How Retirees Can Preserve Wealth with a Safe Withdrawal Rate

In the investment and financial planning world, safe withdrawal rates have gotten a lot of buzz recently. Dave Ramsey, perhaps the world’s most famous and widespread voice in personal finance, recently touted 8% as a sustainable withdrawal rate for retirees living on their portfolio. This is a shockingly high figure and contrary to most conventional financial wisdom. If you came here looking for a slam piece on Dave Ramsey, you will be disappointed. However, given the hype and confusion, I think some discussion on safe withdrawal rates is warranted.

What Does a Safe Withdrawal Rate Mean?

As a financial planner, I regularly discuss safe withdrawal rates with clients who are retired or soon-to-be retired. Clients are eager to know what they can expect for income from their portfolio. It makes sense—they have worked hard and want to know if their nest egg is sufficient to maintain their lifestyle in retirement. We often tell our clients a safe withdrawal rate is about 4%. But what does a safe withdrawal rate mean, and why 4%?

In the early 1990s, a financial advisor by the name of Bill Bengen set out to answer this question. In his analysis, Bengen used historical market returns from 1926 to 1976 to determine how much a retiree could sustainably withdraw from their portfolio without depleting it too quickly.

Bengen found that at a withdrawal rate of 4%, most portfolios in his analysis lasted more than 30 years, and many lasted more than 50 years! This analysis assumes a 50-75% stock allocation and a 25-50% bond allocation. To put these figures into dollars, a retiree with a $1 million portfolio allocated 60/40 to stocks and bonds could sustainably withdraw $40,000/year for the rest of their lives, adjusted for inflation.

Bengen’s finding of a 4% withdrawal rate has become all but enshrined in the financial industry as the gold standard. In reality, it is a helpful rule of thumb, but not the law.

Why You Don’t Want to Withdraw at the Same Rate as Your Returns

A common misunderstanding is that if the portfolio returns on average, say, 7%, you should be able to withdraw 7% and the portfolio will roughly maintain its value. This may make sense in theory. However, in practice, you don’t earn the average year after year; your actual returns will fluctuate.

Volatility risk or sequence-of-returns risk makes it unsustainable to withdraw at a rate near or equal to your portfolio’s average returns. To illustrate this point, the chart below shows how longer-term average returns can be the same while actual annual returns can vary greatly:

As you can see, both scenarios have an average annual return of 7%. One is unrealistic, in which you earn exactly 7% every year; one is hypothetical but more realistic because it shows a fluctuation of returns.

Scenario 2 is much more like what retirees actually experience. Given that, retirees who live on their portfolio need to withdraw significantly less than their expected average return in retirement. Doing so helps mitigate the risk of a poor sequence of returns in retirement. By withdrawing less than their expected average return, retirees also leave some returns in the portfolio, which can allow the portfolio to grow and help it keep pace with inflation over time.

By maintaining a safe withdrawal rate, retirees can move more confidently in retirement, knowing their withdrawal rate is unlikely to deplete their portfolio too quickly.

Your safe withdrawal rate will vary greatly depending on your investment allocation, age, expected length of retirement, and goals for your money. Consult with a full-time fiduciary financial planner if you have questions about your safe withdrawal rate in retirement.

Discuss goals banner

Zac Pohlenz, CFP®

As a Wealth Advisor, Zac works every day to help clients reach their financial goals, and finds it satisfying to know that he has helped someone gain a new perspective that can help change their life.