A safe retirement withdrawal rate? Here’s a better approach. - PWL Capital (2024)

Every year, PWL Capital’s Research Team, including Raymond Kerzérho and Ben Felix, produce an estimate of the annual returns a broadly diversified investment portfolio can be expected to produce over a 30-year time period.

Ben and Ray look at a series of data points and probabilities to calculate these future expected returns and then we use them to construct and review financial plans for our clients.

As you know, last year was a pretty awful year for investors with both global equity and bond markets performing poorly. One silver lining from 2022 was that the market pullbacks meant higher expected returns going forward.

That’s because the market declines produced higher bond yields and lower equity valuations. In turn, higher expected returns suggest—at least in theory—that retirees can safely withdraw more money from their portfolio each year to fund their lifestyle.

But what is a safe withdrawal rate? That turns out to be thorny question. Many of you will be familiar with the 4% rule. It states you can safely spend 4% of your nest egg in the first year of retirement and then adjust that dollar amount for inflation each year for the rest of your life with minimal risk of running out of money.

While many financial advisors and investors use this rule of thumb, Ben argues convincingly in this video that 4% is based on biased data and is too high. He says corrected data indicate a safe withdrawal rate should be between 2% and 3%, depending on the portfolio asset mix and life expectancy of the investor.

This article from Morningstar also puts the safe withdrawal rate below 4%. Their number based on 2022 market data is 3.8%, up from 3.3% in 2021.

A more fundamental question is whether a safe withdrawal rate is a useful tool for financial planning. In the real world, retirees typically don’t withdraw a fixed percentage of their portfolio come hell or high water, especially if it’s putting them on the road to financial ruin.

Instead, they take a flexible approach, adjusting their spending and withdrawals in response to portfolio performance, life events and evolving goals. This makes sense because it reflects how households have always managed their finances. A family may take an extra vacation when someone gets a big bonus at work or, conversely, they may postpone a home renovation or car purchase if someone loses their job.

Recent research by the CFA Institute found the same goes for people in retirement. It found “that households can adjust their spending and that adjustments are likely to be less cataclysmic than success rates and other common financial-planning-outcomes metrics imply.”

Institute researchers surveyed 1,500 retirement plan participants between the ages of 50 and 70. They found that many said they would be able to reduce their spending in retirement by substantial percentages in such areas as food, housing, vehicles, vacations and clothing.

Yet, as the CFA Institute notes, “according to traditional static spending models, 100% of retirees would be unwilling to cut back on any of the listed expenditures.”

The survey also found that 40% of the respondents said a 20% drop in spending would have little or no effect on their lifestyle. An additional 45% said it would cause changes but they could be accommodated.

These results suggest retirees have a lot more flexibility to adjust their spending than what’s assumed in tradition financial planning approaches.

The findings also dovetail with another important factor that’s often given short shrift in retirement planning. It’s the idea that spending tends to decrease as we get older. Later in life, retirees just aren’t as likely to want to renovate their homes, buy a new car or go on adventurous trips. Actuary and financial author Fred Vettese has noted this tendency can help compensate for the impact of inflation on retirement savings.

The bottom line is that your focus shouldn’t be on a magical safe withdrawal rate. It makes more sense to review your portfolio performance and retirement income projections on a regular basis (and especially after bad years in the markets). You can then modify your budget as necessary.

After a year where the markets declined and inflation soared, retirees and pre-retirees should take comfort from the fact that you can adjust your spending to respond to bumps in the road and ensure your savings last a lifetime.