How to implement the 4% safe withdrawal rate

In a previous post (here) I addressed how much you need in assets to retire and how much you can safely withdraw per year to make sure that amount lasts you as long as your retirement lasts. That number, the safe withdrawal rate (SWR), I said was 4% for a 30yr retirement.

Now, how does one actually implement this withdrawal rate? The way the 4% SWR works is as follows, using $500K as an example portfolio. In year 1, you withdraw 4% of you retirement portfolio, $20K in our example, for living expenses. In year 2, you increase your withdrawal by the inflation rate. The majority of studies of SWRs use the Consumer Price Index (CPI) as the inflation rate for adjusting withdrawals. If the CPI for year 1 was 2%, then your withdrawal in year 2 would be $20K times 1.02 which is $20.4K. Then in the following years you repeat this process. Simple.

The important thing to note is that you never look at the total portfolio value to judge your withdrawal rate for any given year. Many people are surprised by this but this is how these studies were done. The idea being that at the minimum a retiree wants to maintain a constant standard of living in retirement, as determined by inflation adjusted spending remaining the same. So, according to this methodology even if your portfolio declined by 10% each year for the first 3 years of retirement you would continue to increase your withdrawal each year (assuming there is no deflation of course). All sounds great in theory, right?

Well, I have a couple of issues with this approach. Primarily, I don’t like the inflexibility of the approach and during hard times I think it is quite hard to implement. Since all these numbers are derived from historical data one needs to remember a classic investment adage, ‘past performance is no guarantee of future results’. In other words in the future the 4% SWR may or may not work. Thus I think its quite important to monitor your progress as you go through retirement. For example, faced with multiple years of negative returns its probably a good idea to adjust your spending or withdrawal rate or both. In a given year one can keep the withdrawal amount flat or even cut back a little. On the other hand, if you have 10 yrs of stellar returns you can probably adjust your spending up.

By making adjustments as one progresses through retirement its possible to even to use higher withdrawal rates. I’ll address alternate withdrawal methodologies in a later post.

The important thing for me is to start with a credible plan, which the 4% SWR is, and remain flexible with a good bias to the conservative side.