Variable Withdrawals

I am not a fan of variable withdrawal rates. Usually, the idea is to withdraw more now in the hope of future success, cutting back only if needed. What planners overlook is how deeply withdrawals can fall: down below 50% of the initial withdrawal rate after accounting for inflation.

The 4% Shocker

From my Building Blocks article:

“There are a variety of approaches to vary withdrawal rates. Gummy’s (retired Professor Peter Ponzo’s) Sensible Withdrawals is among the best. He sets a floor that matches inflation and withdraws a percentage of the excess when his investments do well. Overall, this is a good approach. It is natural. Most retirees cut back during bad times anyway.”

Building Blocks
Building Blocks: Edited
Gummy's Sensible Withdrawal Rates

Do not scorn the general notion of a fixed withdrawal rate after adjusting for inflation. This is the kind of number that you can use in your planning. Yes, it still makes sense to have an emergency fund. That is a separate issue. Yes, your actual expenses are likely to vary. You already plan for that anyway.

Failing to address inflation is a dangerous road. It is what can ruin a retirement on a regular pension or annuity. If your income stream is fixed in nominal dollars (that is, without an inflation adjustment), you should reinvest about 30%.

Traditional Safe Withdrawal Rate studies account for a certain amount of prejudice against fixed withdrawal rates (after adjusting for inflation). Because they failed to account for valuations, they suggested wildly varying outcomes as a matter of routine. They only identified when a balance fell to zero at Year 30.

You can do much better by using the Year 30 SWR and Year 15 SWR buttons on the left. You can plan for any balance at Year 30 or Year 15. You can determine the likely range of outcomes in terms of the original level of P/E10 (Professor Robert Shiller’s measure of valuation). If you know the S&P500 index level, you can use the Stock Returns button to learn today’s P/E10.

You can do even better if you vary allocations in accordance with valuations. This is Valuation Informed Indexing (VII or Lucky 7).

I have come to favor dividend and income approaches. They allow you to plan on a continual income stream. The key is never selling any shares.

Dividend and income approaches do not keep up with inflation exactly. Dividend growth is often erratic. But dividends do keep up with and surpass inflation over a period of years. The best that I have been able to do is isolate the downside risk of the S&P500 dividend amount since 1950. It turned out to be 25% (to 75% of the original purchasing power).

If you are using a dividend or income approach with a withdrawal rate of 5% or more, a temporary setback to 4% of the original balance (plus inflation) is far from a disaster. In fact, it is in line with what many would recommend with inferior strategies anyway. The difference is that the other approaches can end with a zero balance at Year 30 while the dividend approach continues indefinitely.

You can plan on withdrawing 6% of your original balance (plus inflation) by using dividend and income approaches. This came as a pleasant surprise. My earlier numbers were smaller. I had previously overlooked the spread between preferred stock and corporate bonds above treasuries. With Valuation Informed Indexing, you can now plan on withdrawing 5.5% of your original balance (plus inflation). I still recommend caution in the early years just in case I have made a serious error. I do not believe that I have. I recommend caution with any analysis, regardless of its quality. This means cutting withdrawals to 5.0% to 5.5% until you are comfortable with your approach.

Have fun.

John Walter Russell
June 8, 2008