Selecting a Withdrawal Rate for the Long Run
Endurance runners are some of the most physically fit athletes on the planet. Growing in both popularity and intensity, endurance races can last up to a few days and exhibit runners propelling their bodies 26.2, 50, 100, even up to 240 miles in a single race.
How is this possible?
Other than these runners’ extraordinary mental resolve, the answer lies at the molecular level. Whether we’re jogging, swimming, biking, or even walking, our bodies are using one of two metabolic “engines” to produce the energy required by our muscles to function. Our aerobic engine burns a constantly regenerating supply of oxygen for fuel and is utilized at low levels of exertion. As our heart rate increases and we reach an aerobic threshold, our anaerobic engine kicks in, utilizing limited stores of glucose (sugar) for fuel. As glucose stores deplete, our bodies force us to slow down – or stop altogether – until they can return to using the more sustainable aerobic engine.
The key to endurance runners maintaining their energy levels for hours at a time is locking into a sustainable heart rate below their aerobic threshold, rarely wavering, and allowing the aerobic engine to carry them the distance.
What does this have to do with retirement?
The principle of sustainability driving an endurance athlete’s success is remarkably similar to the principle that allows for a sustainable withdrawal strategy throughout retirement. Your retirement life expectancy may be 20, 30, or even 40 years in certain situations.
While the endurance athlete seeks an answer to the question, “How can my energy last for 26.2+ miles?” the recent retiree is likely wondering, “How can my money last for 30+ years?”
How heavily will you depend on your investment assets?
Every soon-to-be or recent retiree’s financial goals and sources of funding for those goals are unique and require detailed, tailored planning. Some might expect their basic living and other expenses to be completely supported by Social Security and other sources of income (e.g. pensions, part-time employment, etc.), relying only minimally on their investment assets. More often, retirees can anticipate only modest supplementary income in retirement and must depend on their judiciously saved investment assets to provide a paycheck through retirement. Setting aside, for now, tax minimization and other planning strategies that ought to be considered in the early years of retirement, a person’s withdrawal strategy from their investment assets is one of the most important pieces of the overall plan to be considered.
How do you measure the sustainability of your retirement plan?
Savant employs a tool known as Monte Carlo analysis to measure the initial success of an investor’s retirement, projected from the year they retire until the end of their life. Using hundreds of data points – from life expectancy and itemized financial goals to anticipated retirement income, current investment assets and the tax, risk, and return characteristics – the analysis generates one thousand unique trials in order to test the strength and sustainability of the plan. In the end, the analysis delivers a single percentage number, known as the “Probability of Success.” The exercise provides an excellent overview of the initial health and sustainability of your retirement plan. However, as in most areas of financial planning, retirement planning is not a static event. These analyses include many fixed assumptions that are maintained throughout the duration of the projection, but reality often demands a willingness to be dynamic and flexible in an ongoing retirement planning and withdrawal strategy.
How can you introduce flexibility into your retirement plan?
As is the case with endurance runners, a successful withdrawal strategy must be sustainable and flexible. Endurance runners do not choose a pace and cadence at the beginning of a race and maintain it regardless of the terrain. Rather, they are constantly adapting to the environmental conditions around them. As they approach uphill stretches or as head winds pick up, they will drop their pace to remain within a sustainable heart rate range below their aerobic threshold. Likewise, as they approach downhill stretches or as tailwinds pick up, they might accelerate their pace to capitalize on the conditions. In the same way, retirees must be flexible in their withdrawal strategies as they monitor the investment environment year over year.
The 4% rule
A traditional rule of thumb for setting a withdrawal rate through retirement is the “4% Rule,” whereby the retiree withdraws 4% of his portfolio value in the first year of retirement and adjusts that value each subsequent year for inflation. While this rule is generally sustainable in static models, in reality it may fail due to its indifference toward volatile investment returns. It ignores one of the most crucial risks facing early retirees: Sequence of Returns Risk. This risk describes the unpredictability of market returns, and it is the reason that flexibility is so important when developing a withdrawal strategy.
If a retiree chooses a static withdrawal strategy, they risk over-spending in years when markets are down, thus compounding the threat of a declining – or depleted – portfolio. When the market is up, the retiree may miss out on opportunities to spend a bit more.
Therefore, it is generally more advisable to adopt a withdrawal strategy that allows for some elasticity when deciding each subsequent year’s withdrawal amount. In a 2020 paper, Vanguard suggested a 5% “ceiling” and a -1.5% “floor.” This means that in a year when a portfolio’s value increases significantly, the withdrawal amount for that year increases as well, but only up to a maximum 5% more than the previous year. Similarly, in a year when a portfolio’s value decreases significantly, the withdrawal amount for that year may only decline by 1.5% from the previous year.
Many retirees adopted a version of this strategy in 2020. As markets declined significantly due to uncertainty around the coronavirus, many decided – or were forced to – delay travel plans, eat out less, and put off major purchases. Though the strategy describes a rather intuitive behavior, it is often helpful to maintain a written rule like this to remove emotion from the crucial and ever-changing arena of retirement planning. To compare the strategies, Vanguard ran a hypothetical Monte Carlo analysis and found the static withdrawal strategy to have a 55% success rate and the dynamic withdrawal strategy to have an 86% success rate.
While the specifics of every individual’s strategy must be tailored to their unique goals and situation, the primary factor contributing to the sustainability of a dynamic withdrawal strategy is the retiree’s ability to make choices and adapt to the volatile market environment, while living primarily on the constantly regenerating interest, dividends, and market returns from their portfolio year over year.
Just as endurance runners slow down when they approach an uphill stretch and accelerate to take advantage of downhill stretches, so retirees must have the discipline to slow down the withdrawal strategy when markets decline, and have the courage – or perhaps the permission – to reap the rewards of their discipline when markets are up.
How do you define financial health?
Many endurance coaches will define physical fitness not as the ability to perform at a high level on a single day, but as the ability to wake up on each subsequent day and feel good enough do it again, and again, with an abundance of energy remaining. In the same way, while there are certainly other areas that must be considered to measure your overall financial health, financial fitness may be partially defined as the ability to achieve each of your financial goals year over year, without depleting your resources, and arriving at your life’s finish line with abundance. With the proper knowledge, preparation, and resources, this is a possibility for anyone with a plan and the discipline to follow it.
Board of Governors of the Federal Reserve System, 2017. Survey of Household Economics and Decision Making. Center for Disease Control, 2019. National Vital Statistics Report, vol. 68, no. 7. Vanguard Research, 2020, From assets to income: A goals-based approach to retirement spending.