If you’re nearing retirement, you might have given thought to how to spend down your nest egg so that it lasts you the remainder of your life. You may have also gone a step further — and considered who or where your money should go to after you die.
Although slightly morbid, this is an important factor in retirement and estate planning, so it’s a good idea to give it some thought. For example, do you plan to leave a significant amount of your wealth behind to your children, grandchildren, or other heirs? Maybe you want to leave your money to charity instead — to your alma mater to fund a scholarship for underprivileged students, for instance. Or perhaps you don’t mind having anything left over so long as you don’t go broke during your lifetime.
If you’re in the last category, the long-standing retirement rule — that you should spend no more than the annual safe withdrawal rate — might still be relevant to you. However, if you want to have money to leave behind for family, friends, or charity, it may be worth revising this piece of popular retirement advice.
What is the safe withdrawal rate?
Invented by financial planner William Bengen in 1994, the safe withdrawal rate (SWR) describes the maximum amount you can distribute from your portfolio per year without running out of money during retirement.
Also known as the 4% rule, the SWR’s recommendation is straightforward: to ensure you have enough to live on for the rest of your life, withdraw no more than 4% of the initial balance of your portfolio every year, adjusted annually for inflation.
As an example, suppose you retire with a $2,000,000 portfolio. This means you can withdraw 4% of $2,000,000, or $80,000, in the first year of your retirement. If the inflation rate over every subsequent year is 2%, you can take out $81,600 in the second year, $83,232 in the third, $84,896 in year four, and so on.
However, the 4% rule has several pitfalls. First, it assumes a 30-year retirement. If you plan to retire early and expect that you’ll be relying on your portfolio for longer than that, you will have to adjust your withdrawal rate downwards.
Next, Bengen’s original calculation assumes a very specific portfolio mix of 50% broad-market equities, which you can replicate via Vanguard’s Total Stock Market Index Fund ETF (NYSEMKT: VTI) — and 50% intermediate-term treasuries, like those in Vanguard’s Intermediate-Term Treasury Index Fund ETF (NASDAQ: VGIT). If your allocation to stocks is lower than this percentage, your personal SWR may be lower than 4%.
However, perhaps the biggest problem with the safe withdrawal rate is its very definition of “safe”. Specifically, the rule defines success as simply not running out of money after 30 years. In other words, any positive ending portfolio value, so long as it is a penny or greater, is considered “safe”.
Perpetual withdrawal rates are safer
It’s difficult to imagine that many retirees would consider a rule of thumb that might leave them nearly broke in the worst-case scenario to be either safe or desirable. After all, dying with only a few dollars on hand isn’t that far off from going entirely broke.
To avoid this undesirable situation, retirees may want to consider the perpetual withdrawal rate (PWR) instead. This is the rate at which money can be withdrawn without ever depleting the inflation-adjusted principal balance of the portfolio. In other words, the PWR helps ensure that your money can last forever.
There are a handful of advantages to using the PWR. For starters, retirement periods are no longer a worry — your portfolio should outlive you regardless of whether you’re aiming for a 30-year or a 60-year retirement.
Additionally, you won’t run the risk of going dangerously close to broke in the worst-case. In fact, as long you’re disciplined about sticking to the PWR, the most “broke” you can become is dying with as little purchasing power as you had in the first year you retired.
Simply put, the PWR allows you to both have your cake and eat it, too. You can fund your retirement in perpetuity, while also leaving behind upon your death at least as much as you initially had upon retirement.
Of course, in order to make your money last forever, PWRs are lower than SWRs — but interestingly, not by very much. And over long periods of time, PWRs and SWRs even tend to converge, meaning you can reap huge benefits by spending just a little less.
For example, for the same 50% stock, 50% bond allocation over a 40-year time period, the PWR is 3.4%. Applying PWR criteria, a portfolio with a principal balance of $2,000,000 can yield $68,000 in the first year or $5,666 per month for the first 12 months.
This amounts to an initial difference of just $12,000 annually or $1,000 per month when compared to the SWR — a small price to pay for perpetual wealth and peace of mind.
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