Determining Rate of Withdrawal

One of the most important decisions new retires make is how much to withdraw from their retirement assets on an annual basis for retirement income.  Though there are number of options for withdrawing income from retirement assets which are discussed in a separate article, a common option is simply to withdraw a percentage annually for income which is often called Rate of Withdrawal [ROW].  For example, if the annual withdrawal is $5,000 and the retirement portfolio is $100,000, the ROW is 5%.  Even for retirees who plan to withdraw a specific dollar amount on an annual basis, for planning purposes, the dollar amount is often converted to a ROW to determine its long-term feasibility. 

With ROW, the long-term objective is for income and retirement assets to maintain and hopefully grow throughout retirement.  Using the above example, if the ROW is 5% and the average annual return is 7%, principal and income will grow throughout retirement.  Conversely, if the ROW is 5% and the average annualized return is 2%, eventually, unless changes are made, assets will deplete.     

This leads to the question, what is a reasonable long-term Rate of Withdrawal for retirees?  There are no guarantees with any ROW that is based on a percentage of the assets, however, as one would expect lower is better.  But many retirees, maybe the majority, in order to maintain a comfortable lifestyle, need to withdraw the largest amount as possible without affecting their long term financial security. 

There have been many articles written recently that 4% ROW is no longer safe.  However, in the articles I have reviewed, these articles are using an inflation adjusted 4% ROW.  Inflation adjusted means that each year the annual withdrawal is increased by the assumed annual inflation rate.  For example, if the first year’s withdrawal was $5,000 and the assumed inflation rate is 3%, then the next year’s withdrawal would be $5,150.  Each subsequent year, the annual withdrawal increases.  I never suggested this as strategy for a couple of reasons.  One reason is never in all the years I worked with clients did I receive a phone call or email in January from a client requesting an increase in monthly income to offset inflation.  If clients did increase the annual withdrawal, it was more likely to happen during a meeting while discussing cash flow and only happened once in a great while.  The other reason is I always felt there was a better option for adjusting for inflation. 

The strategy I often suggested and use personally use is a 5% ROW with no adjustment for inflation.  The assumption is if the Portfolio can increase at a rate in excess of 5%, then the principal and ultimately income will also increase throughout retirement.  

However, theory and reality are often different. 

  • For example, beginning in 1991, having a 5% return through 1999 would have been very attainable.   Interest rates were higher and generally declining which benefited the bond market and the equity markets generally did very well. 
  • By comparison, the next decade, 2000-2009, money market and short-term CD’s were virtually zero for several years, bond returns were generally lower and the stock market as measured by the S&P Index had two major declines and actually had a negative return for the entire decade.  For many if not most retirees, averaging 5% for the decade would have been very difficult.    

Though never guarantees for the future, however, in today’s low interest environment, and at least in my estimation, below average long term returns for parts of the equity markets, I suspect obtaining a return of 5% or greater over an extended period of time, though possible, will continue to be difficult.  I would suggest this will be especially difficult for retirees with a low risk tolerance or low acceptance of volatility, 

To have the opportunity to average 5% or greater over a long period of time, I would suggest the following.

  • Develop and maintain a moderate to moderate growth allocation with 40-60% allocated to equities and alternative strategies.  Monitor with regular reviews of asset allocation and actual holdings. 
  • Maintain a minimum of 3-5 years of income in minimal to low risk holdings.  The reason is during a decline, retirees will be able to withdraw income from minimal and low risk holdings which have not been affected by the decline.  This means they do not have to sell holdings which have declined in market value with the hope of the holdings recovering to previous highs.
  • During up cycles, review equity holdings which have performed as expected and when appropriate, implement transfers into minimal or low risk holdings
  • Focus on long term trends for asset classes and not short-term volatility. 
  • Do not liquidate during a decline turning a paper loss into a real loss.  See articles, “Are you and average investor?’ and “Average annualized return”.    
  • Keep the withdrawal a percentage of the previous year end market value rather than fixed dollar amount.  This will reduce risk during a declining time period.  This could also be done on a quarterly basis or even monthly.   

Is a long-term average 5% ROW realistic going forward?  Again, no guarantees, every time period is different, and history does not predict the future.  At the same time, history can reflect the results in two separate but mostly overlapping time periods.   For example, assume the same initial allocation using a mix of Lipper Indexes representing 11 different asset classes and an initial overall allocation of 55% equities and 45% fixed income. Also, assume an initial investment of $100,000 and a ROW of 5% on a pro-rata basis from each holding.   

  • The first-time period is from 1994 ending 2017 and the retiree’s annual income would have been $5,000 or greater every year and the principal would have been higher at the end of 2017 than the beginning of 1994.  Though 1994 was a negative year for some equity asset classes, the 1990’s was generally very good for equity markets.
  • The second-time period starts in 2000 and also ends in 2017.  Of the 18 total years, in 12 the annual withdrawal would have been less than $5,000 with lows of almost $4,000 in 2003 after 2002 and 2009 after 2008.  At the same time, at the end of 2017 the theoretical retiree would have received over $87,000 in total annual distributions and the ending market value would have been about $94,000. Given the initial objective, the returns would have been less than hoped for.  But given the time period, in my estimation, the returns would have been very attractive.

During both time periods, but especially the second, quality on-going management and decision making could have enhanced returns and income.  Conversely, poor decisions could have made the returns and annual income worse.  For example, taking withdrawals from minimal or low risk asset classes, especially during stock market declines would have enhanced returns as would have shifting gains from equity holdings during up cycles to minimal or low risk asset classes.  By comparison, converting a paper decline into a real one by panicking and selling during a low point would have increased the overall decline. 

In summary, I believe a long-term return of 5% or higher is possible, but will require using ongoing money management strategies and avoid making emotional decisions based on past performance of various asset classes. 

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets.