I haven’t talked about safe withdrawal rates (SWR) in a while. For earlier discussions on what the SWR is on how to use it in retirement see the series of posts here . The SWR basically determines what is the maximum a retiree can withdraw from their portfolio every year and make sure the portfolio lasts through their entire retirement. One of the harder parts of implementing the SWR is making increases in withdrawals at times when the value of the portfolio is heading down. It often takes immense emotional fortitude to trust in history and increase spending in a given year a portfolio just took a 20%+ dive, as happens quite often in markets. After all, the past is no guarantee of future results. Which makes you wonder if there is an early warning indicator for a retirement portfolio that can help a retiree determine if adjustments to spending are necessary? There is such an indicator and its called the current withdrawal rate (CWR).
The SWR represents the percentage of a retirement portfolio withdrawn in the first year of retirement which is then adjusted annually for inflation. The current withdrawal rate would be the dollars withdrawn in a given year divided by the current portfolio value. For example, assume the SWR for a retiree is 4% and the initial portfolio value is $1M. Year 1 withdrawals would be $40K. Also, assume in year 2 inflation is 5% and the portfolio increases by 5% in that year. Year 2 withdrawals are $42K and thus the current withdrawal rate (CWR) in year 2 stays at the same 4% ($42K/$1.05M). All good. Alternatively, if inflation is 5% and the portfolio declines 10% in year 2, the the CWR would be 4.7% ($42K/900K). The retiree would just trust in history, that future returns will more than compensate for short term setbacks and keep living the same lifestyle. The key question is is there a level of CWR that spells trouble?
Lets look at three historical retiree portfolios and their experience with CWRs. The table below shows 3 retiree portfolios; an Oct 1964 retiree, a Jan 1971 retiree, and a Jan 1975 retiree. It shows their respective CWRs in year 1 (in year 1 the CWR is equal to the SWR), 5, 10, 15, and 30.
Source: Conserving Client Portfolios During Retirement – William Bengen
The 3 retirees had quite different experiences in retirement. All 3 began with SWRs of 4.8%. By year 5, the results started to show some big differences. The 1971 retiree saw a huge jump in their CWR to 8%! Almost doubling. This means in real terms their portfolio almost dropped by half. Talk about gut wrenching. However, those were the darkest days for the 1975 retiree. From year 5 on out to year 30 their CWR dropped back to 4.6% and they lived happily ever after. The 1975 retiree had it really easy. They never saw an increase in CWR through their entire retirement. Then there is the 1964 retiree. The first 5 years were ok then things started to head south. By year 10, the CWR was 7% and by year 15 it had climbed to 9% and by year 30 it reached 13%. Truly frightening. And yet this shows the power of the SWR. Even with the awful performance of the 1964 retiree’s portfolio, the portfolio survived for 30 years and is still going. The experience probably did not meet their expectations and surely they do not have as much wealth to pass on as the other retirees but the 1964 retiree was able to maintain their lifestyle which after all is the main goal of the SWR. But they are awfully close to the complete exhaustion of the portfolio. Its seems to be cutting it awfully close. Somewhere before a CWR of 13% some changed would probably have been in order. The CWR can serve as a great indicator as to how the retirement plan is going and can be used as a basis to make retirement changes.
In summary, the CWR is a great indicator as to the health of a retirement portfolio. A portfolio can sustain quite an increase in CWRs from the initial SWR. Increases of 25% to 50% is not anything to be overly concerned about. While these results are still clearly dependent on history it seems to me that increases above 50% in the CWR could be used as early warning indicators for a retirement portfolio. A retiree could then make adjustments in lifestyle or adopt other withdrawal methods to assure the portfolio lasts trough retirement.