William P. Bengen, an aeronautical engineer turned financial advisor, first articulated the 4 percent safe withdrawal rule in a 1994 paper in the Journal of Financial Planning. But to his dismay, that rule transpired to become a widely used hack to guesstimate one’s retirement number.
Though more a rule of thumb than a rule, it says that if you could live on 4 percent of your money starting with the first year of your retirement and inflation-adjust that withdrawal amount each year hence, you’ll never run out.
But that was 1994 when 10-year Treasury bonds yielded 8 percent. There was no way to fail unless you did something truly dumb.
That same Treasury bond yields about 4 percent today1. That matches the safe withdrawal rate as just described but does not factor in inflation, so you must do more work than just buying Treasury bonds.
And that inflation-adjusted safe withdrawal rate must last longer than your joint (you and your partner’s) life-expectancy.
But say you are 20 years out from when you think you’ll retire, and you know what your expenses are today. There are some big-ticket items in there like mortgage and college costs and then there are the trinkets like paying for food and travel.
But you shouldn’t assume your expenses from today to last forever. You need to think about what your expenses will be 20 years out.
The two big spends – mortgage and college costs – would be done by then. What will remain are costs that are relatively tiny in the grand scheme of things and that is what we’ll use as a guidepost to plan for.
So, say those trinkets cost 80,000 dollars each year today. That is quite a chunk to spend on food and travel but say that is what you want. There is spending on healthcare in the future but you’ve planned around that by funding say a Health Savings Account.
So, 80,000 dollars is what you need today. Subtract 30,000 from it that will come from Social Security and now you have to plan for 50,000 dollars in income if you were retired today.
But your planned retirement is 20 years out. Assuming historical inflation rates, if you need $50,000 in income today, you’ll need $100,000 in income 20 years from now to afford the same quality of life.
So, you would want to plan for 100,000 dollars in income draw each year from your portfolio when you retire and inflation-adjust that amount for the remainder of your joint lives.
A 4 percent safe withdrawal rate hence means you’ll want to build to a portfolio value of $100,000 divided by 4 percent = $2.5 million.
A big number, yes, but you have 20 years to get to it.
But say you want to make your plan bulletproof plus leave a legacy behind, you can then plan around a safe withdrawal rate of 3 percent.
That means you will need to plan towards a portfolio value of $100,000 divided by 3 percent = $3.33 million, a 33 percent increase for a mere one percent decrease in safe withdrawal rate. But that is what a 100-year joint life expectancy costs. And you should plan for that.
But if you want to plan for generational wealth (it will not last though), use a 2 percent safe withdrawal rate. You now have to plan for a portfolio value at retirement of $100,000 divided by 2 percent = $5 million. The portfolio structure will be different than the usual balance portfolios you will use for say the 4 percent safe withdrawal rate though the bigger deal is to equip the next generation to manage all that wealth. Doable but not easy and hence one of the reasons inherited wealth dissipates quickly.
And $5 million might look like an insurmountable goal but plausible for folks who got this far reading this. Plus, you have 20 years to get to it.
Thank you for your time.
Cover image credit – Julie Aagaard, Pexels
1 March 31, 2024