The 4% safe withdrawal rate might not be so safe anymore. After a huge run-up in the valuations of both stocks and bonds since the coronavirus crash of March 2020, expected returns for both asset classes are much lower than they used to be. When retirees can’t count on their portfolios returning as much on their investments without additional risk, they need to accept a lower withdrawal percentage every year.
Morningstar suggests the safe withdrawal rate for a 30-year retirement is just 3.3% for a portfolio made up of 50% stocks and 50% bonds based on its expected returns and volatility of the asset classes. Here’s why that’s considered safe, what investors can do to increase their withdrawal rate, and what investors should avoid.
Adjust your expectations
Morningstar expects a well-diversified portfolio of stocks consisting of mostly large-cap stocks with a few small caps and foreign stocks will return about 8% per year before adjusting for inflation. That’s substantially lower than the 10.7% average returns the stock market has provided over the last 30 years.
A portfolio of bonds, composed primarily of investment-grade U.S. bonds and a small amount of foreign bonds and U.S. Treasuries, will return less than 2% per year. That return comes with significantly less volatility than stocks. Consider, however, that fixed-income assets historically return over 5%, according to Vanguard.
Combined, a 50-50 portfolio will return just over 5% per year, according to Morningstar’s analysts.
Yes, that’s above the 4% many retirees are banking on to be able to safely withdraw from their portfolio every year. But average returns are just half the equation. Retirees also have to plan for the expected volatility of their portfolio.
The analysts expect the standard deviation for annual returns on a 50-50 portfolio is 8.8 percentage points. So, for any given year, investors should expect the return of the portfolio to be worse than minus 3.5% about one-third of the time. A few bad years in a row, especially at the start of retirement, could put you into ruin if your withdrawal rate is too high.
Therefore, Morningstar only expects a 4% withdrawal rate to last 25 years 90% of the time. To make it a full 30 years, you’d have to drop to 3.3%.
How to increase your withdrawal rate safely
If a 3.3% withdrawal rate on your portfolio won’t meet your needs in retirement, you have a few options to improve that rate.
One thing you should not do, however, is chase returns by allocating more capital to stocks. While a greater allocation toward stocks will increase your expected returns over time, it comes with greater volatility. Therefore, the risk of an extended decline in portfolio value increases. While there may be some areas of the market currently presenting greater risk/return potential right now (like value stocks), the volatility of those asset classes is still significantly higher than bonds.
Indeed, the safe withdrawal rate for portfolios with higher allocations toward stocks is actually lower than the 50-50 stock/bond portfolio, according to Morningstar’s research.
One of the simplest ways to adjust your initial withdrawal rate higher is by foregoing inflation adjustments after years when your portfolio declined in value. This creates a permanent reduction in spending power when it happens, but the good news is that it raises the starting safe withdrawal rate to 3.76%.
A better option, but one requiring more work and planning, is called the guardrails method, where a retiree starts with an expected safe withdrawal rate and adjusts that amount by inflation every year. If, in any given year, the actual withdrawal rate falls to less than 80% of the initial withdrawal rate, the retiree adjusts the withdrawal upward by 10%. Likewise, if the actual withdrawal rate climbs above 120% of the initial withdrawal rate, the amount is cut by 10%.
For example, if a person retires with $1 million and starts with a 4% withdrawal rate, they’ll take $40,000 in the first year of retirement. If inflation is 2%, they’ll adjust their withdrawal to $40,800 in year two. However, if the portfolio has climbed to $1,360,000, that $40,800 is just 3%, less than 80% of the initial 4% withdrawal rate. So the retiree increases their withdrawal amount by 10% to $44,880.
While the sword swings both ways at the start of retirement, the strategy does allow retirees to forego downward adjustments in the last 15 years of retirement while still making upward adjustments. Importantly, it allows for a starting safe withdrawal rate of 4.86% and an average withdrawal rate of 4.11% over the life of a 30-year retirement.
Using the guardrails retirement withdrawal strategy may require you to take a pay cut from time to time, but it’s ultimately a very efficient way to use your portfolio and safely use a higher starting withdrawal rate. Just make sure there’s room in your retirement budget to cut back if necessary.
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