The right way to draw down on retirement savings

Stave off retirement ruin with some quick math

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by

From the January 2017 issue of the magazine.

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The problem with rules of thumb is that time and circumstances can make them out of date. Such may be the case with the time-honoured safe withdrawal rate of 4%—a rule of thumb attributed to William Bengen, an American financial planner and author. Bengen coined the term “SAFEMAX” to describe a realistic maximum annual withdrawal percentage from retirement nest eggs that would not result in “retirement ruin.”

Bengen published his findings in the October 1994 issue of the Journal of Financial Planning, later popularizing them in the book Conserving Client Portfolios During Retirement. His safe 4% annual withdrawal rate was dubbed “The 4% Rule” or “The Bengen Rule.” It described the maximum annual withdrawal rates (adjusted for inflation) that ensure investors won’t outlive their money over a 30-year retirement. Over a decade later, in 2006, Bengen loosened the rule a bit for U.S. investors, for withdrawal up to 4.5% for tax-sheltered investment accounts and 4.1% for taxable ones.

However, in these days of minuscule and sometimes negative interest rates, financial planners are more cautious about 4%, some preferring to pencil in 3%. (In the last issue of MoneySense, it was noted that the rule may be too high a percentage for those aged 65 but too low for those 75 or older.) Even the same journal that Bengen was in later published The 4% Rule is not Safe in a Low-Yield World, by Wade Pfau. It argued that unless bond returns revert to their historical levels within 10 years, 32% of nest eggs would “evaporate early.” In a Morningstar article, Pfau added that a nest egg with 40% in equities could withdraw only 2.8% a year initially to have a 90% chance of lasting 30 years. Yet, in 2013 T. Rowe Price found a portfolio with 60% stocks could use an initial withdrawal rate of 4.3%.

Clearly, retirees living on capital must pay close attention to asset allocation, tax efficiency and actual spending levels. Markets have a lot to do with it, unpredictable though they may be. In the original 4% formulation, Bengen used the worst 30-year retirement period in the last 90 years: the 1973-1974 recession had both high inflation and deep market declines. The Vanguard Group suggested “a more dynamic approach” that varies withdrawal rates with market performance. It found a 50/50 asset mix and a 3.8% withdrawal rate adjusted to inflation would have an 85% chance of lasting over 30 years.

Whether you go with a cautious 3% or a more aggressive 4% or 5% rate with expectations of slowly digging into capital over time, retirees should keep in mind that linear projections cannot indefinitely be projected into the future. Doug Dahmer, president of Burlington-based Emeritus Retirement Solutions, says retirees must factor in years when spending will jump well beyond normal withdrawal levels. Typical expenditures will be house-related maintenance like replacing a roof or furnace, buying a new car, or costly “once in a lifetime” world tours.

Then there’s inflation. The calculation is relatively simple. Note Bengen’s 4% is used when opening the portfolio at retirement. That fixed dollar amount is adjusted for inflation each subsequent year. For example, with an opening balance of $500,000, 4% is $20,000 in the first year. With a 2% inflation the withdrawal amount will be $20,400 the following year. If inflation were 3% the year after that, then you’d multiply $20,400 by 1.03 to get $21,012.

Despite all the variations, one advisor still likes and uses the 4% rule. John DeGoey, portfolio manager with Toronto-based Industrial Alliance Securities Inc. and author of The Professional Financial Advisor, uses a tweak he calls the “Rule of 16.” He says sustainable depletion rates depend partly on the age you start to draw down a portfolio. “The earlier you start, the lower the necessary depletion rate.” DeGoey divides the number 16 into the client’s age for a target “safe depletion rate number” indexed to inflation. So if you retire and start to draw down your portfolio at 64, dividing by 16 gives you exactly the 4% annual withdrawal rate. Retire earlier and the rate drops; retire later and the rate rises, which is what you’d expect. Someone who retires at 72 can take out more than 4% and feel safe, DeGoey says: “Unless we have another 1930s cycle, or that person lives to 103!”

Planning horizon (30 years)

Hypothetical portfolio withdrawal rates assuming 30-year planning horizon

Screen Shot 2017-01-11 at 4.46.28 PM

Notes: This figure models expense ratios of 0% (for 0-cost), and 0.25% (for low-cost), and 1.25% (for high-cost). This figure’s projections, generated by the Vanguard Capital Markets Model, are based in U.S. dollars as of December 31, 2011, and assume an 85% overall portfolio success rate.

Source: Vanguard

Jonathan Chevreau is Founder of the Financial Independence hub and co-author of Victory Lap Retirement. Read more of his Retired Money column here

 

7 comments on “The right way to draw down on retirement savings

  1. Isn’t a minimim we must withdraw once we reach age 71? it used to be 7.something and now I think it’s 5. something – then the 3,or 4% does not work

    Reply

  2. Isn’t a minimim we must withdraw once we reach age 71? it used to be 7.something and now I think it’s 5. something – then the 3,or 4% does not work

    Reply

  3. I guess the rates are based upon leaving a legacy? Im 58 retired and fully intend to withdraw 4% of capital every year. By the time i reach 75 i wont be spending much money and if living is painful, will be availing myself of assisted dying. Spend it while you can and enjoy your mobile years

    Reply

  4. It is also to be noted that if your lucky enough to get 5% your likely paying someone 1.5% to manage that for you,then take into consideration that an investment today that would pay 5% is likely open to downfall ,so if you make 5% one year and lose 10% the next year and pay someone 1.5 to manage that,you might be more satisfied to get a 2 %GIC and manage it yourself. This comment is based for those already in retirement.

    Reply

  5. does the 4% RULE INCLUDE DIVIDEND INCOME IN THE PORTFOLIO.
    MY PORTFOLIO GENERATES 3-4% DIVIDENDS, IF I WITHDRAW THESE DIVIDENDS MY PORTFOLIO WILL LAST ALMOST FOREVER

    Reply

  6. The government sets the rules 5. — 20 %

    Reply

  7. Instead of taking a chance withdrawing 4% from a traditional balanced portfolio of 60/40 or the new recommended 50/50, when retiring with an established nest egg I would think it better to transition it to a proper income portfolio of quality dividend stocks paying 4 to 6 per cent, or a low cost dividend fund or two (such as XDV or CDZ), plus a healthy dose of preferred shares or a good preferred fund paying 5%. That way, the retiree doesn’t really have to worry much about short-term market fluctuations and can live off the created 4 to 6 per cent income stream. Dividends can always be cut in a downturn, but quality companies usually don’t. Capital can be dipped into occasionally when necessary, for emergencies or for a large purchase, but essentially the majority of the assets are preserved and will still be there for the estate (family or charity).

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