Retire at the Coffeehouse: Chapter 1: Safe Withdrawal Rate

» bob90245 - Chapter 1: Safe Withdrawal Rate

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After reading a few books and numerous articles on the subject (listed below), I have a deeper understanding of what’s involved with withdrawing from a retirement portfolio. This article and the articles in this series will go into great detail with many examples.

Historical Rates of Returns

The first step to understanding the process is to make reasonable assumptions about rates of return. In the next few chapters, I will review historical rates of returns for stocks, intermediate-term bonds (5 years), cash and inflation. Briefly, these can be summarized with approximate numbers:

Large-cap stocks 11%
Small-cap stocks 12%
Bonds 5%
Cash 4%
Inflation 3%

Growth Rate for a Balanced Portfolio

A reasonable assumption for a balanced portfolio would be as follows:

• Have 50% in stocks with an expected average rate of return of 10%.
• Have 50% in fixed income (bonds and cash) with a combined expected average rate of return of 4%.

With these assumptions, a balanced portfolio can roughly achieve an overall average rate of return of 7% calculated as follows:

50% stocks x 10% = 5%
50% fixed income x 4% = 2%

So adding 5% return from stocks plus 2% return from fixed income would generate an overall average return of 7%.

Calculating a Withdrawal Rate

So now we have two key numbers. First, if we want our nest egg to keep pace with inflation, it must grow each year by 3%. (This assumes that your expenses will grow more or less in line with inflation. This topic can get very complicated. For example, health care expenses might grow much faster at a later stage in retirement. But for the sake of simplicity, I will use 3% in order to demonstrate this example.)

Second, we have assumed that our nest egg can grow at an average annual rate 7%. The difference between the average growth rate (7%) and the average inflation rate (3%) is what we can safely withdraw (4%).

Written as a formula:

Initial withdrawal rate =
(Portfolio average annual growth rate) – (Average inflation rate)

As I will show in the following chapters on historical returns, we can expect stocks to experience good years and bad years. So we need to be smart about how we take withdrawals from the portfolio. This is because withdrawing from declining stock funds can deplete your portfolio sooner than necessary. I explain this concept of “reverse dollar cost averaging” in this article.

How Large Should Your Retirement Nest Egg Be?

The answer may be shocking and surprising. Let me give you this example. (I’m assuming no other sources of income such as pensions or social security). If we withdraw 4% from the portfolio each year and we want to spend $40,000 in the first year of retirement, then the retirement nest egg will need to be $1,000,000. That’s right, a million dollars! Here’s the math:

$1,000,000 x 4% = $40,000

Alternatively, you will need 25 times the first year’s amount you require from your nest egg. 25 is the inverse of 4%.

Further Reading

In contrast with the large number of books written on how to accumulate a retirement nest egg, there are precious few books written on a strategy showing how to withdraw money from your nest egg and make it last your lifetime. And none really satisfies me in a way that I can fully recommend. This is the motivation for me to write these articles. There are many pieces of the puzzle from many different books and internet articles. And it’s taken me a long time to make all the pieces from these many sources fit together in a manner that I can be comfortable with. With that said, here are three books. Some ideas I found useful, some not so useful.

The Grangaard Strategy: Invest Right During Retirement by Paul A. Grangaard

Plan Right for Retirement With the Grangaard Strategy by Paul A. Grangaard

Buckets of Money : How to Retire in Comfort and Safety by Raymond J. Lucia

You can read many different articles on this subject at this link.

http://www.suite101.com/discussion.cfm/i...

In the next few chapters, I will review historical rates of returns.

-- posted by bob90245