Safe Withdrawal Rule for Retirement Funds

by Mike Holman

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Yesterday I posted part one of this topic Why Retirees Should Have Equities In Their Portfolio.

One of the biggest concerns for retirees is the fear of running out of money. If you are retired and living off a pension which is indexed for inflation then you don’t have much to worry about since the pension should keep going until you expire. What happens if you have no pension or only a little bit of pension income from a source like a government pension plan? Then you need to live off income from your investments.

How much can I safely withdraw from my retirement funds?

Simple – use the 4% rule. This will give you a great chance of not running out of your money and it’s valid for 25+ year periods. If you are at an advanced life stage where 25 years is a dream then the 4% can be adjusted upwards.

The way the 4% rule works is that you start by taking 4% out of your portfolio in the first year – this includes dividends, interest, withdrawals. The next year you take out the same figure you took out the first year plus inflation. So if you start by taking $40,000 out and then inflation is 3% then the second year you take out $40,000 + 3% ($1200) = $41,200. Every year after that you adjust the previous year’s withdrawal amount by the inflation rate.

Keep in mind that this amount only covers the withdrawals from your investments. Any other income you have, such as pensions, will be in addition to the withdrawals. If you find the 4% rule doesn’t give you enough income then you can either cut back your spending or increase the withdrawal amount (which will increase the chance you will run out of money later on).

The 4% rule is really a guideline rather than a hard and fast rule – If your equities perform better than expected then you can spend a bit more than the 4% rule amount however the opposite is also true, if you encounter a bear market and the value of your portfolio drops then you should be prepared to cut back on the withdrawals.

 

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{ 28 comments… read them below or add one }

1 Ron@TheWisdomJournal

You know, the thoughts of only having $40,000 for retirement should scare the stuffing out of someone.

If someone wants to know how much they will have to save and want to be able to incorporate the 4% rule, divide how much you’ll need each year in retirement by 0.04. Make sure you adjust for inflation in your projections though.

$75,000 per year? You’ll need $1.875 million.
$50,000 per year? $1.25 million.

Folks, you better get started today and you simply MUST get out of debt.

2 Four Pillars

Ron – $40k (in today’s dollars) is the exact amount that we are planning for. Of course in 15 years or so when I hopefully start retirement, that amount should be about $65k assuming 3% inflation.

Mike

3 FinancialJungle

What should the right course of action be if a deep correction sinks a retirement portfolio from $1 million to $900k after the first year of retirement? Should the retiree take out $41,200 + inflation in the second year anyway?

That would be a 4.58% withdrawal on the remain.

4 Dennis

Why would having “only 40,000/year” indexed to inflation be scary? As long as you have no mortgage or other large debt during retirement 40,000 should be plenty. Even if that 40,000 total included CPP and OAS, anyone with a little bit of spending discipline should be able to “make do”. I can appreciate that people have different spending habits, and a little belt-tightening might be called for, but to use the phrase “scare the stuffing” suggests people without a couple million dollars in their retirement portfolio will be living in a van and eating dogfood during their golden years.

5 Four Pillars

FJ – great question. I’m planning to do more detailed posts on the topic to cover my thoughts on various scenarios such as the one you mentioned.

There is no one right answer but a few things to think about:

1) There is nothing wrong with the percentage withdrawal increasing – this can happen over time anyways.

2) Bernstein says if you hit a bear market at any time but especially early in the retirement, then you should reduce your withdrawals to increase your odds of not running out of money. The problem is that it’s not clear how much to reduce by or what constitutes a bear market worth reacting too.

3) Bernstein and others recommend having five years worth of spending in cash so that could be used to weather a bear market.

4) Berstein also recommends not having more than 75% in equities so you don’t necessarily have to sell equities every year.

What would I do?

One very conservative strategy that I would consider in your scenario is just restarting the 4% rule in year 2 which is in effect the same thing as just lowering your withdrawals. Another strategy that I would consider strongly is to do nothing – 10% decline might not be enough to change your strategy over.

6 Four Pillars

Dennis – I agree. $40k is more than enough for the majority retirees. Especially if they are splitting income.

7 Canadian Dream

Ok, I just have to comment on this.

1) On your previous post about having a higher amount in equities. You are on to a good idea, but we also have to keep in mind a retiree will also require a cash float to be able to ride out those down years. Otherwise the lose could be terminal for the overall portfolio in the long term.
2) 4% is considered a safe number if you want to pass along a lump sum at the end. Otherwise a higher percentage is possible, but your risk of running out of money increases. I’m likely going to run with 5% with some of my funds and keep another part at 4%.

O, and $40K/year is more than enough for most lifestyles. Some people would require more and would likely have to work longer to get it.

Tim

8 Four Pillars

CD – as I mentioned in my previous comment, Bernstein says you should have five years of cash – which is as you say.

4% is considered a safe number if you want to pass along a lump sum at the end.

This is incorrect – the 4% rule is not based on leaving behind any money or trying to use it all up. It’s based on the odds (based on historical info) of not running out of money over a 25 or 30 year time period.

The 4% rule (as a guide) is supposed to get you through rough times like low real returns over extended periods and high inflation. If you are flexible with the withdrawals then you can certainly deviate from the 4% rule and keep the risk level the same. Not all retirees are comfortable with planning a retirement where the income levels are potentially changing quite a bit. Another thing to think about is to build a good cushion in your withdrawals ie if you are doing a 5% rule (let’s say that $50k in the first year) but you know you can get by pretty easily with $35k then that flexibility will allow you 5% withdrawals.

Mike

9 FinancialJungle.com

FP – Remember when you left this comment in my http://financialjungle.com/2008/01/17/investing/top-5-reasons-why-dividend-investing-over-etf/ post?

>>JungleGuy: 4% withdrawal on ETF fluctuates with the market

>> FourPillar: That’s not how the 4% rule works although you could do it like that. Next Friday I have a post on the 4% rule.

I believe your suggestion is to adjust the withdrawal based on market condition. I’m a little confused still. :(

Even with the 5 year cash reserver, if the correction comes in the second year when the retiree’s cash capacity dwindles to 4 years, he’ll have to replenish his cash reserve by selling equities in a depressed market or take a chance hoping the market will recover by then.

With dividend investing, you get the $40,000 in bull or bear market.

10 Four Pillars

FJ – yes, I do remember.

The strict version of the 4% rule means you never deviate from the 4% plus inflation amount. However desperate times call for desperate measures. In your scenario of a 10% decline I don’t think that’s enough of a drop to change the 4% value but if you want to be flexible with it then that’s ok. The 4% rule is intended to be a guide – not an absolute rule.

The 4% rule also applies to dividend investing – the more you take out of the portfolio, the greater the chance of running out of money.

Dividend investing is not immune to downturns – dividends get cut, inflation goes up – the dividend investor should have have a cash reserver as well.

Mike

11 CanadianInvestor

Good post. The links to the series is very handy too. Found some UK bloggers, so thanks for that too..

12 FinancialJungle

>>”The 4% rule also applies to dividend investing – the more you take out of the portfolio, the greater the chance of running out of money.”

That’s not true, but it’ll take an effort to explain. Instead, I’ll simplify it with a toll bridge example. A $1 million toll bridge A is making $50,000 per year but distributing $40,000 to shareholders. Suppose you own this toll bridge, you can collect $40,000 (+ inflation) for life without ever running out of money. I.e. you’ll never have to worry about how the bridge is priced by the market and you never have to adjust down your income stream amidst a deteriorate market condition.

On the other hand, if you own toll bridge B that retains 100% of earnings, you’ll have to rely on capital gains to fund your retirement. If poor market sentiment decides that the bridge is only worth $800k, then selling $40,000 worth of shares is like giving up $1 of equity for a lousy 80 cents.

>>”Dividend investing is not immune to downturns – dividends get cut, inflation goes up – the dividend investor should have a cash reserve as well.”

In a downturn, which drops faster? Equity or dividend? I don’t have the numbers at my fingertips, but I think TSX and S&P500 are probably down 10-15% from their Oct highs, but dividends are still up! XIU.to raised distribution from 38 to 39 cents, while SPY raised theirs from 72 to 78 cents.

This isn’t an isolated case. XIU.to was distributing 16 cents at the peak of the tech bubble, but leaped to 18 cents after the market suffered a 50% decline. Similarly, SPY raised their dividends from 38 cents to 44 cents over the same period.

I can give you countless examples of individual dividend stocks that hiked their dividends during market downturns.

Dividend investing is the perfect remedy to combat inflation. Guess who are charging higher fees in an inflationary environment? Dividend paying companies like Royal Bank, Great West, Saputo, Fortis, Rothmans, Reitmans, TransCanada, Consumers’ Waterheater, Boston Pizza, etc.

13 Four Pillars

First of all – if you truly want to understand the 4% rule – I would recommend reading Bernstein because he does a way better job of explaining it than I.

Bridge example – I don’t get this – why is it that poor market sentiment affects the share price of bridge B but not the dividend of bridge A? Short term market hysteria aside – companies tend to get valued on their earnings regardless of how or if the earnings get paid out. Over the long haul (ie 10 yrs or more) if the bridge’s earnings go down then you should see the share price go down as well as the dividend.
The 4% rule is a bit conservative in order to handle really bad events – like real returns of zero percent for 20 years which has happened in the past.

but I think TSX and S&P500 are probably down 10-15% from their Oct highs, but dividends are still up This is meaningless because of the short term – what I’m talking about are companies that have reduced earnings over a long period of time 5-10 years – in those cases I think you will see a stronger correlation between dividends and stock price.

XIU.to was distributing 16 cents at the peak of the tech bubble, but leaped to 18 cents after the market suffered a 50% decline. Similarly, SPY raised their dividends from 38 cents to 44 cents over the same period.

I think you are talking apples & oranges here – the market decline was because of non-dividend stocks ie tech stocks whereas the payouts of XIU and SPY are from larger dividend companies that weren’t part of the tech debacle.

Dividend investing is the perfect remedy to combat inflation. In theory I would agree with this – although if you are relying on any ROC payments – they won’t be inflation protected.

Summary – I think dividend is a great way to invest however as I apply the 4% rule, a dividend investor should still only take the 4% + inflation amount out of their portfolio – if they get extra then reinvest it.

Am I right? Who knows? I really hope that neither of us experiences any type of severe conditions that will test both the 4% rule and dividends investing strategies.

14 FinancialJungle

>>”why is it that poor market sentiment affects the share price of bridge B but not the dividend of bridge A?”

This is the beauty of dividend investing, because we’re indifferent of what the general market sentiment or the market price of bridge A is. Shares of bridge A can suffer a 20% correction too, but the $40,000 distribution keeps on coming. The market can price the bridges however they wish, but they can never discount the $40,000 yield from bridge A no matter how grim the stock market is.

>>”This is meaningless because of the short term”

This means a lot preciously because it’s short term. A 30 year-old investor has a long time horizon, but a retiree must worry about short-term volatility. We talked about having a 5-year cash reserve for ETF retirees, but if the market is down 20% during the second year and your cash reserve plummets to 4 years remaining, doesn’t the ETF retiree have to sell enough depressed equities to replenish the cash reserve back to 5 years? Isn’t that short-term investing?

Dividend investing, on the other hand, is truly long-term, because dividend retirees never have to touch the equity portion even during down markets.

>>”I think you are talking apples & oranges here – the market decline was because of non-dividend stocks ie tech stocks whereas the payouts of XIU and SPY are from larger dividend companies that weren’t part of the tech debacle.”

That begs the question if most high-quality dividend companies cut their payout when their stocks are heading south, and the answer is a resounding no:

http://www.fortis.ca/InvestorCentre/FortisStock/DividendHistory.aspx
http://www.rbc.com/investorrelations/ir_dividend_common.html
http://www.investor.jnj.com/divhistory.cfm?history=true
http://www.hr-reit.com/finance/history.asp
http://phx.corporate-ir.net/phoenix.zhtml?c=71595&p=irol-dividends
http://www.ge.com/investors/stock_info/dividend_history.html

>>”although if you are relying on any ROC payments – they won’t be inflation protected.”

Why would ROC not indexed to inflation? REITs distribute plenty of ROC, but their distributions (and ROC) are indexed to inflation as they raise their rents ever year. ROC is returned of your capital in the eye of the taxman, but ROC in REITs is earned cash from their properties.

15 Four Pillars

First of all – I do think that dividend investing in good companies is a great way to invest but it seems from your comments that you have completely dissociated the idea that dividends have any connections to earnings.

With respect to the bridge question – if earnings decline or even fail to keep up with inflation over the LONG TERM then the share price will go down and if there is a dividend then it could go down as well.

As far as short term volatility affecting the retiree – with a five year cash cushion AND an appropriate asset allocation and a safe withdrawal rate ie 4% – they should be able to handle most market situations.

As far ROC is concerned I was talking about income trusts in general. I didn’t know that REIT ROC is actually cash generated their properties – why are they ROC and not gross earnings I wonder?

Mike

16 FinancialJungle

>>”if earnings decline or even fail to keep up with inflation over the LONG TERM then …”

TSX 60, like any other market weighted ETF, is a top heavy ETF. Anyone of the top holdings can have earnings fall behind inflation, so this is moot point.

In reality – as I demonstrated – virtually all high-quality dividend stocks increase their dividend every year. So what if 1 stock out of 20 cuts its dividend? The rest of the 19 will pick up the slack. Do you believe it’s likely for a 20-stock dividend portfolio to cut net distribution by even a mere 5%? Not likely.

In contrast, with ETF, share prices tend to move in group. It’s a recurring event for the aggregate of TSX60 to decline 10% or more, and it tumbled 50% after the dot-com bubble.

>>”As far as short term volatility affecting the retiree – with a five year cash cushion AND an appropriate asset allocation and a safe withdrawal rate ie 4% – they should be able to handle most market situations.”

Huh? To maintain the appropriate asset allocation is even more detrimental to your cash reserve. So if the market is down 50% after the first year, you’ll funnel your 4-year (remaining) cash reserve to buy even more equity in order to rebalance your asset allocation? Wouldn’t that drain your cash reserve even faster especially if the market doesn’t recover over the next 1 or 2 years? Many bear markets have been prolonged by multi-years in the past.

With dividend investing, the retiree doesn’t have to stress over short-term market movements. The $40,000 (and rising) keeps on coming in an up or down market.

>>”why are [REITs] ROC and not gross earnings I wonder”

They don’t call them earnings because earnings are taxable. Within boundary, REITs can classify a portion of their distributions as ROC to defer taxes.

17 Four Pillars

Do you believe it’s likely for a 20-stock dividend portfolio to cut net distribution by even a mere 5%? Not likely.

No, I don’t think this is likely but I also don’t think a 90% decline in equities is likely either – but it did happen (in 1929).

All Bernstein’s retirement scenarios involve being able to weather the roughest storms – if you don’t think those rough storms will ever happen again because of better financial management by governments then you can ignore his advice and take out a higher percentage of your portfolio.

If the economy is bad enough then companies en masse will be cutting their dividends – do you think the banks raised their dividends during the great depression? Again, no I don’t think this is likely but it could happen.

Huh? To maintain the appropriate asset allocation is even more detrimental to your cash reserve. So if the market is down 50% after the first year, you’ll funnel your 4-year (remaining) cash reserve to buy even more equity in order to rebalance your asset allocation?

You don’t have to rebalance every year – in the case of a major decline of 50% I would do the following (note that this is MY interpretation)
1) Reduce spending – this would reduce the cash cushion necessary.
2) Rebalance, but keep my cash cushion – note that this might mean not keeping your former asset allocation.
3) Say a few prayers to the financial gods :)

18 FinancialJungle

>>”No, I don’t think this is likely but I also don’t think a 90% decline in equities is likely either – but it did happen (in 1929). All Bernstein’s retirement scenarios involve being able to weather the roughest storms”

This is starting to open up a can of worms. :)

It sounds real good on a paper/book to say build an armoured portfolio that can weather the roughest storms, but that doesn’t translate well in the real world, especially for ETF investors. Someone who’s preparing for a 90% drop must allocate nearly the entire portfolio to government bonds, which don’t boost real value after-tax and after-inflation, and have to work well pass 65 in order to save for a larger nest egg.

If you want to retire at 65 or sooner on a normal salary, it’s not possibly to elimate all conceivable risks, in my opinion. You “pick your” battle by ranking all the risks in the order of probability and attack them one-by-one starting from the most probable. What are the top risks?

1. Market volatility – Having my retirement at the mercy of short-term market volatility isn’t an ideal retirement for me. Short-term can mean 5 years.

2. Inflation – Even if the bear market comes out even after 5 years, inflation would’ve push all prices up by 16%. Receiving the $40k after 5 years is a reduction in quality of lifesytle.

3. Taxes – One can invest mostly in government bonds to weather a recession storm, but interest income from bonds is much higher than dividend. You solve an improbable problem by creating a guaranteed problem.

(last). Great recession. The cost of embattling your portfolio to fight a great recession is so great that it’s not worth it (for ETF or dividend investors), unless you’re willing to grind along in your golden years.

19 Four Pillars

One point about the 1929 crash – Bernstein uses that as a ‘worst case’ scenario when he talks about someone who is retiring and encounters a bear market early in their retirement.

He said that if someone who was invested in equities and retired at the peak of the market would have been fine as long as they cut back on their withdrawals significantly and didn’t sell any of their equities. If they had sold their equities then they would have eventually run out of money but if not then they would have ended up doing really well because eventually equities recovered quite well.

Anyways, all I can say is read the book because his advice is not intended to be perfect or to protect against the worst case scenario – but rather to give you a better chance to survive it.

He’s not even consistent in his books with respect to rebalancing because he (and Malkiel for that matter) talk extensively about buying equities when they are doing poorly (ie after a big crash) so they are not 100% about passive management in that respect.

Mike

20 FinancialJungle

I suppose dividend investors can also cut back on spendings during a great depression.

Okay. Let’s just leave it as that. Nice chatting with you, Mike. Cheers. :)

FJ

21 john

My rule will be to simply take out the dividends the portfolio generates (minus any taxes due)

That will be a bit less then 4% in my case but I will likely never run out

To the extent that most of my investments are dividends then my withdrawals will grow (fall) as the companies I have chosen increase (cut) their dividends

22 Four Pillars

FJ – let’s call it a draw!

John – that’s not a bad strategy but the problem is that you could assemble a portfolio of very high yielding stocks ie average yield of 6% or higher if you chose.

Mike

23 Dividends4Life

Excellent post! Thanks for sharing it. I plan to include your article in my weekly carnival review this Friday.

Best Wishes,
D4L

24 john

Mike

Someone building a portfolio today would definitely get a good % return of dividends.

My “outside the RRSP portfolio” was a self made clone of XDV put together over the last few years when prices were high and dividends were low.

Based on my current market value my dividend rate is way up but that is a the cost of all the capital gains I have lost since the Oct 31 2007 market crash))))

If the market drops another 20% my dividends will be approaching 8%))) (but in reality the absolute $$ value paid each year remains the same)

John

25 Four Pillars

D4L – thanks!

John, you are right – now might a great time to assemble a portfolio.

Mike

26 Jon Monson

Obviously I don’t understand how to apply the 4% rule. If you withdraw 4% of your portfolio (dividends, interest, withdrawals), market yield would have to be no more than equal inflation (say 3%), for your money to run out in 25 or so years.
Balance – withdrawal + income
year one: $100,000 – $4,000 + $3,000 =
year two: $ 99,000 – $4,120 + $2,970 =
year 3 : $ 97,850 – $4,244 + $2,936 =
Help.
Jon

27 Four Pillars

Jon – I believe that the 4% rule assumes that the total real return will be greater than 0% ie 3 or 4%. If the real return is only zero then you would eventually have to cut down the withdrawals because starting at 4% would be too much.

Mike

28 Tim

Why not take all the guess work out of it and buy a life insurance policy and an immediate annuity to boost your income for life? If you have a portfolio of 500,000 and life insurance in retirement of 500,000 you could put your account into an immediate annuity to receive an income much higher than 4% that you cannot out live. The life insurance protects your spouse from premature death so you can get the higher payout. Just like options on your pension, having the life insurance gives you the permission to take the highest payout while you and your spouse are enjoying retirement. If you predecease your spouse the life insurance will refill the account for his/her use. No market risk.

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