS. Diversification is the closest thing in finance to a free lunch so take it.
2) If possible try to accumulate enough assets or reduce your spending to withdraw less than 4% of your retirement nest egg each year. You may even be able to live off interest and dividends and keep your principal intact for your heirs.
3) Otherwise, you may just want to make sure that you have enough in Social Security, inflation-adjusted annuities, and assets (at a 4% withdrawal rate) to cover basic living expenses like food and medical care that tend to increase with inflation. You can then use the rest of your portfolio to pay for travel and entertainment or leave a bequest, depending on how well the investments perform.
How much a retiree withdraws from their portfolio has a huge impact on their living standard and the likelihood they may have to eat cat food in their later years. Unfortunately, many people, including even financial advisors, are basing decisions on these studies without being aware of these issues. If you know anyone in or approaching retirement, do them a favor and share this post with them.