What is a Safe Withdrawal Rate?
When you retire, you will need to switch your thinking from being a saver to being a spender. The trick is to balance your withdrawals from spending too little and potentially dying with too much money and spending it so quickly that you run out of money.
What is the withdrawal rate?
The term that describes how much money you take out of your portfolio is the withdrawal rate. It is the amount of income that you are going to draw off your investments. If you have $100,000 in your portfolio and you have a withdrawal rate of 5%, you would withdraw $5000 per year for income. You can adjust your withdrawal rate as you need. I like to think of your portfolio as a bucket of money and when you need income, you are going to punch a hole into the bottom of the bucket and put a tap on it to regulate that income. You would adjust the withdrawal rate by opening the tap bigger or making it smaller.
Choosing the right withdrawal rate is a bit of an art and science. Although we all would love more income, opening the tap too much might cause your bucket of money to drain too fast. Keeping the withdrawal rate low can keep your portfolio intact or even grow it but it means less income.
The good old days
Back in the 1980’s retirement would have been a lot easier from the simple perspective that you did not have to think too much about your investments. Back then, you could stick your money in a GIC at 10% to as high as 21%. You could keep your capital guaranteed and live off the interest. Investing was pretty simple.
From 1990 to today, interest rates have fallen over 75% and GIC investors have had to look for alternative investments. People looking for income flocked in droves to income trusts, REITs and income paying mutual funds earning yields of 6% to 10% or more. Not bad either in a low interest rate environment but that did not last either. In 2006, Finance Minister Jim Flaherty announce that there would be a change in how income trusts would be taxed and income trust investors everywhere were left in disarray.
Back in the good old days, it was not uncommon to see projections using withdrawal rates of 7% or more. At the time, 7% actually seemed quite reasonable.
Tougher times today
Unfortunately for retirees of today and tomorrow, the future is uncertain. One one hand, inflation can cause interest rates to rise. On the other hand, with the amount of debt in the system at all levels, it is tough to envision really high interest rates staying for a long period of time. If retirees look to the stock market to find investments that produce income, they see more volatility and concern.
What is a Safe Withdrawal Rate (SWR)?
Most would agree that the days of a withdrawal rate of 7% or more are long gone unless you are OK with draining your bucket of money quickly. In fact, I remember conservative projections used to use a 5% withdrawal rate. Today, many experts and studies suggest that a safe withdrawal rate is about 4%. The point of choosing a safe withdrawal rate is to minimize or avoid the risk of running out of money
Depends on how long you want the money to last
Choosing the right safe withdrawal rate depends on a few key factors. The chart below looks at how long you want your money to last. Common sense suggests that you might be able to use a higher safe withdrawal rate if you only need money to last 20 years and you might need a lower safe withdrawal rate if you need your money to last 35 years.
Safe Withdrawal Rate - Chance of losing money
|Withdrawal rate||35 years||30 years||25 years||20 years|
Let’s say you retire at 60, you have $100,000 and you want your money to last at least 30 years. If you choose a withdrawal rate of 4% or $4000 per year, you have a 21% chance of running out of money before you turn 90.
On the other hand if you retire at 65 and only want this $100,000 to last 20 years, your chance of running out of money before the 20 years drops to only 5%.
This data is based on running hundreds of return scenarios using a safe withdrawal calculator.
Related article: Variable returns can work against you in retirement
Depends on how you invest
If you put all your money in GICs, you might earn 1.5% to 3.5% depending on the term. Let’s say for simplicity sake you earn 2.5%. Logic would say if you earn 2.5% and you take out 4%, your capital will deplete in about 23.5 years. If you are 65, that takes you to almost 90 years of age.
Most investors will not invest 100% into GICs. Instead they seek to find some balance in their portfolio and diversify some into stocks, mutual funds, EFTs and alternative investments.
The problem with market-based investments is there are no guarantees. The market does what the market does. You cannot control the market and you cannot predict where the market is going to go.
As a result, most retirees need to find a balance in their portfolios. I call it goldilocks investing. Not too aggressive (hot) and not too conservative (cold). This is the key to success. Build a portfolio with some cash to create liquidity and short-term income, some fixed income to create income for the next 5 years and the balance can go into equities.
The higher the withdrawal rate, the more equities are needed in the portfolio to reduce the risk of running out of money too early. However, the more equity you have, the less control and predictability you have over your future income. With equities, there is a high probability you may need to decrease your income in tough times and give yourself a raise in good times.
The point is simple: make sure you choose your withdrawal rate carefully.
Safe Withdrawal Rates and RRIFs
It’s also important to note that RRIFs have a minimum income schedule determined by law. This overrides the ability to have complete control over your withdrawal rate. In a RRIF, you can take more income than the minimum but not less.
Related article: RRIF Minimum income rules