« Question From a Reader - Calculating Personal Rate of Return | Main | One Bad Thing About Exchange-Traded Funds: Tracking Error »
A 2% Withdrawal Rate For Retirement?
By JLP | January 17, 2007
Holy cow! The withdrawal rate recommended by “experts” for income during retirement just keeps on getting smaller and smaller. At least that’s what I took away from today’s Getting Going column titled How to Survive Retirement - Even if You’re Short on Savings (free) by Jonathan Clements. I found this quote from William Bernstein interesting:
“Two percent is bullet-proof, 3% is probably safe, 4% is pushing it and, at 5%, you’re eating Alpo in your old age,” reckons William Bernstein, an investment adviser in North Bend, Ore. “If you take out 5% and you live into your 90s, there’s a 50% chance you will run out of money.”
Let’s think about that for a minute. Let’s say you’re 50 now and want to retire at 65. You currently make $75,000 per year and feel that you could live comfortably on that amount during retirement. After you take into account the impact of modest inflation of 3.5%, you will need an income of $125,651 the first year of your retirement in order to have the same purchasing power that $75,000 gives you today. Here’s how I figured that out:
Seems like a lot doesn’t it? Of course Social Security will take care of some of this need. For this example we’ll say that Social Security is $25,000 per year. That leaves around $100,000 that must come from your retirement savings. (NOTE: These figures do not include taxes) If your goal is to use no more than 2% of your capital (retirement account), you will need an asset base of $5,000,000 on the day you retire ($100,000 ÷ .02 = $5,000,000). That’s a lot of money especially when you consider the fact that most people in their 50s have around $90,000 in savings (I got that number from Clements’ column).
Now, what happens if we raise the withdrawal percentage to 3% of your capital? It reduces the required asset base to $3.3 million, a reduction of nearly $2 million from the $5 million. It’s amazing the impact that 1% has. To illustrate, look at the graphic I put together:
The risk of withdrawing too much is that it could eat into your asset base, leaving you with a smaller base from which to take future withdrawals. So, there’s a lot at stake when figuring out a proper withdrawal strategy.
This is an important topic for all of us to consider (even those of use who are still decades from retiring). I’m going to devote more time to this topic in the future. In the meantime, here’s some other posts you may want to read regarding this topic:
A Review of “The Grangaard Strategy” by Paul Grangaard
A Simple Example of the Grangaard Strategy
More on the Grangaard Strategy
What Kind of Millionaire Do You Want to Be?
A Roth Conversion Strategy For Those With Higher Incomes
Topics: Getting Going, Investing, Jonathan Clements, Retirement Planning |
January 17th, 2007 at 2:05 pm
The tendency for serious heinie-covering by retirement pundits is actually a very bad thing, since many people will simply say “to heck with it” and not save at all. And politically, it’ll create a push for SS increases beyond our current unsustainable levels that the country can’t afford.
January 17th, 2007 at 2:08 pm
Your post is timely, as I have been having a debate with my planner, my wife, and some of my friends about exactly how to approach The Number (i.e. how much will you need to have in order to live well in retirement). Of course, the number depends of how you define “living well”, but it’s the methodology that I am trying to get my arms around.
As I’m sure you’re aware, the issue with the example you just gave is that while the $100,000 desired income might be sufficient in the 1st year of retirement, over a 30 year period, the value of that income will diminish greatly. In 30 years that income stream will lose 2/3’s of it’s buying power @ 3.5% inflation (i.e. $100K will shrink to $34K of purchasing power, or conversely, it would take an income $280K to maintain the same purchasing power. Of course within 30-40 yrs of retirement, most of us expect to be dead anyhow.
But you get my point, which is that The Number is far greater than most people imagine. My planner uses a very sophisticated model (and I’m sure you use something similar) which factors inflation into all the calculations. When I first saw the figures, I thought the model must be total crap. But, the more I look at it, and the more I see what inflation has done to the life quality of present-day retirees, the more I see that the rather bleak picture it paints is painfully accurate. I know more than a few retirees that started out years ago with plenty of fluff in their income, only to find it increasingly difficult to make ends meet today.
January 17th, 2007 at 2:10 pm
Foobarista,
You are VERY right with your assessment. My dad and I talk about this all the time, particularly with expected rates of return. The stock market has returned 10% +/- per year over the last 70 years. Yet, all the articles you read tell you to expect 6% - 8% when planning for future needs. That in itself is discouraging.
January 17th, 2007 at 2:25 pm
In thinking about a little further, it does seem like the withdrawl rate concept accounts for the inflation component. What’s not clearly stated is that the withdrawl with have to go up over time to keep pace with inflation - i.e. if you start at a 2% withdrawl, that will need to increase over time. The 2% probably accounts for that issue, though I’m not sure yet how to approach the calculation that would prove this.
January 17th, 2007 at 2:35 pm
Regarding the returns, 6%-8% seems like a decent proxy for returns after expenses. The expenses really eat away at the returns.
Regarding the withdrawl rate, I think I would approach it by taking the desired income ($100K) and calculating the PV over 30 years, at an inflation-adjusted return such as 4%. That gave me a $1.7mm PV, which suggests that the 4% withdrawl rate is not a bad practice. What do you think?
January 17th, 2007 at 2:40 pm
Clarification: What I mean to say is that using 4% as the assumption for the income needed in the 1st year of retirement works, though in reality the withdrawls will need to increase over the retirement period to account for inflation. It’s another way of saying take your 1st year retirement income need and multiply by 25 (the inverse of 4%) or 50 if you want to be extremely conservative (the inverse of 2%).
Sorry about the rambling.
January 17th, 2007 at 2:51 pm
Miguel,
If you leave your withdrawal rate at the same percentage every year, you will get a raise (inflation hedge) each year that the portfolio performs at least as well as the inflation rate (taxes aside). Of course, you will also get a reduction in the years that the portfolio doesn’t keep up with inflation.
January 17th, 2007 at 3:53 pm
2%??? Now I have to save an extra $2.5M before I can retire!
Seriously, though, to me this highlights a general issue; there is no right answer for how to save enough for retirement, and financial advisors are full of bunk if they claim otherwise.
If the advice of a group of “experts” (and I use that term very generously) on something as fundamental as how much money you need to retire for a desired income can vary from $2M to $5M, then in my opinion one is better off taking the $500 he might have paid for the financial planner and putting it in porkbelly futures.
I realize that there can never be a “correct” answer for how much one needs to save. And personally I tend to err on the side of caution. But why bother consulting an expert if all the expert is going to do is make up some numbers about expected rate of return, ask you to make up some numbers about your risk aversion, and then give you a made up number about how much you need to save to get to where you want to be?
For someone in their 20s or 30s, here’s the reality: We’ll save what we think we need to save, and when we get to retirement age, we’ll look at what we’ve got and figure out if we can retire, if we just need to cut back, or if we must keep working. The story is different for someone closer to retirement. He may be able to get an accurate picture of where he’ll be financially, and what steps he needs to take to shore up shortfalls.
Those of us (and I am one) who come up with a savings plan at age 30 to have $X by retirement age are fooling ourselves if we think the models we’ve created in Excel will come close to resembling reality in 30 or 40 years.
January 17th, 2007 at 4:32 pm
To fully appreciate that figure, you really should read The Four Pillars of Investment by Bernstein, the source Clements refers to. It’s a pretty discouraging read, frankly. But it’s hard to debate his outlook.
January 17th, 2007 at 6:47 pm
@JLP - I should have read the Clements column before commenting - would have saved myself a lot of thinking. BTW, just took a look at your ret portfolio. Way to go! I can totally respect those results - and you’re not even 40 yet to boot and have kids.
@samewriter - There is no certainty in the world of investing, though yes, I wish the tools available to the gen’l public were more sophisticated.
@tolak - I took a look at the Bernstein book - I basically subscribe to the asset allocation model he advocates.
January 18th, 2007 at 11:53 am
I’m with the first poster. I think more people will say the heck with it and not bother investing at all.
So what’s the assumption? That the retirement fund isn’t offering a return at all?
January 18th, 2007 at 12:12 pm
We need are in our second year of retirement and now realize we need to manage the tax concequences of withdrals from our IRA’s. Anyone with any advice there, it would be appreciated. What do I read, etc. Anyway, you all shoould relax some about the pot of money you will need. You will find that you need less and less money as you age. We were big savers, not real big earners; perhaps $100k a year. So we were really living on about 60k considering saving, kids, mortages, work expenses that now are gone. You will be surprised at how much less you eat out, buy clothes, etc. With SSI and some pension were are now worryiing about having to take out more money than we need. The most important thing is to approach retirementt debt free.
January 18th, 2007 at 3:14 pm
I’m far from retired, but my impression from my parents and older relatives is that Jan is right, and the implications for retirement pundits are that they should preface ultra-conservative - and unhelpfully discouraging - discussions about withdrawal rates with some discussion about actual lifestyles in retirement and cash needed for them. Otherwise, talk about how you’ll need mega-millions to retire makes the lotto - or government goodies from taxing politicians - sound quite rational.
One interesting point on this is the more you save, the less cash you’ll need in retirement to maintain your current spending level, even if you don’t take into account not having mortgages, kids to pay for, less income exposed to tax, etc. If you save 30% of your gross - and don’t expect to “live much larger” than you currently do - you’re living (or paying taxes with) 70% of it, so 70% is probably the upper bound of what you’ll need in retirement.
January 18th, 2007 at 3:46 pm
I did a quick spreadsheet with the assumptions that you start out with a $2,000,000 account and took $75,000 out at the beginning of year 1 (3.8%) and increased the draw by 3% each year (i.e. $77,250 at the beginning of year 2, $131,315 at the beginning of year 20). Meanwhile whatever was left grew at 5% per year. With this formulation the $2,000,000 balance would run out in 37 years.
Also we shouldn’t forget the fact that while saving $2,000,000 sounds like a lot TODAY, we are actually talking about $2,000,000 in 15 years, which won’t sound like quite that much. I may be doing the calculation wrong but if you invested $600,000 today in the stock market (and didn’t add anything) and got 8% annual return, you would have about $2,000,000 in 15 years.
January 19th, 2007 at 10:50 am
[...] At All Financial Matters, there’s a great post called A 2% Withdrawal Rate For Retirement? which discusses the consequences of withdrawing amounts from your nest egg at varying rates. It sure sounds like we’ll need more and more money to retire; an unsettling thought to say the least. [...]