If there were a college course on Retirement Planning 101, its core concepts would include safe withdrawal rates and sequence risk.
Why? Because safe withdrawal rates help you answer two critical questions for retirement planning. First, how much do you need to save for retirement? And its close cousin: how much can you withdraw every year in retirement, without worrying about running out of money?
Here’s the retirement lesson you never learned in college, to help you plan a long, stress-free retirement.
What Are Safe Withdrawal Rates?
If you retire at 65, and want your nest egg to last for at least another 30 years, how much can you pull out every year?
In 1994, financial planner Bill Bengen released a groundbreaking study that answered that very question. He analyzed half a century’s data, and found that if retirees withdrew no more than 4% of their nest egg every year, in no scenario would they have run out of money in less than 30 years.
His finding became popularized as the “4% Rule.”
For his data, he assumed that retirees had 60% of their nest egg invested in a fund tracking the S&P 500, and 40% of their money in intermediate-term US government bonds.
And it makes sense: if your annual returns average in the 7-10% range, and you pull out 4% each year, your nest egg will likely grow faster than you’re withdrawing money. Even after adjusting for inflation.
Inflation and Cost of Living Increases
Bengen did account for inflation and cost of living increases. He assumed a 2% increase each year in the annual withdrawals, to compensate for inflation.
Thus, it’s only the first year of retirement that the withdrawal equals 4% of the nest egg.
Imagine you retire with a million dollars saved and invested. In your first year of retirement, you withdraw $40,000 – 4% – to live on.
The following year, you withdraw $40,800 to live on, giving yourself a 2% cost-of-living raise.
Keep in mind, your nest egg in the second year may be $1,100,000, or it may be $800,000, but you still withdraw $40,800. Your withdrawal is based on 4% of your starting balance, plus a small inflation increase.
How Safe Withdrawal Rates Help You Calculate Your Retirement Savings Target
If you can safely withdraw 4% of your nest egg every year, then you know exactly how much you need to retire.
How? By multiplying your annual spending by 25.
The math is simple: 4% x 25 = 100%. Consider the example above: just as a 4% withdrawal rate suggests you can withdraw $40,000 if your nest egg is $1,000,000, the inverse is that if your annual spending is $40,000, you need a nest egg of $1,000,000.
This inverse is known as the 25X Rule: your annual spending multiplied by 25 is how much you need to save for retirement. If, of course, you’re following the 4% Rule – which not everyone does (more on that shortly).
Granted, you may receive income from sources other than your investments. Perhaps you’re eligible for Social Security benefits, or perhaps you earn income from royalties or rental properties or some other source.
If your annual spending is $40,000, but $15,000 of that will be covered by Social Security or other income sources, then your necessary retirement savings will shrink considerably. The annual income you need from your nest egg drops to $25,000, which multiplies by 25 to mean a target nest egg of $625,000.
That then becomes how much you need to reach financial independence.
How Long Does Your Nest Egg Need to Last?
Bengen based his calculations on a 30-year retirement. But what if you plan on a 15-year retirement?
How about a 50-year retirement?
The math changes. Professor Wade Pfau at The American College demonstrates how a 6% withdrawal rate will not cause your nest egg to run out of money in under 15 years (assuming a 50/50 stocks/bonds asset allocation). He goes on to show that a 5% withdrawal rate has a 99% chance of leaving your nest egg intact for at least 20 years, and an 85% chance of surviving at least 25 years.
If you want to retire young, let’s say at 40, and want your nest egg to last another 50 or 60 years, you’ll need to withdraw less.
Financial planner Michael Kitces shows that 3.5% serves as a “forever” safe withdrawal rate. In other words, if you withdraw no more than 3.5% of your nest egg every year, then your nest egg should theoretically keep growing forever.
These numbers change your retirement calculations. If you only plan to live for 15 years after retirement, and can withdraw money at 6% each year, then you can multiply your annual spending by 16.67 to reach your target nest egg.
By contrast, if you plan to live for another 50 years after retiring, then you’re limited to a 3.5% withdrawal rate, which means you’ll need to multiply your annual spending by 28.6 to discover your target nest egg.
Tips to Make Your Nest Egg Last Longer
Sure, “spend less” is good advice, and a staple of financial literacy. But what else can retirees do to maximize their chances of a wealthy retirement?
Bear in mind that the first few years of retirement are your most vulnerable, financially speaking. That may sound counter-intuitive; after all, your nest egg is likely to be large and healthy when you first retire!
But new retirees are vulnerable to something called sequence risk, or sequence of return risk. In short, it’s the risk that the stock market crashes shortly after you retire.
Why does that matter?
If the market crashes right after you retire, then withdrawing 4% of your original nest egg may look more like 7% of your nest egg, after the market crash. You have to sell more stocks to produce the same amount of income.
You don’t benefit from the lower stock prices, because you’re not buying. A stock market crash becomes all downside for you.
When the recovery comes around, you’ll have far less than when you started, because you’ve had to sell of stocks at a faster pace.
Retirees can mitigate sequence risk by keeping their spending – and even their income – flexible. If the market crashes, can you slash your spending so you rely more on Social Security, and less on selling off stocks?
Or perhaps you can even go back to work, even if it’s part-time or doing something fun that doesn’t pay particularly well, but still helps you avoid selling off stocks while they’re down.
Your Retirement Planning Is Unique
Where can you play around with these retirement calculations?
For that matter, how much do you need to invest every year in order to build your target nest egg?
Our more-than-just-retirement calculator will help you plan out exactly what you need to save for retirement. Your target nest egg, and your monthly contributions to retirement accounts.
Sure, the 4% Rule is a simple and effective rule of thumb. But as pointed out above, your personal safe withdrawal rate depends on how long you plan to live after retiring. A post-retirement lifespan of 30 years is not a one-size-fits-all estimate.
Also remember that the younger you are, the less you can count on Social Security. Social Security benefits in real dollars have been shrinking, even as Americans rely more on Social Security in retirement. Social Security benefits may look very different by the time you reach retirement age, if you’re in your 30s.
Go beyond financial literacy, and develop your wealth literacy by taking control of your own retirement planning. It’s not as scary as it seems, and the more you invest today, the younger you can retire!