How Safe Does Your Safe Withdrawal Rate Need to Be to Retire?

Many retirees use the 4% rule to plan for their retirement spending. The 4% rule, based on a study by Bill Bengen, suggests you can safely withdraw 4% of your starting portfolio value for 30 years without running out of money.

Bengen used historical data from 1994 to find the highest withdrawal rate that survived 100% of cases, and his 4% safe withdrawal rate has held up ever since. But do you really need 100% certainty to retire?

What is the safe withdrawal rate protecting against?

A safe withdrawal rate, like 4% for a 30-year retirement, is designed to protect retirees against a bad sequence of returns early in retirement. The first decade of retirement is the riskiest period as a few bad years, combined with regular withdrawals, can quickly diminish a nest egg to an unsustainable level.

The upside to this reality is that you’ll know relatively quickly whether your retirement plan needs adjusting. If you can cut back on spending or find new sources of income, you can reduce your withdrawals and allow your portfolio to recover from a market downturn.

If you have any wiggle room at all to cut back on spending, you should be able to afford a higher withdrawal rate that might require some adjustments down the road. Perhaps that means spending on more luxuries early in retirement, like a nice vacation, knowing you may need to stay home for a few years if a prolonged stock market slump eats into your retirement funds.

If you delay Social Security, you might withdraw more of your investment portfolio early in retirement and then use Social Security income to reduce your retirement portfolio withdrawals later, if need be. In fact, that strategy ought to provide better protection against a poor sequence of returns because the returns on delaying Social Security are very predictable.

It’s important to note that the vast majority of the time, following a safe withdrawal rate with a very high percentage of success (like the 4% rule) will result in a portfolio much larger than what you started with by the end of retirement. That’s even after you spent money from it for 30 years.

How and when to make adjustments

There are a couple of strategies that you could implement if you need to make adjustments to your withdrawal rate and reduce (or increase) spending. The first is simple.

Any year in which your portfolio declines in value, refrain from taking an inflation adjustment the next year. This will allow you to start with a higher initial withdrawal rate, and you probably won’t notice the cutback in real spending in most years.

The second option is to use guardrails on your withdrawal rate. An example of the guardrails method is to increase your withdrawal rate 10% when it falls below 80% of your initial rate, or decrease it 10% when it rises above 120%.

Let’s assume someone is using the above guardrails, has a $1 million portfolio, a 5% initial withdrawal rate, and experiences 2% inflation annually. At the start of retirement, they withdraw $50,000 to live on. Unfortunately, the market drops that first year, and their portfolio loses $100,000 in value, leaving them with just $850,000 after making the withdrawal.

At the start of the next year, the initial withdrawal of $50,000 is adjusted 2% for inflation to $51,000. But $51,000 is 6% of the $850,000 portfolio. 6% is the upper guardrail — 120% of the initial withdrawal rate. So, the withdrawal amount is adjusted down by 10% to $45,900. That amount will be adjusted for inflation at the start of year three and the same math will determine whether it also needs a guardrail adjustment.

If you can stay flexible in retirement, you may be able to take advantage of a much higher withdrawal rate, with a small chance of having to adjust some things early on. Some good contingency plans that will allow you to cut back on withdrawals, if needed, can help make your retirement much more enjoyable.

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