The 4% Safe Withdrawal Rate (SWR) was first introduced by William Bengen in 1994 and later supported by the Trinity Study in 1998. The rule basically states that when you hit retirement age, you can withdraw 4% of your total retirement savings initially. Each year, you increase the amount by the inflation rate. Assuming you continue to invest the money in a balanced mix of stocks and bonds investments (e.g., 60/40), your chance of running out of money in your retirement is very low.
For example, let’s assume you saved $1 million by the time you’re ready to retire. In your first year, you can withdraw up to 4% of $1 million, or $40,000. Let’s assume the inflation rate is 2%, the next year you could withdraw up to $40,800.
4% Safe Withdrawal Rate Example
Here is an example of a 4% Safe Withdrawal Rate based on real historical stocks and bonds data from 1988 to 2018 with a starting retirement portfolio of $1 million.
For this example, we use the 120 Minus Age Rule. This starts the Stocks asset allocation at 55% and Bonds at 45%; then we decrease the Stocks allocation by 1% per year.
To better understand the Safe Withdrawal Rate, you should take into account these seven important considerations:
- Tax Rates
- Investment Expenses
- Asset Location
- Asset Allocation
- Bond Yield
- Inflation Rate
- Initial Market Condition
The withdrawal amount shown does not include taxes. An often overlooked aspect of determining your safe withdrawal rate is which retirement accounts you will be pulling your retirement income from. For example:
- Roth Accounts – Withdrawals are entirely tax-free.
- Tax-Deferred Accounts – Withdrawals are taxed at your ordinary income tax rate. Also, you’ll be subject to the Required Minimum Distribution when you turn 70½.
- Taxable Accounts – Dividends, interest, sales of assets held less than one year are taxed at your ordinary income tax rate. Sales of assets held for more than one year are taxed at long-term capital gains tax rate.
There are several techniques you can use to help you minimize taxes during your retirement. In general, you should do everything you can to keep your taxes as low as possible.
Nowadays, you should be able to keep your investment expenses well below 0.35%. The Safe Withdrawal Rule doesn’t take into account investment expenses, so this model could fall apart if you’re paying high expenses for your investments and/or advisory service.
For example, if your investment expenses total 0.5% of your portfolio and you have an advisor that charges you 0.75% per year, the total expense of 1.25% could cause your portfolio to run out of money.
The Safe Withdrawal Rule doesn’t consider Asset Location. In real life, your retirement savings are spread across three different types of accounts: Tax-Free (e.g., Roth IRA and Roth 401(k), Tax-Deferred (e.g., Traditional IRA and 401(k)) and Taxable accounts.
The location of your investments plays a significant role in how tax-efficient you’ll be and how long your investments will last.
Your investment mix is important even after you retire. The higher the percentage of your portfolio you put into stocks, the higher the returns you can expect. However, you can also expect much greater volatility in stocks than in fixed-income investments such as bonds.
In the example above, we assume you start at 55% Stocks and 45% Bonds. You could achieve this mix with as little as two ETFs: Vanguard S&P 500 ETF (VOO) and Vanguard Long-Term Bond ETF (BLV). If you want global exposure, you could diversify by adding ETFs like Vanguard Total World Stock ETF (VT) and Vanguard Total World Bond ETF (BNDW).
If you can afford a lower withdrawal rate over your retirement, it makes sense to put a larger percentage of your portfolio into fixed-income investments. This will smooth out the ups and downs of the stock market while still providing you the income you need.
Likewise, if you want a higher withdrawal rate, you must accept some risks by mixing in more volatile stock investments into your retirement plan.
As you can see from the historical data, bond yield used to be a lot higher than what it is now. This leads many people to say that the 4% withdrawal rate is no longer safe and we should be lowering it to 3% or maybe even less. Although this is an important factor to keep in mind, it doesn’t necessarily mean that you have to lower the withdrawal rate below 4%.
Using our calculator, the portfolio survives even at 0% bond yield, assuming we hold all other variables.
In our Safe Withdrawal spreadsheet, we assumed a 3% inflation rate, which is higher than our recent inflation rates. However, the rule could fall apart if the inflation rate climbs too high.
Using the calculator, the portfolio survives even if we bump the inflation rate up to 5%. And in reality, the Fed will increase the federal funds rate, which in turn increases yield and keep inflation in check; so the impact of inflation should be minimal.
But this factor highlights why you can’t put your portfolio into 100% cash once you hit retirement. You still need your portfolio to grow at least at the pace of inflation just so your retirement income doesn’t take a hit over time.
Initial Market Condition
One of the biggest threats to the Safe Withdrawal Rule is the market performance in the first few years. In the chart above, I highlighted two major market crashes: the Dot Com Bubble of 2000 and the Financial Crisis of 2008.
Using the calculator, the portfolio survives if we substitute in stock performance for 2000-2002 or 2008-2010 as the starting point.
Other Retirement Withdrawal Strategies
So how do you determine the right withdrawal strategy for your retirement? There isn’t a single rule of thumb that will fit every situation. The above factors will determine your safe withdrawal rate; however, there is an alternative:
The Standard 4% Rule
The standard rule sets your withdrawal rate based on the initial balance of your retirement savings, and then increase the withdrawal by the inflation rate each year.
For example, the first-year withdrawal for a $1 million portfolio is $40,000. If the inflation rate is 3%, the next year’s withdrawal is set at $41,200. This inflation adjustment happens each year based on the previous year’s withdrawal amount.
This strategy works well because it maintains your purchasing power and provides you with predictable income to work with each year.
The Fixed 4% Rule
An alternative strategy is to withdraw 4% of your beginning of the year retirement portfolio balance each year. If your portfolio increases in value, then you will be able to withdraw a larger amount with the same 4% — and less if your portfolio decreases in value. This is similar to how your RMD is calculated.
For example, if your fixed percentage is 4% and you start out with $1 million, you would withdraw $40,000 in the first year. Let’s assume your portfolio goes up to $1.1 million in the second year; you would withdraw $44,000 that year. And in the 3rd year, your portfolio goes down to $950,000, so you would only withdraw $38,000.
The only problem with this strategy is the income is unpredictable and could swing up and down too much to be realistic.
It’s a question everyone must confront sooner or later: How much income can I withdraw from savings without running out of money before I run out of life? Knowing your safe withdrawal rate is arguably the most important issue you will face in retirement planning because it determines:
- The lifestyle you can afford.
- How much you need to save for retirement to support that lifestyle.
- The risk of going broke if you get it wrong.
The 4% rule attempted to answer that question by applying a simple rule-based system; however, many factors could cause the rule to fail. Now you understand what these factors are, and you could use the knowledge to help make your savings last your lifetime.
Pinyo Bhulipongsanon is the owner of Moolanomy Personal Finance and a Realtor® licensed in Virginia and Maryland. Over the past 20 years, Pinyo has enjoyed a diverse career as an investor, entrepreneur, business executive, educator, financial literacy author, and Realtor®.