One of the most important questions that investors need to understand is how much income they can expect to safely draw from their portfolios over a long time horizon. This income problem is often characterized as an attempt to determine a safe or sustainable withdrawal rate (SWR).
I have written about sustainable withdrawal rates in a range of articles, as well as in detailed case studies. While there are many variations on the theme, the most commonly discussed outcome from SWR studies is what is called the ‘4% rule,’ which states that you can safely draw an inflation-adjusted income equal to 4% of the value of your portfolio in the year of retirement. If you retire with $1 Million, you can draw $40,000 the first year, and then increase this amount each year by 3% to keep pace with inflation.
Questioning the 4% Rule
To begin any discussion of SWRs, it is important to understand the assumptions that go into the 4% rule. First, the portfolio is usually assumed to be 60% S&P500 and 40% bonds, or something close to this. This portfolio is usually assumed to return something like 7% per year, with volatility (risk) of 10% per year. This assumption is pretty optimistic, given that the average retail investor has averaged nothing close to this level, even when the broader market does. For the twenty-year period through 2009, for example, the S&P500 averaged more than 8% per year yet the average stock fund investor made less than 2% per year! The low returns earned by investors reflect high expense fund choices and terrible timing decisions: buying at the top and selling at the bottom.
The second key assumption that is typically made in determining SWRs is that the income that the investor draws will not vary at all, except to incrementally increase each year to keep pace with inflation. This is not a terribly realistic assumption I hope. One of the most powerful ways to increase your effective income draw is to have the ability to periodically re-evaluate your income draw rate.
If people work longer, they don’t need to plan for as many years of retirement income, so the SWR increases with retirement age. The typical assumption is that you need to plan for a 30-year retirement. If you retire later, your savings don’t need to last as long.
The combination of better-designed portfolios with a financial plan that is periodically re-evalued and adjusted can substantially improve the sustainability of a long-term financial plan, thereby enabling a larger expected income draw. It is important to understand that any discussion of SWRs is based on averages over a large number of possible futures–and you will get to experience only one of these. If you have good luck in your choice of retirement year, you will end up being able to draw a lot more income. If you have bad luck, you can end up broke. This is the sad reality of the SWR discussion: someone is going to end up with really bad outcomes and it might be you.
Investing in Annuities
One way to reduce the role of chance in your retirement plan is to annuitize all or part of your retirement savings. When you buy an immediate annuity, you spend some amount of your savings to purchase a promise of lifetime income from an insurance company. My research suggests that spending some part of your savings on an annuity can meaningfully increase your lifetime sustainable withdrawal rate.
One of the confusing issues for investors considering annuities vs. drawing income directly from their portfolios is how to deal with inflation effects. The ‘4% rule’ is based on an assumption that investors will increase their draw by 2%-3% per year to keep up with inflation. Most annuities (almost all, in fact) have the income that they provide in dollars in each year, and this amount does not increase with inflation. There are annuities that have inflation adjustments or annual increases in payments, however.
Despite the obvious over-simplifications in the standard ‘4% rule’, calculations, this baseline draw rate makes sense for the average investor who plans to retire at around age 65 as long as he/she plans to make adjustments through time. The biggest risk that the calculations do not take into account is the possibility that the portfolio grows so large, that the hypothetical investor can easily afford a higher draw but sacrifice’s his/her standard of living by not adjusting the draw rate upward. By re-assessing the draw rate through time, this problem is corrected for.