Clients often ask “How much can I safely withdraw each year from my retirement portfolio?”
In 1995, Peter Lynch was famous for saying that a 7% annual withdrawal rate would work with an all-stock portfolio. Mr. Lynch later retracted this when a newspaper reporter proved that a 7% withdrawal rate could result in an retiree returning to work just to have enough money to eat.
While few people think about the end of the rainbow, and the amount of research reflects this missed focus, there are a several scholarly studies on “safe” withdrawal rates. Here are a few:
The Bengen Study
Back in February of 1997, a Wall Street Journal reporter, Jonathan Clements, cited a study by William Bengen, a financial planner in San Diego. Bengen had studied year-by-year returns since 1925 for a 50/50 stock/bond portfolio. Mr. Bengen presumed half the portfolio was in the S&P 500 and the other half in intermediate term government bonds. Using his 30-year holding period, Mr. Bengen determined that a 4.1% withdrawal rate would allow you to survive the worst market declines.
The Harvard Study
A generation earlier, in 1973, Harvard University conducted a study to determine what they could safely withdraw from their endowment fund without eating up their principal. Assuming a portfolio of 50% stocks and 50% bonds and cash, these scholarly Harvard analysts figured they could withdraw 4% the first year and then adjust the subsequent year’s withdrawals for inflation (that hidden tax!). For example, if there was 5% inflation, the second year’s withdrawal would be 4.2% of the first year portfolio value.
The Trinity Study
Several reporters have written more recently on a “safe” withdrawal study by three Trinity University researchers. This Trinity Study measures the “success rate” of several portfolios from 1926 to 1995. The “success rate” is the percent of time a retiree could maintain their withdrawal rate without running out of money. Their optimal investment mix was 75% stock and 25% long-term corporate bonds. Over a 30 year time period and a 4% withdrawal rate from original principal, this investment mix had a 98% success rate. Better yet, a 3% withdrawal rate, the same 75% stocks and 25% bonds had a 100% success rate.
In 2009, the original study was updated, and the same 4% withdrawal rate would fail only 5% of the time. In other words, a 95% success rate. That's doesn't sound bad, unless you're the one in twenty that ran out of money, in which case a 4% withdrawal rate is VERY BAD. When you run out of money during retirement, you may not be able to work to replace that income.
There are problems with these studies. First, they do not consider investment management expenses. If you’re paying a broker (registered representative) or investment advisor an annual fee of 1.5% of assets and she has you invested in no-load (or load-waived) mutual funds with a 1.0% expense ratio, then your total annual expenses are 2.5%, and your “safe” withdrawal rate is is now 2.5% lower than what these studies show.
Let's do the math: 4% minus 2.5% = 1.5%
If you have $100,000 in an IRA, then the "safe" withdrawal rate with an investment advisor would only be 1.5%, or $1,500 per year. That's only $125 per month.
Second, they do not take into account the hidden tax known as inflation.
Annuities: A Better Way
Many of our clients say that when they retire, they want a guarantee that they won’t ever run out of money. Furthermore, they often tell us that they don't want to be forced to start a second career. We have several solutions.
- A Single Premium Immediate Annuity. As of this writing, a 60 year old man can pay a premium of $100,000 and receive $553 per month guaranteed for the rest of his life. That's a of 6.64% payout rate. The downside is that there's nothing left for heirs. We solve this problem with life insurance, which the annuity owner can afford while the investor in a risky portfolio may not be able to afford when they can only take out $125 per month from the same lump sum. Plus, a Single Premium Immediate Annuity can protect your purchasing power with a Cost of Living Adjustment rider.
- An Fixed Annuity or Index Annuity. Because fixed and index annuities do not suffer losses of principal during market declines, the risk of Reverse Dollar Cost Averaging is eliminated.