The 4% withdrawal rule for retirement planning assumes excessive equity allocation (50-75%), which makes it impractical. To make this worse, the 4% rule is often misunderstood and misapplied, so it is not a useful tool for retirement planning for most people. Here is an alternative idea.
What is a safe withdrawal rate? The safe withdrawal rate is the annual withdrawal amount divided by the available retirement corpus in the first year of retirement. How is this connected to the 4% rule? What is “safe” about this withdrawal rate?
Assuming you retire with a corpus of INR 1 crore and invest it in yielding an overall annual after-tax return of 7%, this may seem like a straightforward retirement plan. However, it is important to note that this approach is simplistic and potentially risky. Additionally, factoring in an annual inflation rate of 7%, your expenses are expected to increase by the same percentage each year without accounting for any sudden increases.
So, one crore is invested, and you withdraw an amount equal to current annual expenses each year. Let us assume your expenses in the first year of retirement are Rs. 4 lakhs.
The initial withdrawal rate is 4 lakh divided by one crore = 4%. This is the same 4% association with the 4% rule. The withdrawal rate in the first year of retirement is 4%. In the second year, the expenses are Rs. 4.28 lakh (7% inflation), the corpus has grown by 7% to Rs. 1.0272 Crores (Rs. 102.72 lakhs).
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The withdrawal rate in the second year of retirement is 4.28/102.72 = 4.17%. The withdrawal rate keeps increasing as we draw more and more from the corpus. The corpus drops to zero after 25 years of retirement, and the withdrawal rate increases to 100%, as shown below.
What is the 4% rule? The 4% rule is a rule of thumb for determining safe retirement withdrawal rates, as William Bengen proposed. In a Reddit AMA (ask me anything), Bengen explains the rule most eloquently as follows.
The “4% rule” is actually the “4.5% rule”- I modified it some years ago on the basis of new research. The 4.5% is the percentage you could “safely” withdraw from a tax-advantaged portfolio (like an IRA, Roth IRA, or 401(k)) the first year of retirement, with the expectation you would live for 30 years in retirement. After the first year, you “throw away” the 4.5% rule and just increase the dollar amount of your withdrawals each year by the prior year’s inflation rate. Example: $100,000 in an IRA at retirement. First year withdrawal $4,500. Inflation first year is 10%, so second-year withdrawal would be $4,950
You throw away the 4% or 4.5% rule after one year of retirement because it will keep increasing, as shown above. Unfortunately, the 4% rule has been misinterpreted as “the safe amount you can withdraw in any year of retirement.”
To be more precise, assume you are a financial planner. A client just about to retire comes to you and says, X is my retirement corpus, and Y is my annual expenses. How should I manage my money in retirement?
You compute the withdrawal rate in the first year as Y/X. Suppose this is less than or equal to 4.5%. Then, there is a reasonable chance that the corpus will not reach zero before your lifetime. If the withdrawal rate is higher than this, then taking on capital market risk would be dangerous. However, how high is too high is arbitrary.
It is practical to define a safe withdrawal rate (SWR) as the following: If the initial withdrawal rate is less, or in other words, the corpus will last the lifetime of a retiree with a reasonable return and inflation expectations (or a reasonable asset allocation). We can refer to it as a “safe” withdrawal rate. If the expenses are too high or the corpus is too low, the withdrawal rate will be high, and the corpus will get depleted soon if we keep withdrawing from it. Such a withdrawal rate is, therefore, unsafe, and the retiree will have to settle for a pension (annuity),
For example, in the above example, with a one crore corpus, if the initial annual expenses are five lakhs, the initial withdrawal rate becomes 5%, and the corpus will only last 20 years and not 25 years. What would you do then? Say this is too risky, and buy a pension plan for as much corpus as possible. When do you say the retiree cannot take any risk? At 5% WR or 5.5% WR? No one knows. It becomes an opinion.
There is some leeway available in the assumptions. One could try a little bit more equity (never more than 30%, though), a little higher equity return expectation (not more than 11,12% post-tax), and a little lower inflation (5%, 4% or 3%). We are working on a new tool that would allow such adjustments. If the corpus is still insufficient after these accommodations, then an annuity is the only choice.
Most financial advisors in India do not have experience handling such cases, and to make things worse, because of conflict of interest, they would propose bizarre solutions such as monthly dividends or SWP from a “balanced advantage” fund.
The 4% rule is based on US historical data, but newer studies argue this even is flawed: The 4% retirement rule is wrong! Based on that, do not retire early in India (or the US)!
The main catch is the assumption of at least 50% equity. This implies that the overall post-retirement return expectation is high. This is neither practical nor reasonable. That much equity in the portfolio makes it extremely susceptible to the sequence of returns risk.
Any poor run of returns would mean the corpus would erode faster than it should, and the retiree would run out of money sooner than expected. Such an over-dependence on the stock market after retirement is dangerous.
This is why the freefincal robo advisor tool does not recommend more than 30-35% equity for most retirees and rarely about 40% for early retirees.
The withdrawal rate can be misleading and easily misinterpreted. Many in the FIRE community assert they will maintain a withdrawal rate of less than 4% per year during retirement. However, this is only feasible if additional income sources are utilized alongside corpus withdrawals.
Alternative to the safe withdrawal rate
There are two problems here. (1) How much risk should a retiree take? (2) How should I manage my corpus after I retire in 10, 15, 20, or 25 years? Most retirees in India today have no capital market experience and not much of a corpus to play with.
Those who have ample time to plan for retirement have some choices to work with.
- Income buffer: Ensure 15 years of inflation-protected income with an income bucket. One chunk of the corpus goes here. During this time, the rest of the corpus is divided among low-risk, medium-risk, and high-risk buckets and is managed actively. This is the logic used in the freefincal robo advisor tool.
- This gives ample cushion to combat the sequence of returns risk.
- As discussed in the Online Course on Goal-based portfolio management, an alternative innovative variation of gradually increasing equity allocation (0 to 30/40%) in retirement is also possible.
Our research shows that lowering equity allocation and ensuring an ample income buffer will help retirees effectively manage money. These steps are an effective alternative to using the withdrawal rate.
Here are some sample illustrations using the robo-advisor tool.
- I am 30 and wish to retire by 50; how should I plan my investments?
- Retirement plan review: Am I on track to retire by 50?
- How to create retirement buckets for inflation-protected income
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Dr M. Pattabiraman (PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. He has over 14 years of experience publishing news analysis, research and financial product development.
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