PC: C. Castle
Just as the phrase “Mitochondria is the powerhouse of the cell” was drilled into our heads in middle school, in the personal finance world, “The 4% rule” is a similarly ubiquitous mantra. While we’re comfortable knowing that the U.S. stock market has returned an average inflation-adjusted return of about 7% over the long term, it often comes as a surprise to realize we cannot withdraw 7% every year in retirement.
Logically, you’re probably wondering WHY? Why is the recommended safe withdrawal rate set at 4%, when the market historically returns an average of 7% per year? It almost seems like a contradiction. If your portfolio is growing at 7%, why shouldn’t you be able to withdraw 7% and still be okay? There are a couple of reasons for this, but the two biggest are related to the unpredictability of investment returns and impact of volatility.
Volatility:
In the pre-retirement years, volatility is just part of the investing lifecycle, providing opportunities to buy shares at a lower cost over long periods of time. In the retirement years, however, volatility is no longer your friend as it becomes a significant risk because you’re systematically selling your portfolio rather than buying more. So, if you’re dollar-cost-averaging out of a volatile investment, you’ll be selling more shares when the price is low and fewer shares when the price is high. This can hurt your portfolio quicker than you might expect.
The takeaway here is that once you begin liquidating your investments, volatility takes on a whole new meaning: It directly reduces your returns.
Here’s an analogy to help drive the message home: In retirement, when you take money out of your savings, think of it like having a piggy bank with some toys inside that can change value. Sometimes, the toys are worth a lot (high price), and sometimes they’re not worth much (low price).
If you take out more toys out of your piggy bank (aka your nest egg/portfolio) when they’re not worth much, you’ll need to take out more of them to get the same amount of money. But when the toys are worth a lot, you only need to take out a few. Over time, if you keep taking out lots of toys when they’re not worth much, your piggy bank empties faster than you’d like, leaving you with fewer toys for the future
Sequence of Return Risk (aka Luck)
Sequence of returns risk is the second big reason why it’s not safe to withdraw 7% per year from your retirement portfolio, even if you expect it to earn an average return of 7% annually. All “Sequence of Return Risk” really means is that the order in which you experience returns matters significantly more than one might think!
When you’re consistently withdrawing money from your investment portfolio, the returns in your early years, while your portfolio is still large, have the most significant impact. If you withdraw more than a few percent per year and encounter a severe bear market or a severe years of downturn early in retirement, your portfolio might not recover enough to support you later, even if the market eventually rebounds.
Example
John retires with a $500,000 portfolio and withdraws $20,000 at the beginning of each year. Over the first five years of his retirement, his portfolio earns the following annual returns: 10%, 8%, 2%, -5%, -10%. Here’s how his portfolio changes each year:
- Year 1: $528,000
- Year 2: $548,640
- Year 3: $539,212
- Year 4: $493,252
- Year 5: $425,926
Final Portfolio Value After 5 Years: $425,926
Now, if the returns had occurred in the opposite order, his portfolio value would look like this:
- Year 1: $432,000
- Year 2: $391,400
- Year 3: $378,828
- Year 4: $387,534
- Year 5: $404,287
Final Portfolio Value After 5 Years: $404,287
First Scenario (10%, 8%, 2%, -5%, -10%): Final value = $425,926
Second Scenario (-10%, -5%, 2%, 8%, 10%): Final value = $404,287
The difference in final portfolio value after 5 years is about $21,639 only because the order of returns is varied! This highlights how the sequence of returns can significantly impact retirement savings.
While there’s no way to eliminate these risks completely, using a low withdrawal can at least reduce the possibility of running out of money due to unfavorable market conditions or sequence of returns.