Determining a Safe Withdrawal Rate in Retirement

At one time, Canadian retirees used their savings to fund particular expenses such as a new car, home renovations or a special trip.  Regular monthly expenses were paid from government and private pensions.  Some people will still be able to fund their lifestyle this way, but it’s more likely that today’s retirees will be relying on their own investments for a good part of their retirement cash flow needs.

The challenge is figuring out a safe withdrawal rate that will last you for life without having to spend too cautiously. 

Related:  Assessing your retirement cash flow

Do you know how much you can withdraw from your retirement savings each year, and be sure that you’ll never run out of money?

What is a safe withdrawal rate?

What do retirees in 1921, 1966, and 2010 have in common?

Each faced a different life expectancy and invested in dramatically different economic conditions with varying inflation, interest rates, and market valuations.  Yet they all may well have shared the same withdrawal rate in retirement – roughly 4%.

How could that be?

A commonly accepted rule of thumb – the “4% withdrawal rule” – has been used for a while as a convenient way to draw down assets. It was developed in the 1994 by William Bengen and based on long-term capital market assumptions for a model portfolio of 60% stocks and 40% bonds. The reasoning is that if you retire at 65, the 4% rule should provide 30 – 35 years of income.

Financial planner Michael Kitces has analyzed data going back to the 1870s and found that Bengen’s portfolio allocation would never have run out of money in less than 30 years – not even in the worst 30-year periods.

In fact, in more than 90% of the time, investors would have ended up with more than the amount they started with.

Wade Pfau, a professor of retirement planning at The American College of Financial Services found that a portfolio of 75% stocks and 25% bonds had a 92% chance of surviving for 40 years!

It turns out that if a portfolio can survive the first 10 to 15 years with minimal losses, it’s likely to continue growing forever.

Spending in retirement

Statistics Canada studies have shown that the average 65-year-old spends about 25% more than the average 80-year-old. In fact, the average retiree can expect three phases of retirement and it’s logical to assume that spending patterns will also change:

  • Early years – a period of travel, hobbies and adventure and spending more freely
  • Middle years – some activities, more socializing and relaxation
  • Later years – a time of winding down, discretionary expenses fall significantly if restricted to spending most days at home.

In that case, it’s not reasonable to expect to withdraw a static percentage amount throughout your retirement years.

Another problem with planning for retirement income is the big unknown – how long will you live?  Not everyone will still be around for 30 to 40 years after retiring.

But, according to Pfau, even a 6% withdrawal rate has a 97% chance of lasting at least 15 years.

The bottom line

Selecting a long-term strategy for withdrawing your retirement assets can be a daunting task.

While the 4% safe withdrawal rate can be a good starting point, no simple financial rule can take into account all the variance and complexities of real life.

Because the future is based on assumptions (and your life may not turn out to be “average”) start with a withdrawal rate that’s sensible and monitor the performance of your portfolio closely.  Think about what you will have to do if your investments lag behind your expectations.

Make adjustments along the way and you’ll increase your chances of getting the most out of the retirement savings you have, yet still allow you to spend freely enough so you can enjoy the retirement you’ve worked and saved for.

Related:  Generating Cash Flow in Retirement

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