Retiring During A Bull Market: What’s A Safe Withdrawal Rate?

The old 4% drawdown formula is now hazardous. Try 3%.

Lucky you, to be retiring today, when your retirement assets are so richly valued. But not as lucky as you think. Rich stock and bond prices help only so much.

The big question for someone living off savings is how much can be safely pulled out every year. The old rule of thumb was 4%: If you had $1 million in your IRA, you could spend $40,000 the first year and kick up the annual withdrawal just enough to match inflation. At that rate you probably wouldn’t outlive your assets. Such a conclusion could be reached by looking back at stock and bond returns over the past century.

But now, with asset prices high? When prices are high, it’s easier for them to fall and harder for them to keep up with the cost of living. That changes everything.

We are living in strange times. Yields on bonds are abnormally low—indeed, for safe Treasury bonds, yields scarcely top the rate of inflation. Earnings yields are stocks are abnormally low, too. That is the same as saying that price/earnings ratios are high.

Who knows why this is. It could be that investors are irrationally exuberant, or that the globe is awash in savings, or that the Federal Reserve is tossing dollars out of helicopters. Whatever the cause, it complicates the matter of safe withdrawal rates.

Stock prices have doubled in the last seven years. That helps, since you will be selling stocks as you age. But it doesn’t leave you in a position to double your spending.

To see why, imagine that your sole investment asset is a nice rental property. The real estate generates, say, $30,000 a year of rent after expenses. Suppose that last year the building was worth $500,000 but that now, amidst real estate euphoria, it’s worth $1 million, even though the rental income is no higher. Are you better off?

Yes and no. If you are about to sell the building and use the proceeds to acquire a sailboat, you are better off by a factor of two. If, on the other hand, you’re planning to hold onto the real estate and cover living expenses with the income from it, you are no better off at all.

A new retiree sitting on a pile of stocks and bonds is midway between those extremes. If your assets need to last you 30 years, but not forever, you are half landlord and half sailor. Like a landlord you are earning a current return on your assets, and that current return drives a lot of your spending power. But you are also, like the sailor, selling off a little of the property every year, and property prices matter for that.

In November 2013 the S&P 500 index hovered around 1,800, and index earnings came to $100 for the year. The index has climbed to 3,600 but earnings are down, to an estimated $94 for 2020. That equates to a current earnings yield of 2.6%, down from 5.6% in 2013. The earning power of equity capital is meager, and that makes for meager future returns in the stock market.

Yes, earnings will rebound a bit with the arrival of vaccines and the resumption of a normal economy. But they won’t double next year. They will remain small in relation to today’s stock prices.

The story is the same in fixed income. Yields on long-term Treasuries (1.6%) are a bit less than half as high as they were seven years ago (3.8%). If you bought some of those bonds in 2013 you’re looking at a handsome gain in their value, but this gain does nothing for the interest coupons on the bonds. If you are trying to live on the interest without dipping into principal, you are no better off.

Your IRA statement probably says that you are twice as rich as you were in 2013. Nice, but don’t get carried away. The percentage of the account you can spend annually has gone down. That is the consequence of low bond yields and low stock earnings yields.  

What’s a safe withdrawal rate now? That’s a matter of debate. A 3% draw seems defensible; at this level, I think, you can afford to give yourself raises to keep up with the CPI. It’s appropriate for a newly retired 67-year-old who might live to 97, or whose spouse might live until 2050.

That is, a $1 million account, somewhat conservatively invested 60% in stocks and 40% in bonds, is good for $2,500 a month to start. If inflation comes to 2%, you can step up to $2,550 a month the second year.

You could go higher than 3% if you knew there wouldn’t be any stock market crash early in your retirement, and if you also knew there wouldn’t be any burst of inflation between now and 2050. But you can’t know either of these things.

You could also go higher if you were emotionally equipped to cut your spending during a crash in stock or bond prices. Belt-tightening would protect more of your principal from the irrecoverable damage of selling in a down market. Not everyone is so equipped.

Related: Expected Returns 2020-2040

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