Creating A Safe (but Flexible) Retirement Withdrawal Strategy

For the past 20 or 30 years you have saved and saved and probably have seen your accounts get steadily higher throughout the years.  Saving isn’t easy, but creating a withdrawal strategy may be even more difficult.  It isn’t easy seeing your life savings gradually start to go down.  Maybe you are nervous about taking money out and exhausting it too quickly.  At the same time, you need to feel comfortable withdrawing enough that you are able to enjoy retirement.  Having (and sticking to) a withdrawal strategy will help you feel confident that your assets will last in retirement.  There are really two main decisions that you will need to make with your withdrawal strategy:  

  1. How much can I safely withdraw each year?   
  2. From which accounts should the distributions come from?  

This article addresses how much you can safely withdraw each year.

A Safe Withdrawal Rate

You have probably heard the rule-of-thumb that you can take out 4% per year from your retirement accounts and you will be safe. Withdraw 4% per year and you won’t run out of money before you die. This assumption is that you take out 4% from your starting balance, and each year increase the distribution by the inflation rate.  For example, if you have a $1 million retirement account, you can take out $40,000 the first year.  If inflation during the first year is 3.5%, the distribution during the second year is moved up to $41,400.  This assumes a 30 year retirement time frame and assumes a consistent 60% stock and 40% bond portfolio.  Michael Kitces from has done some incredible research on this topic and much of the content below is from his research.  I suggest checking out his website for more information on safe withdrawal rates.  

So, how did this 4% safe withdrawal rate become the king of all financial rules of thumb? William Bengen published a paper in 1994 titled “Determining Withdrawal Rates Using Historical Data”. The paper explains that during the worst 30 year period in the stock market a person could still safely withdraw 4% per year and not exhaust their assets given a 60% stock/40% bond strategy.  If you are curious, retiring in 1966 would have been the worst time financially to have ever retired, but we are still too early to tell how those people who retired in 2007 will fare.  

If you have thought to yourself that a 4% distribution rate seems low, you would be right. The median safe withdrawal rate over a 30 year period is actually closer to 6.5%.   The problem is that you don’t know what 30 year period you are about to encounter. Therefore, the very safe 4% withdrawal rate is used although it is the extremely lazy approach to creating a withdrawal strategy.  There are only 4 times in the past 100 years in which the 4% rule would result in less money at death than when retirement started.  In fact, on average the 4% withdrawal rate would result in 2.8 times more money at death than when the individual started retirement! If your goal is to maximize your kids inheritance, than the 4% rule is great.  If your goal is to maximize your retirement income, which should be the goal, than the 4% withdrawal rate is too conservative.

While you were working you probably had good and bad years in which your income fluctuated.  The financial crisis in 2008 caused many companies to cut bonuses, eliminate raises, and maybe even lower base pay.  When that happens most people will tighten their belts and spend less money. Maybe families forgo the tropical vacation, spend less on Christmas gifts, or wait to purchase the new car.  Retirement should be no different.  In retirement you will rely on your investment income much more than prior to retirement and you will experience a lot of market ups and downs in retirement.  Ultimately, if you can be flexible on your distributions, you can maximize your income much greater than just taking out 4% of the starting account balance  

The Flexible 5% Withdrawal Strategy

Instead of the 4% withdrawal rate, I use a Flexible 5% withdrawal strategy. This strategy starts off with a 5% withdrawal rate for the first year of retirement. This is just the starting point though and by remaining flexible we are able to withdraw more than the 4% safe withdrawal rule.  Each year I will look at my clients accounts and sometimes we have to make changes based on their account balance.  If the account balance drops 15% from the starting account balance, we will reduce their income by 10%.  If the account drops by 25% from the initial account value we drop the distributions by 20%.  For example, if a person starts with $1 million in invested assets, we start out with a 5% starting distribution which is $50,000.  If because of distributions and investment performance the accounts drops to $850,000, we will reduce the distributions by 10%, to $45,000 per year.  If the account drops to $750,000, we will reduce the distributions to $40,000 per year.  If/When the account rebounds, we then raise the distributions back to where they started. Ultimately, this causes you to withdraw less when the stock market is low and when the stock market rallies, it will be easier to catch up and raise your distributions back to where you started.  

You also probably remember (maybe less) those really good years of your career.  A promotion which causes a pay raise, a great sales year which causes a bigger bonus, etc. Retirement should be no different.  Although we tend to remember the market crashes more than the really good years in the market, if the stock market looks like it has over the past 70 years, there will be more good years than bad years.  In those good years you deserve to give yourself a raise. Using the same formula as before, if your account balance increases by 15% from the initial account value, you should feel comfortable giving yourself a 10% pay raise.  If your account grows by 25%, a 20% pay raise is in order.  Using the same example as above, if your account grows from $1 million to $1.15 million, you would give yourself a pay raise from $50,000 to $55,000.  If your accounts grow to $1.25 million, another $5,000 pay raise is in order.  Again, the goal in retirement shouldn’t be to maximize your kids inheritance.  Celebrate the fact that you are doing well financially and take a little more out for a vacation or to splurge on the grandkids.  

Here is a quick recap of the Flexible 5% Withdrawal Strategy:

  • Start off by withdrawing 5% of your total savings
  • Lower distributions by 10% (of starting distribution rate) if your total savings drops 15%
  • Lower distributions by 20% if total savings drops 10% more (25% total)
  • Raise distributions by 10% if total savings increases by 15%
  • Raise distributions by 20% if total savings increases by 10% more (25% total)

An example of the Flexible 5% Withdrawal Strategy

Year Account Value (Start of Year) Yearly Distribution
2006 $1,00,000 $50,000
2007 $1,150,000 $55,000
2008 $1,150,000 $55,000
2009 $750,000 $40,000
2010 $800,000 $45,000
2011 $850,000 $45,000
2012 $850,000 $45,000
2013 $900,000 $50,000
2014 $1,050,000 $50,000
2015 $1,150,000 $55,000

This is an example of what your account might have done over this 10-year time frame. Yes, you are changing your yearly distributions on a fairly regular basis, but your distributions are quite a bit higher than simply taking out 4%, or $40,000, per year.  If you are willing to be flexible, this strategy will allow you more income over the long-run.  

If you want a steady stream of income that never changes and reduces your distributions but also the risk of running out of money, the 4% rule may be fine for you.  I find the 4% withdrawal to be a too conservative rule.  Why limit your distributions because one time in history taking withdrawals over 4% would have resulted in running out of money?  Yes, it is a safe withdrawal rule but it is too conservative in my mind as long as you are comfortable being flexible.  The truth is that you are probably already comfortable being flexible with your income, and this shouldn’t be any different in retirement.  Ultimately, having a flexible withdrawal strategy will result in quite a bit more income for you and a more comfortable retirement.

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