Safe Withdrawal Rate (SWR) is the term that investment advisors, financial planners, and do-it-yourself investors use to represent the acceptable rate at which funds can be withdrawn from an investment portfolio while still providing a high confidence of income for the balance of a retiree’s lifetime. SWR is often stated as the percentage of an investor’s initial portfolio that can be safely withdrawn annually after retirement to cover life’s expenses.
Some advisors or planners will go so far as to advocate that today’s long-term retirees invest heavily in the stock market. Those pundits say, “A market that has never lost money over thirty-year periods won’t let you down in the future.” It’s true that there has never been a thirty-year period when stock market investors overall have lost money, yet there have been quite a few thirty-year periods that have bankrupted senior citizens who were relying upon their stock portfolios for retirement income.
Most analysts and models suggest that a retiree can withdraw 4% to 5% of the original balance each year, increased annually to cover inflation, and still have a very good chance of not running out of money. The models, however, often do not use reasonable assumptions and do not sufficiently consider risk. Generally, such high withdrawal rates relate to investment portfolios that are significantly weighted toward stocks, especially during the current and recent environment of low bond returns.
Using history since 1900 as the laboratory to assess the likelihood of success, a retiring couple who start with withdrawals of 4% have a 95% chance of success. In other words, they have a 95% chance of not running out of money before the last surviving spouse no longer needs withdrawals. For example, this represents an initial annual withdrawal of $40,000 for a retiree with $1 million, increasing the $40,000 at the start of each year by the inflation rate. By the way, about half of retirees will live past the expected average lifespan; thus the success rates are actually lower for the half of retirees in the lucky group.
A 95% chance of success sounds pretty good—on average. The 95% success rate, however, means that you have a 1-in-20 chance of having to find a job at age eighty. If you have enough money to be thinking about SWR, you likely have a lifestyle that you don’t want to compromise. When you think about last-to-survive issues, it has even greater significance.
To further emphasize the concept of success rate, assume that the doctor comes into your hospital room and says that your upcoming surgery has a good success rate: a 95% chance of success. The doctor performs this procedure five times a day. Since that’s twenty per week, how many of you will immediately hope that you will not be the one that week who does not make it.
A 95% success rate sounds good to all those who are standing around the operating table, but it is quite different for the one who is actually on the table. The patient will be thinking about his or her particular circumstances—whether the odds are more likely to be above or below the 95%. A high success rate may still represent a significant risk.
What are the implications for investors, especially at this stage of a secular bear market? For retirees who are primarily invested in the stock market, the most significant factor determining future returns is the level of valuation at the time of initial investment, as measured by the P/E ratio. So the level of the P/E at retirement has a significant impact on the individual investor’s chances of success in retirement.
To better understand the potential success rate for a couple entering retirement, stock market history can be dissected into five ranked sets called quintiles. These sets are organized from the highest to the lowest P/E ratio at the start of the respective thirty-year periods. The result is that the highest quintile (the top 20% of all periods) includes the thirty-year periods since 1900 that started with P/Es of 18.7 and higher. The second set (the next 20%) cuts off at a P/E of 15.1, the third at 12.2, the fourth at 10.4, and the last at 5.3.
Why does this matter? While the success rate for the entire group was 95%, for a retiree who enters retirement with a portfolio dedicated to stocks when P/E is 18.7 or higher, the expected success rate based upon history is 76%—analogous to more than one loss per day for the surgeon, rather than one per week using the overall average.
When P/E started at relatively high levels historically, thereby fundamentally positioning the stock market for below-average returns, there was a significant adverse impact on future success. When P/E started at relatively lower levels, returns were always sufficient for 4% withdrawals—100% success from periods that started with a low P/E.
As figure 11.2 reflects, the starting level of P/E has a direct impact on retirement success and on ending capital. The implication for today’s investor is that the likelihood of financial success in retirement is considerably less than most pundits advocate. Twenty years from now, a response of “who knew?” won’t be much comfort for retirees in the employment line at the local job fair. This is especially true since a rational understanding of history and the drivers of longer-term stock market returns can help today’s retiree avoid that surprise.
Figure 11.2. SWR Profile By P/E Quintile: 4% SWR, 30-Year Periods Since 1900
Keep in mind that success provides a wide path, but failure is a thin line: those who succeed will end with a little or a lot; those who fail get to zero, or start counting pennies as their savings dwindle. Further, in reality, for retirees who invest during top quintile periods, the chance of suffering the painful effects of failure is even higher than 24%. Since a few of the periods ended relatively close to zero, fear forced some retirees to drastically reduce spending as their portfolios dwindled toward the end.
Most important, it does not matter how many of the scenarios provide your heirs with multimillions; you will likely be most concerned about reducing the chances of being forced to work again at eighty. Risk management is not just about enhancing success; it is about avoiding the unacceptable failures.
Retirees during secular bear markets may be limited to withdrawal rates that are less than 3%, or in some scenarios as much as 4%, to sustain their desired lifestyle successfully throughout retirement. Retirees who want to withdraw 5% or more will need a more consistent and higher return profile for their investments than passive investments in the stock market or bond market can provide when starting valuations are high. For those retirees, it will require a more actively managed and value-added approach to their portfolios, including investments in the stock market, even then with no guarantees of success.
There is no magic solution, no one way to achieve success. Given that retirees over this decade and longer are confronting the conditions of a secular bear market, it is important to start with a reasonable expectation about future returns and market conditions, then to apply appropriate investment strategies and approaches.