A sustainable withdrawal rate is a projection, based on historical data, of the maximum annual amount that may be withdrawn from your current portfolio. It is one of the common questions facing an individual upon withdrawing money from his or her portfolio is, "How much can I withdraw safely?" Conversely, the retiree wonders, "How long will my portfolio last?" Unfortunately, as will be shown, the answer to these questions depends not only withdrawal rate and the underlying rate of return of the portfolio, but also on the variability of returns and the sequence in which good or bad years occur.
The Trinity study
Much of the literature on withdrawal rates dates from an academic study of pension plans by three professors at Trinity University. This work is commonly called the Trinity Study, and is usually used as an initial basis for discussions. The conclusion of this work was that a withdrawal rate of 3-4%, adjusted for inflation, would not exhaust a portfolio of stocks and bonds. This is often called "the 4% safe withdrawal rule", and is often considered a "rule of thumb". However, because it is based on past returns, not future returns (which are unknown), there can be no guarantee that a retiree withdrawing a fixed inflation-adjusted 4% of his or her initial portfolio will not in fact run out of money. Thus, the "4% rule" should be considered no more than a starting point.
Finke et al. (2013) write that "the success of the 4% rule in the U.S. may be an historical anomaly" and that using it in a low interest rate environment may lead to high failure rates. Examination of safe withdrawal rates in countries other than the US, using 109 years of data for 17 developed market economies, shows that a 50% stocks, 50% bonds portfolio cannot typically sustain 4% withdrawal over 30 years.
Effect of market valuations
Pfau has suggested that market valuations can be used to estimate sustainable withdrawal rates. He says:
This study suggests that a 4 percent withdrawal rate cannot be considered as safe for U.S. retirees in recent years when the cyclically-adjusted price-earnings ratio has experienced historical highs and the dividend yield has experienced historical lows. What must be clear, as I explain at length in the article, is that the events that have taken place since about 1990 have very little impact on the results of the updated Trinity study, even though it uses data through 2009. What we have experienced in terms of record-high PE10 levels and record-low dividend yields during the past 15 years explain why the model predicts sustainable withdrawal rates falling below 3 percent since 1999, and even below two percent in the years since 2003.
A spreadsheet allowing estimation of withdrawal rates can be found here.
Sequence of returns risk
Should a retiree be unfortunate enough to run into a bear market - that is, a severe drop in stocks - during the first few years of retirement, the portfolio will be further depleted by withdrawals and may never recover. Conversely, if the retiree is fortunate enough to have good returns in the first few years, sufficient reserves may be built up that the portfolio is never depleted and a significant estate remains.
Consider the following graphs. The left-hand graph shows the actual S&P 500 return sequence from 1970 to 2000 (blue line) as well as the return sequence ordered from best to worst (green line) and worst to best (red line). The right-hand graph shows the effect of a constant withdrawal, unadjusted for inflation, of 6% of the initial amount. This gives a relatively constant residual portfolio based on the actual return sequence (see the blue line in the right-hand graph), and a larger estate if the returns are ordered from best to worst. However, if all the bad returns had been clustered at the beginning, the portfolio will be exhausted in 34 months. This effect is called sequence of returns risk.
According to Pfau (2014), solutions to reduce sequence of returns risk include varying spending in response to market performance and reducing portfolio volatility (downside risk).
Probability of ruin
The term "Probability of Ruin" has been used by Milevsky to cover the concept that a retiree may run out of money during retirement. The calculation can be performed on spreadsheets available from QWeMA, as well as additional calculations discussed in a recent book. Alternatively, a simple Excel spreadsheet that is based directly on the IFID paper is available here.
If there is a good chance that the retiree may run out of money, he or she may wish to consider alternatives. The simplest strategy is to vary the withdrawal amount, spending less following years with poor returns. Another alternative is to consider purchasing an annuity with some of the available funds, since this will provide a guaranteed lifetime income. Very sophisticated investors may also consider purchasing put options to guard against a major market drop. Milevsky and Macqueen have championed the purchase of "Guaranteed Lifetime Withdrawal Benefit Products" from life insurance companies to supplement pensions and portfolio withdrawals.
Any chosen strategy that involves transfer of risk from the retiree to another party will incur additional costs.
There are also several withdrawal spreadsheets at gummy stuff.
- Cooley, Philip L., Carl M. Hubbard, and Daniel T. Walz. 1998. "Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable." AAII Journal 10, 3: 16–21
- Finke MS, Fpau WD, Blanchett D (2013) The 4 Percent Rule is Not Safe in a Low-Yield World, Journal of Financial Planning, v. 26, p. 46–55, viewed February 7, 2018, available on SSRN
- Pfau WD (2010) An International Perspective on Safe Withdrawal Rates: The Demise of the 4 Percent Rule?, Journal of Financial Planning v. 23 p. 52–61, viewed February 7, 2018, available on SSRN
- Wade D. Pfau, Can We Predict the Sustainable Withdrawal Rate for New Retirees?, Retirement Researcher Blog, Monday May 6, 2011. Viewed June 12 2012.
- Pfau WD (2014) The Lifetime Sequence of Returns—A Retirement Planning Conundrum, Journal of Financial Service Professionals, v. 68, p. 53-58, viewed February 7, 2018, available on SSRN
- "gummy", about Random Walks and Investing, viewed June 11, 2012.
- Annuity Digest, Sequence of returns risk, viewed June 12, 2012.
- M.A. Milevsky, Sustainability and Ruin, IFID Center Research Magazine, April 2007.
- Milevsky, Moshe A. (2012). The 7 Most Important Equations for Your Retirement: The Fascinating People and Ideas Behind Planning Your Retirement Income. John Wiley and Sons, Canada Ltd. ISBN 978-1118-29153-5.
- Milevsky, Moshe A.; Macqeen, Alexandra C. (2010). Pensionize Your Nest Egg. John Wiley and Sons, Canada Ltd. ISBN 978-0-470-68099-5.
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