Upon retirement, you may be excited to start withdrawing from your retirement pot to finally indulge in that vacation you always wanted, or splurge on activities you were otherwise too busy for before retirement; however, be cautious as your withdrawal rate may break the bank. There’s nothing worse than going on a first class trip around the world only to find your pot extremely impacted. And while most people have a gut feeling inducing them to be cautious spenders at the beginning of their retirement, we are actually able to put pen to paper and analyze which draw-down rates are likely to ensure that you don't outlive your retirement pot.
As noted in a previous blog, there is no crystal ball when looking into the future. There is very little that can be perfectly planned for or expected; thus, it is crucial to determine how long you may need your retirement pot to last. We are living in a time where people are living longer than they have ever had, so, you must plan your retirement accordingly. While the average UK life expectancies shown above give a good estimate for how long to plan for, there is nothing scarier than underestimation. As a rule of thumb, these projections should serve as a starting point, as many in each age group tend to live longer than expected. You definitely will want to plan for longer—there is nothing worse than running out of funds when you’re in your eighties or nineties! As such, a good rule of thumb is to add another 5 to 8 years in life expectancy, just to take care of the scenario that you are one of the blessed retirees who manages to reach above average life expectancy due to good genes, great health or future medical advances.
While having a bucket list for retirement and going on vacations is something to look forward to, using the "4% withdrawal rate" is often cited as a good starting point. This 4% withdrawal rate is only a broad rule of thumb and, once you factor in your own individual circumstances, risk profiles, and investment strategy, it can look quite different for each individual. Just as many retirement plans and goals differ, so will your withdrawal rate.
Saving for retirement and figuring out how to allocate funds once retired can be a puzzling process. However, as you can see, over a 15-year withdrawal term, any withdrawal rate between 2% and 6% would be highly sustainable, saving both your funds, and the ability to consistently withdraw. But, of course, this would mean to only retire at the age of 71, according to the life expectancy chart in table 1 above. Even at a 6% withdrawal rate, you would have a 91.4% chance of sustaining sufficient funds over 15 years at such a late retirement starting age. On the other hand, consistently withdrawing 4% or below across any term is considered quite sustainable and imposes manageable risk in regards to sustainability of funds. In other words, taking out more than 4% initially won’t break the bank, but withdrawing only 4% or less throughout the retirement period ensures that you will have enough funds for your planned retirement period. With this withdrawal rate, you’re safe from high levels of volatility and can rest assured that your funds will last you through retirement.
4% may seem low for a retirement withdrawal rate; however, it also depends largely on the composition of the retirement portfolio. The first image above, the result of a specific Monte Carlo simulation, is run at a 50/50% risk profile, meaning that the portfolio composition entails 50% stocks and 50% bonds—this is considered to be a safe ratio, much safer than one with a higher percentage of stocks as shown in the graphic below. Furthermore, the more heavily the portfolio relies on bonds, the less volatile, and the more sustainable future withdrawal rates will be. This is something that should be considered when contemplating your retirement portfolio and withdrawal rate as retirement funds are not something you’d want to gamble away or subject to wild equity market gyrations.
As demonstrated in the image above, you can clearly see differences in volatility amongst portfolios heavy in stocks versus those heavy in bonds. Portfolios containing more stocks than bonds quite obviously generate higher long term returns; however, in terms of retirement, it is also evident that the volatility that comes with the higher returns is greatly increased and can provide an unstable environment from which to withdraw funds. There is nothing more fear-striking than having a retirement portfolio that can suffer from a dramatic loss of up to 50% due to global stock market crises. Playing with an equity-heavy portfolio can be akin to juggling—drop a ball and the whole thing could potentially become a mess.
In terms of portfolio stock/bond ratios, as shown in the growth of wealth of the ten sample portfolios in the picture above, as well as corresponding Monte Carlo simulations, any portfolio with less than 50% bonds would be unsustainable over a normal withdrawal period of 30 or 35 years.
So, when considering the rate at which you would like to withdraw from the retirement pot, or, when considering the composition of your retirement portfolio, think about how sustainable your intended or implied withdrawal rate really is, and deliberate how risk averse you are or should be in light of impending retirement. You should not be on the market-gyration induced roller coaster ride in high risk portfolios 5 years prior to retirement going forward.
Sources: - UK Office of National Statistics - Table of retirement sustainability scores calculated using Monte Carlo Simulations - 1988-2016 Market returns of the 10 portfolios depicted in the article is based on CRSP data