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What Are Safe Retirement Withdrawal Rates?

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A woman calculates her safe withdrawal rate in retirement.

One of the most pressing questions you’ll face when planning for retirement is how much you can safely withdraw from your nest egg each year. This percentage, known as a safe withdrawal rate, aims to ensure that you don’t deplete your savings prematurely. Calculating your safe withdrawal rate requires you to account for your age and spending, inflation and investment returns. While the 4% rule is the most famous and commonly cited withdrawal rate, there are other, more dynamic, ways to approach your account withdrawals and overall retirement income plan.

A financial advisor can help you build an income plan for retirement and determine how much you can afford to withdraw each year. Connect with a fiduciary advisor today.

What Is a Safe Withdrawal Rate for Retirement?

Imagine a retiree who after years of saving is now faced with the challenge of making their retirement fund last. They understand that spending too much too soon could jeopardize their financial future. But they also want to enjoy the fruits of their labor.

Striking a balance between your savings and spending could feel like a tightrope walk in retirement. But establishing a safe withdrawal rate can help you find the stability you will need to avoid depleting your savings while affording a comfortable lifestyle.

Investment diversification can play a key role here, spreading risk and enhancing the likelihood of consistent returns. But it’s not just a set-it-and-forget-it strategy. As a retiree you will need to recalibrate your withdrawal rate to reflect current market trends and personal circumstances.

How much a retiree can safely afford to withdraw from their assets each year will depend on a variety of factors, including:

  • Time horizon: How many years they expect to live and take withdrawals. Typically, the shorter the time horizon, the higher the safe withdrawal rate can be.
  • Asset allocation: This is the percentage of a portfolio’s assets invested in equities, fixed-income securities and cash. Too high of an equity allocation can expose you to sequence risk, which refers to how the timing of withdrawals could damage the overall return of a retirement portfolio. Too low of an equity exposure can mean a lower long-term rate of return to sustain higher withdrawals going forward.
  • Market returns: How a portfolio performs over the course of the given time horizon will have a significant impact on the retiree’s safe withdrawal rate. If the market outperforms projections, the retiree may be able to increase their withdrawal rate and take out more money than planned each year. Of course, the opposite may be true as well.
  • Inflation: The rising cost of goods and services will also impact safe withdrawal rates. If inflation is higher than projected, the retiree may need to withdraw more money to meet their spending needs. However, this may deplete their portfolio faster and increase their longevity risk.

The 4% Rule

Formulated by William Bengen in 1994, the 4% Rule suggests that retirees can withdraw 4% of their retirement portfolio in the first year of retirement, adjusting subsequent withdrawals for inflation to ensure the sustainability of funds over a 30-year span. Bengen’s research, emerging in the wake of events like the Black Monday crash of 1987, became a guiding light for retirees working through a nationwide shift from defined benefit to defined contribution plans.

Bengen’s model, which served as the foundation for the rule’s success, initially assumes a portfolio with a balanced allocation: 50% equities and 50% fixed-income assets. His research also showed that results remained relatively consistent with an equity allocation as high as a 75%, but allocations outside of this 50% to 75% range could cause concern.

Consider, for example, another retiree who has diligently saved for their golden years. Upon retiring, they calculate 4% of their $500,000 nest egg, which amounts to $20,000. This is their first year’s withdrawal. As inflation rises by 2%, they increase their withdrawal amount to $20,400 to preserve their purchasing power and maintain their lifestyle. By following this pattern each year, they stand a reasonable chance of extending their savings across three decades.

Limitations of the 4% Rule

Despite its popularity, the rule is not immune to criticism, particularly regarding its reliance on historical market returns – a factor that may not predict future performances with certainty. This reliance, based on historical events, may not hold up under different market conditions, making it a risky bet for future retirees. After all, past market performance is not an absolute predictor of future outcomes, especially when considering the application of the 4% Rule to your retirement planning.

Beyond its dependence on historical returns, the 4% Rule has other limitations, primarily it’s rigidity. This rule of thumb presumes a consistent 30-year retirement period and does not account for personal spending changes over time. A retirees’ spending habits or income needs may change during the course of a 30-year retirement. Research suggests that typical spending in retirement follows the shape of a smile. It starts at one level before dipping in the middle portion of retirement and then rises again toward the end of a person’s life as they presumably spend more on medical care and/or long-term care.

Longevity risk is another potential reason more dynamic or conservative income planning is needed. As people live longer, there’s an increased chance of outliving the 30-year benchmark set by the rule.

Alternatives to the 4% Rule for Safe Withdrawals

The guardrail approach is a retirement withdrawal strategy that can be an alternative to the 4% rule.

Keeping the potential shortcomings of the 4% rule in mind, here are three common alternatives to help you navigate through the complexities of retirement planning, especially during uncertain times.

Guardrails Approach

The guardrails or floor-to-ceiling approach to retirement withdrawals represents a flexible and responsive method that can adapt to the ebbs and flows of your investment portfolio. This strategy involves setting an initial withdrawal rate based on your risk tolerance and then adjusting that rate within certain boundaries – or guardrails – based on your portfolio’s performance. It’s a strategy that acknowledges the unpredictable twists and turns of the financial markets.

For example, during periods of strong investment returns, retirees may choose to increase their withdrawals to enjoy a higher standard of living. Conversely, during market downturns or economic uncertainty, they may opt to reduce their withdrawals to preserve their savings and avoid outliving their assets.

One key aspect of the guardrails approach is the concept of dynamic spending. Rather than adhering to a rigid withdrawal rate, retirees using this strategy have the flexibility to adjust their spending based on factors such as investment performance, inflation and longevity.

To employ this method effectively, you’ll need to establish a withdrawal rate you’re comfortable with. Then, define the guardrail limits that will trigger adjustments to this rate. Let’s say you start with a 4% withdrawal rate, with guardrails set at 5% and 3%. Should your portfolio grow, you might increase your withdrawals up to the 5% limit, but if it shrinks, you’d decrease them to protect your capital.

TIPS Ladder

In the face of inflation, which can silently erode the value of your retirement savings, Treasury Inflation-Protected Securities (TIPS) offer a safeguard. These securities are specifically designed to grow with inflation. Unlike traditional bonds, whose fixed interest payments lose purchasing power as inflation rises, the principal value of TIPS adjusts with changes in the Consumer Price Index (CPI). This means that as the cost of living goes up, so too does the value of the TIPS investment, helping to preserve the purchasing power of the investor’s capital.

Imagine building a ladder with rungs of different heights representing TIPS with different maturity dates. This setup can provide you with a steady flow of income that adjusts for inflation, aligning with your anticipated retirement expenses. A TIPS ladder can allow retirees to spread out their exposure to interest rate and inflation risk while maintaining liquidity and potentially achieving higher overall returns.

However, it’s important to approach this strategy with caution, recognizing that while TIPS protect against inflation, they are not a cure-all and come with their own set of limitations, such as interest rate risk and lower yields when compared with non-inflation-protected securities.

RMD Approach

Some retirees may choose to simply align their annual withdrawal rate with their required minimum distributions (RMDs). Mandated by the IRS, these withdrawals start at age 73 and apply to traditional IRAs, 401(k)s, 403(b)s and other tax-deferred retirement accounts. Roth IRAs, and designated Roth accounts within retirement plans, do not require withdrawals during the account holder’s lifetime.

But, similar to the 4% rule, one size may not fit all. Your annual expenses might not align with the RMDs calculated by the IRS, leading to potential issues. If your expenses are lower, you might find yourself with a higher tax bill, and if they’re higher, the RMDs may fall short of covering your needs. And what if you retire well before RMD age? You’ll need to come up with a withdrawal strategy for those years first.

It’s essential to weigh your financial requirements against this tax-driven strategy, recognizing that the RMD approach may be more of a starting point than a complete solution.

Hurdle Rate vs. Safe Withdrawal Rate

A woman who's approaching retirement calculates how much she can afford to safely withdrawal from her account each year.

While safe withdrawal rate refers to how much a person can afford to withdraw from their savings each year without running out of money, hurdle rate represents a minimum acceptable return on investment or a portfolio. When applied to retirement planning, the hurdle rate helps individuals assess the viability of different retirement savings vehicles and investment opportunities in achieving their long-term financial goals.

Hurdle rate influences decisions regarding the selection of retirement income sources. Individuals may evaluate annuities, pensions, Social Security benefits and other retirement vehicles based on their ability to generate returns that meet or exceed the hurdle rate. Understanding how these income streams contribute to overall retirement income can aid in constructing a diversified and sustainable retirement income plan.

While a hurdle rate dictates how a portfolio may be invested, a safe withdrawal rate determines how much can be reasonably withdrawn from a portfolio to ensure that it lasts for a given period of time.

Bottom Line

When planning for a financially secure retirement, identifying a safe withdrawal rate is important to preserve your nest egg. This is the percentage of total assets that can be withdrawn on a yearly basis to ensure your money lasts for a minimum number of years. While the 4% rule is a common example of a safe withdrawal rate, it has a number of limitations and potential risks. Finding a safe withdrawal rate may require targeted planning for your specific needs and greater flexibility.

Retirement Planning Tips

  • RMDs are an important component of retirement income planning. Not only do you need to know how much you’ll be required to withdraw each year, but you should also think about how your RMDs will impact your tax bracket. The added income from RMDs can propel you into a higher tax bracket and result in a larger-than-expected tax liability.
  • A financial advisor can help you plan for retirement and calculate how much you can reasonably afford to withdraw each year. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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