What Is a Safe Retirement Withdrawal Rate?
Determining the Payout You Can Take from Your Investments
Back in the late 1990's, a study came out that has since been dubbed the "Trinity Study" in the money management industry. It's famous because it proved, with all academic rigor normally reserved for scientific journals, that a portfolio with a 4% retirement withdrawal rate could survive almost all economic conditions, including another Great Depression. This became the default assumption in almost all planning meetings, from small bank trust departments to large private wealth firms managing enormous fortunes that span multiple continents.
Lately, there has been a flurry of discussion in the asset management world about whether the 4% retirement withdrawal rate is acceptable anymore, with one recent study indicating that the real, more accurate figure is 3%. In other words, an investor with $1,000,000 in his portfolio is now considered foolhardy if he draws down the formerly safe $40,000 instead of the new $30,000 amount the well-heeled advisors advocate.
Who is right? Were they wrong all those years? Was 3% always the real, better number?
A Safe Retirement Withdrawal Rate Depends on the Investment Fees You Are Paying, Both Directly and Indirectly
It turns out the answer has to do with investment fees such as advisor fees, mutual fund expense ratios, and the like. The folks advocating for the lower 3% retirement withdrawal rate are often assuming that these costs run roughly 1% of net assets. That is a reasonable assumption if you have your money in financial products or you use an advisor. For inexperienced investors, that 1% fee can save them a lot of heartbreak and loss by giving them a level-headed person to talk them down from the cliff when markets have lost 30% or 50%+ of their value in a short period, which they have done, and will continue to do.
Yet, for those who are sophisticated and handle their own asset allocation, including investing in stocks or bonds directly, it creates a misleading picture. Take my own household portfolios. My investment expenses as a percentage of assets are virtually non-existant; far lower than even the cheapest rock-bottom Vanguard index funds. They are less than a fraction of a fraction of a fraction of 1%. It's because I tend to pile up cash, wait for an investment I like, buy a big block of ownership, then park it for years, even decades.
Despite being in my 30's now, I am still sitting on shares of gasket manufacturers and bank holding companies I bought back when I was a teenager or college student. Aside from an initial commission, there is practically no turnover as I choose my stocks as long-term holdings rather than short-term speculations. Thus, there are no taxes as I allow the power of deferred tax leverage to increase my net returns. My asset size is large enough I don't have to pay many of the fees a lot of other investors do, providing further economies of scale.
Many of you are in the same position. Like Jack MacDonald, Anne Scheiber, Grace Groner, or the dairy farmer I once told you about, you live frugally and buy shares of your favorite blue chip stocks, amassing wealth over time. Other than a few small custody fees, you may not be paying anything at all. I know for a fact that a decent minority of you prefer to take advantage of direct stock purchase plans and DRIPs so you hardly have any costs! (Even I have taken advantage of these in my own family, using them as a teaching tool for the youngest members.
Those of you who have never heard of them should take a few minutes to discover why I love most dividend reinvestment plans.) Being in this situation, with little or no money going to Wall Street or middlemen, a comparable size portfolio can support the higher withdrawal rate while still avoiding wipe-out risk under most conditions. That's because you get to keep the funds that were being shipped off to professionals.
Others of you are paying 2% or more and risk running out of money someday, or at the very least, experiencing a cut in your purchasing power as inflation and taxes begin to erode the value of each dollar generated.
Safe Retirement Withdrawal Rates Are Influenced By the Type of Asset Mix You Own
Another consideration is the type of asset mix you maintain. Consider an investor approaching retirement with most of her money in cash generating real estate. The rents can ordinarily be raised over time, assuming the property is in good working order and a nice neighborhood. Even if most of the rental income is spent, the property itself provides a sort of natural inflation hedge as it is appreciating in value and the rents can increase without a lot of reinvestment. Bonds are the opposite.
With a bond, you aren't going to get an increase in the interest rate you are paid, nor is the bond itself going to appreciate much absent special circumstances. Twenty years down the line, an investor heavily weighted towards bonds is likely going to have far less purchasing power than the real estate investor assuming identical cost structures and withdrawal rates.
The final verdict? It depends. For some of you, 3% is the safe withdrawal rate. For others, 4% is the better figure.