4% Withdrawal Rule
In the 1990s, a financial advisor analyzed stock and bond returns for every rolling 30-year period from 1926–1955 to the then present. The advisor found that a 60/40 mix (60% S&P 500 and 40% medium-term government bonds) would allow a retiree to take a 4.15% annual withdrawal, adjusted for inflation, for at least 30 years. The unprecedented consecutive three-year decline in the stock market starting in 2000 changed everything.
For example, consider a $100,000 55/45 (stock/bond) portfolio on January 1, 2000, that is rebalanced monthly and includes a 4% annual withdrawal rate plus a 3% increase each year for inflation (e.g., $4,000 the first year, $4,120 the second year, $4,244 the third year, etc.). By 2010, the portfolio’s value would have declined by a third, and there would only be a 29% chance of making it through three decades (source: T. Rowe Price).
Market returns during the initial years of withdrawal can have a huge impact on portfolio sustainability. Three ways to minimize such an impact are as follows: [1] use an immediate fixed-rate annuity instead of bonds, [2] use a variable annuity with a guaranteed withdrawal benefit to replace part or all of the portfolio’s stock portion, [3] use IRS life expectancy tables and portfolio value every December 31 to determine next year’s withdrawal, or [4] use stock valuations (P/E ratios) to adjust the portfolio’s equity weighting.
The shortcoming of [1] and [2] above is there may be little, or no, principal remaining with the annuity upon the owner’s death—this is fine for someone single (or married if a joint benefit option is used) if there is no donative intent. Strategy [3] means withdrawal amounts are at the mercy of portfolio returns—a $1 million portfolio and an IRS life expectancy of 23 years translate into $43,478 one year, but the next year’s portfolio may be worth, say, $900,000 and the life expectancy might be 22.4 years ($900K/22.4 = $40,179 income that year). In a similar vein, strategy [4] means increasing the portfolio’s stock portion when the market is considered undervalued (e.g., an S&P 500 P/E of 12) and reducing stock exposure when it is considered overvalued historically (e.g., an S&P P/E of 21).