For a person who has been investing in equity (directly/indirectly) for several years, the question, "how much equity exposure should I have after retirement?" is not so hard to answer. However, that is not the case for most 50+ investors heading towards retirement. They would have little or no experience with equity or any market-related product. The retirement withdrawal rate or the initial retirement withdrawal rate, to be exact gives an approximate idea of the quantum of risk a retiree can take after retirement.
Before we begin, would like to clarify that I prefer a more detailed calculation to answer the above question. That tool can be found here: When should senior citizens purchase an annuity?
What is the retirement withdrawal rate?
The withdrawal rate is simply the pre-tax annual withdrawal from a retirement corpus divided by the available corpus (before withdrawal). This article was first published on Mar 17th, 2013. It is repeated for the benefit (hopefully!) of new readers.
So if I have an annual expense of about 3L and a corpus of 75L, the withdrawal rate in the first year of retirement is 4%.
There is a tonne of material (analysis and debate) available on the 4% withdrawal rate - Is it safe to last a lifetime, or not. Personally, I do not care much for this.
Any significant deviation from this 4% level is considered to be risky. That is my expenses are higher, say 5L, then the initial withdrawal rate is 6.7%. This means, that I will be drawing a lot of money from the corpus. If I take a risk and lose some money, then I will run out of money soon. So it is dangerous to consider equity exposure if the initial withdrawal rate is upwards of 4.5%*. Perhaps a small amount, but there should be enough corpus left to handle expenses. If we start withdrawing from the principal instead of generating an interest income (annuity), it will not last long.
This is the dilemma facing current retirees. If they lock their money in an annuity, they cannot handle inflation down the line. If they take risk and lose money, they will not be able to manage expenses down the line. It is important to recognise that there is no such thing as notional losses for a retiree. This is because they will need that money for income and if they withdraw from a depleted corpus, it will run out faster.
* In any standard, "how long will my money last?" calculator, for 25 years in retirement and interest rate = inflation (zero real return), the withdrawal rate for the first year will be 4%. So with zero real return, if the withdrawal rate is 4.5% or more, it is better to think real hard before using equity mutual funds or "balanced advantage" funds!
Note: Thumb rules were necessary at a time calculations could only be done by hand. Today we can get any complex calculation done in under a minute on our mobiles. So to hell with the 4%, 'rule of 72' kind of rules. They are inaccurate and misleading.
The withdrawal rate (let's denote this by w) is not a constant (common misconception!). In order to calculate the withdrawal rates for the 2nd, 3rd, 4th ... years in retirement, we need to realise that it depends on
- the rate of inflation during retirement (i)
- the rate of return on the corpus (r)
- duration of retirement (k)
This is the formula connecting w, i,r and k (feel free to ignore it if math nauseates you!)
It is often assumed that the withdrawal rate for the second year will increase with inflation. That is if inflation is 8% then w(2nd year) = 2.4%X(1+8%) = 2.6% and so on. However, this is not true and the above formula has to be used.
This is how the withdrawal rate typically looks for each year in retirement. The initial rate (for 1st year) is 3.5% in this example. (Click on the picture for a clearer view)
Safe to say that the withdrawal rate changes with time in a complicated way! The point is, only the withdrawal rate for the 1st year in retirement or the initial withdrawal rate can be guessed (along with other assumptions: at least two out of i, r and k). The withdrawal rate for subsequent years should not be guessed and has to be computed using the above formula.
Here are some further insights about the initial withdrawal rate (Click the pictures for a clearer view)
How long the corpus lasts depends on whether returns can beat inflation or not. For a 4% initial withdrawal rate and 8% post-retirement inflation, if returns are 2% above inflation the corpus will for nearly 33 years. However, if returns are 2% below inflation the corpus will last only for about 21 years. This will make a huge difference for a person who retires in his/her mid-50s.
Notice that the initial withdrawal rate decreases with increase in inflation. Counter-intuitive as this may seem it is due to the need for a higher corpus due to higher inflation. Here again, inflation rates between 6-8% correspond to withdrawal rates between 3.5-4.5% for a return of 7%
How long with a corpus last calculator This will tell you the relationship between a withdrawal rate and the life of a retirement corpus. Lower, the corpus or higher the withdrawals, higher the withdrawal rate and shorter the life of the corpus.
Download the Withdrawal Rate based Retirement Calculator This will tell you withdrawal rate for each year in retirement.
(please note: the mathematics remains the same for all retirement calculators and can be rewritten depending on what you wish to see as output.)
Again, I would urge you to use this When should senior citizens purchase an annuity? to decide on the level of risk that a retiree can take.
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