The best way to avoid outliving your retirement nest-egg is an untimely death. Barring that, you need to take into account many factors that you can't control. The main ones are your longevity (how long you expect to draw on the funds), the expected rate of return of the portfolio and the expected inflation during this period. Churning these numbers should give you the magical Safe Withdrawal Rate (SWR): the amount of money you can withdraw from your portfolio annually (adjusted to inflation) without exhausting it prematurely.
Financial guides usually quote figures between 3% to 5%. This might sound like a small difference, but in terms of the amount you need to save, it makes a huge difference. For example, if you need $90K annually, with SWR of 3% you need a nest-egg of $3M. With SWR of 5% you'll need only $1.8M.
A simple application of high-school math (which I'll show in my next math break blog) demonstrates the connection between these variables:
- The number of years of withdrawing money (N)
- The inflation rate
- The expected portfolio growth rate
- The SWR
Next, calculate
SWR = (1 - 1/R) / (1 - 1/RN)
In our example, when assuming 50 years of withdrawals, you'll get 0.051 or 5.1%. A more conservative assumption, say of 6% growth vs. 4% inflation will lead to a SWR of about 3%.
I've calculated for you the SWR for 30 years and 50 years under different assumptions. The results are below.
For 30 years:
| Growth | Inflation | SWR |
|---|---|---|
| 3% | 3% | 3.3% |
| 4% | 3% | 3.8% |
| 5% | 3% | 4.3% |
| 6% | 3% | 4.9% |
| 7% | 3% | 5.5% |
| 8% | 3% | 6.1% |
| 9% | 3% | 6.7% |
| 10% | 3% | 7.4% |
| Growth | Inflation | SWR |
|---|---|---|
| 3% | 3% | 2.0% |
| 4% | 3% | 2.5% |
| 5% | 3% | 3.1% |
| 6% | 3% | 3.7% |
| 7% | 3% | 4.4% |
| 8% | 3% | 5.1% |
| 9% | 3% | 5.8% |
| 10% | 3% | 6.6% |
Note: even though the tables are for 3% inflation only, the SWR roughly depends only on the difference between growth and inflation. For example, the SWR assuming growth of 7% and inflation of 4% is almost the same as with assuming growth of 6% and inflation of 3%.
The important lesson from these tables is that there's no universal SWR. Your situation, your time horizon and your expectations of the economy will determine your SWR. A very conservative person will assume almost no gain over inflation, leading to SWR close to 1/N. More optimistic people may assume that historic rates of return (around 8%) will rule in the long term. My personal choice is 5% growth with 3% inflation - a very conservative assumption but one that I feel comfortable with in this economy.
In the next blog I'll describe the simple math behind this formula.
It seems like one should also try to compensate for a decade or two of no growth/decline in the stock market as these have happened historically.
ReplyDeletePerhaps there should also be some cushion added to try and compensate for a potential decade or so of bad returns immediately after retirement? Another option would be to have shifted to a much more conservative asset allocation before retirement (which perhaps is a good reason to stick with a low growth rate for these calculations).
Ben, you bring into the discussion some important points - volatility, and in particular market risk. In the long term, I believe that market forces will prevail and a well-balanced portfolio will reach the average growth numbers I listed above. Of course, that long-term may be longer than your life span (as someone once said, "In the long term, we're all dead"). But then, a sudden death will also mean you need less money :-)
ReplyDeletePersonally, I choose to stick with an average low growth estimate for my portfolio, and like you suggested, gradually move my assets to less risky funds. But including this in the calculation would have been way too complicated. At some point we have to accept that there's a limit to how much we can compute and prepare in advance - our estimates are, after all, only estimates, even if we improve them to perfection.