What you need to know about safe investment portfolio withdrawal rates.
Recently, Dave Ramsey, a radio personality who gives financial advice without a securities license, told his 20 million listeners that 8% was a safe investment portfolio withdrawal rate for retirees. He explained his reasoning like this, “If you’re making 12 (percent) in good mutual funds and the S&P is averaging 11.8%, and if inflation for the last 80 years is 4%, if you make 12 and you need to leave 4% in there for average inflation raises, that leaves you 8. So, I’m perfectly comfortable drawing eight. But if you want to be a little bit conservative, seven. But, sure, not five or three.” And Ramsey didn’t stop there, he added that, an investor with a $1 million stock portfolio should be able to withdraw $80,000 each year, “forever” without destroying the nest egg. To top it off, Ramsey called the proponents of the 4% rule, “goobers and supernerds who have spent far too many hours in their moms’ basements studying safe withdrawal rates”.
Ramsey’s comments caused an uproar among financial advisors, many of whom swear by the “4% rule”, a concept initially introduced by Bill Bengen in four papers that appeared in the Journal of Financial Planning from 1994 through 2001 and later in his 2006 book, “Conserving Client Portfolios During Retirement”.
Unfortunately for Ramsey, financial advisors aren’t the only ones who “study” safe withdrawal rates. Industry giant Morningstar recently published its annual State of Retirement Income report for 2023, (https://www.morningstar.com/retirement/good-news-safe-withdrawal-rates). According to the report, the highest safe starting withdrawal rate for retirees spending from an investment portfolio is 4.0%. The report also states that there is a 90% probability a retiree will have still have funds remaining at the end of 30 years.
The debate has been entertaining, but it also emphasizes the significance a withdrawal strategy plays in determining the rate and the amount of portfolio distributions during retirement. Here’s what you need to know:
- It’s not about the withdrawal rate, it’s about the strategy
Although the safe withdrawal rate is an important consideration, it shouldn’t be the sole focal point of the discussion. Rather, investors need to determine if they want their retirement portfolio to have long-term sustainability. If they are indifferent, they can approach their withdrawals in any manner they prefer. However, if they want to prolong the life of their investment portfolio, they should work with a knowledgeable professional who understands Bengen’s research, stays up to date on the latest papers published on the subject and employs process for structuring sustainable investment portfolios. - What Bengen’s taught us
In his research, Bengen employed “actual historical investment returns and rates of inflation to test assumptions about withdrawal rates, asset allocation, portfolio longevity (and other variables)”. The purpose of his work was to generate a process that will “sustain withdrawals from a client’s portfolio during retirement (he used a 30-year retirement as his assumption), while minimizing the risk of exhausting that portfolio prematurely”. - If you want to make an informed decision about withdrawals from an investment portfolio, you need to understand “sequence of returns”
During his research, Bengen identified the concept of “sequence of returns risk” which recognizes that an investor who retires during a period of low inflation and increasing stock prices may find that their portfolio lasts for 30 years; while another investor who retires with the same investment portfolio during a period of increasing inflation and declining stock prices could fall short of their goal for a 30-year retirement.
Exhibit 1 Sequence of Returns
Understanding the impact of a sequence of returns is critical to creating a successful retirement withdrawal plan. Sequence of returns refers to the order of returns generated by a pool of investment assets.
Exhibit 1 illustrates 20 years of actual returns from the S&P 500 Index (1989-2008) and then reverses the order of the returns (2008-1989) to illustrate the impact investment returns can have on a portfolio. As you can see from the analysis, the average compounded annual return for both sequences is 8.43%
If you look at the left-hand column of the chart (1989-2008), you will notice that during nine of the first ten years the investor earned positive returns that far exceeded any withdrawal rate that would have allowed the portfolio to grow significantly. When we reverse the same sequence of returns in the right-hand column (2008-1989) you see that during four of the first ten years the investor earned negative returns, beginning with a 37% decline in value the first year. The sequence of returns would have created substantial pressure on a portfolio that was already undergoing the stress of systematic withdrawals.
Title: Exhibit 2 Sequence of Returns Effect on Portfolio Distributing 5% Inflation-Adjusted Annual Withdrawals
Using the same returns as the chart in Exhibit 1, the chart in Exhibit 2 illustrates the effect the sequence of returns would have on the value of a hypothetical retiree’s investment portfolio.
The chart in Exhibit 2, assumes that an investor is withdrawing 5% per year from a $1 million retirement portfolio (performance represented by the S&P 500 Index). The retiree withdraws $50,000 in the first year and that amount will be increased by the change in the Consumer Price Index (CPI-U) each year (3.05% average for the period). As you will see in the chart, over 20 years in retirement, the 1989-2008 sequence of returns (shown in dark blue) supported the retiree’s withdrawals while allowing the portfolio to grow to over $3 million in value, even after a challenging year in 2008.
When we reverse the performance results using the 2008-1989 returns (shown in light blue), the results are dramatically different. The negative performance in year one followed by negative investment returns in years seven, eight and nine, dramatically reduced the portfolio value to just over $235,000 by the end of 20 years.
Using a fixed withdrawal approach like the one Ramsey recommends is problematic in two ways. First, if an investment portfolio has produced an average return of 12%, that does not mean it returns 12% every year. It means that some years it’s more than 12% and others it’s less than 12%. It is an average. Second, his approach doesn’t make allowances for adjustments that should be made to spending during declining or bear markets.
Given the reality of increasing life expectancy, it is imperative for investors to adopt a retirement withdrawal strategy that is based on extensive research. It is highly advisable to seek assistance from a qualified financial advisor who can provide expert advice in a professional setting.
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