In order to provide the best possible advice to clients, a financial planner needs to determine the following:
- What is the correct asset allocation for each client?
- How much income can a client safely withdraw to ensure investments do not run out during his or her lifetime?
In 1994, U.S financial planner William Bengen published an article which analyzed investment data back to 1929 to determine a maximum safe withdrawal rate, based on the percentage of a person’s initial investment portfolio. Assuming a minimum requirement of 30 years of portfolio longevity, Mr. Bengen concluded that a first-year withdrawal rate of 4% followed by inflation-adjusted withdrawals in subsequent years would be safe.
The 4% rule has been taken as gospel ever since, but the question remains: Does it still hold true today? According to T. Rowe Price Group, had you retired in 2000 and withdrawn 4% from your 55% stock/45% bond portfolio, you would likely have spent one-third of your investment by 2010, giving you only a 30% chance of outliving your investments.
If you have a $2 million retirement nest egg and would like to draw $80,000 of annual inflation-adjusted income from your investments, can you rely on the 4% golden rule? It depends on the modelling tool used by your financial planner. While there are many sophisticated tools available, one simple method is to use life expectancy. Choosing this method, let’s assume you are a 62-year old male dentist with a portfolio of $2 million.
Life expectancy tables predict you will live for another 18 years. To calculate the first-year withdrawal, divide $2 million by 18, which is $111,000. Next year, your portfolio value will be $1,946,000 assuming a 3% after tax return. The life expectancy remains at 18 years, which means that you can safely withdraw $108,000. Fast forward our illustration to age 70, with an assumed $1.4 million remaining in your portfolio and a life expectancy of 13 years, you can withdraw $108,000. Under the life expectancy method, your withdrawal will fluctuate each year.
The bottom line
Many financial planners counsel clients to consider a safe withdrawal rate of 3% rather than 4% if you expect the following:
- You anticipate your retirement will exceed 30 years;
- The majority of your portfolio is in fixed income investments, including term deposits and bonds.
You might consider an initial withdrawal rate of 5% if you believe the following:
- Your expected retirement will be less than 30 years
- You have a portfolio consisting of more than 75% equities
- You are willing to tighten your belt and spend less if market conditions dictate.
