If you’re close to retirement, a key planning question is How much can I withdraw from my portfolio annually? Or in financial planning terms, what is a safe withdrawal rate? It’s a challenging question because we don’t know future rates of return. But what we do know is that you can’t just project “average” or historical returns in a straight line and use that as your basis for withdrawals.
Unlike a portfolio in accumulation, a portfolio under distribution is greatly dependent on the order of returns. We might have a 7% average return over 30 years, but in certain rare circumstances, a portfolio under distribution could be wiped out if there were negative returns in the first handful of years. This is known as sequence of returns risk.
Today, we have several reasons to believe that future returns may be lower than historical returns. This impacts the level of withdrawal that we can safely achieve in a retirement portfolio. In my planning process, I use projected returns rather than historical returns, because I am concerned that historical returns may over-estimate the likelihood of success.
This issue is too complex to address in the space of a blog post, but I want to educate as many people as possible about the challenges of funding a retirement in a lower return environment. I have written a whitepaper on this subject and strongly encourage anyone interested in their retirement to read more:
If you’re not close to retirement, this is still a relevant issue because the amount you need to accumulate is determined on your future retirement withdrawal rate. A simple way to calculate your finish line is by multiplying the reciprocal of your withdrawal rate times your annual need.
For example, a 4% withdrawal rate (1/25), gives us a multiplier of 25. A 5% withdrawal rate equals a multiplier of 20. If your annual need is $100,000, your portfolio target would be $2,500,000 under a 4% withdrawal program. Decreasing the withdrawal rate from 5% to 4% would increase your portfolio target from $2 million to $2.5 million. And that’s why the safe withdrawal rate matters to everyone seeking financial independence.