In order to provide the best possible advice to clients, a financial planner needs to take into account:
- What should be the asset allocation for the particular client?
- How much income can the client safely withdraw to ensure that the investments do not run out during his/her lifetime?
The U.S financial planner William Bengen published an article in 1994 in which he summarized an analysis of investment data back to 1929 to determine the maximum safe withdrawal rate, based on the percentage of the initial investment portfolio. Assuming a minimum requirement of 30 years of portfolio longevity, Mr. Bengen concluded that a first-year withdrawal rate of 4% followed by inflation-adjusted withdrawals in subsequent years would be safe.
The 4% rule has been gospel ever since, but the question remains: Does it still hold true today?
According to T. Rowe Price Group, had you retired in 2000 and withdrawn 4% from your 55% stock/45% bond portfolio, you would likely have lost one-third of your investment by 2010, giving you only a 30% chance of outliving your investments.
If you need $80,000 of annual inflation-adjusted income from your investments, can you rely on the golden rule of 4% and build a $2 million retirement nest egg? Many financial planners use sophisticated modelling tools to calculate the annual withdrawal rate from the portfolio. One alternative method to calculate the annual withdrawal rate is to use your life expectancy. Choosing this method, let’s assume you are a 62-year old male doctor with a portfolio of $2 million.
Using life expectancy tables, you are expected to live for another 18 years. To calculate the first year withdrawal, you divide $2 million by 18, which is $111,000. Next year, your portfolio value is $1,946,000 assuming a 3% after tax return. The life expectancy remains at 18 years, which means that you can safely withdraw $108,000. Fast forward our illustration to age 70, with an assumed $1.4 million in your portfolio and a life expectancy of 13 years, you can withdraw $108,000. Under the life expectancy method, your withdrawal will fluctuate each year.
The bottom line
Many financial planners suggest that you consider a safe withdrawal rate of 3% rather than 4%:
- You are anticipating retirement exceeds 30 years;
- The majority of your portfolio is in fixed income investments, including term deposits and bonds.
Consider an initial withdrawal rate of 5%:
- Your expected retirement is less than 30 years
- You have a portfolio with more than 75% of equities
- You are willing to tighten your belt and spend less if market conditions dictate.
