Initial Withdrawal Rates And The Decade Before Retirement

The last 10 years before retirement is when most people start taking retirement seriously. I am not trying to imply that this is when they begin investing for retirement. Just that this is when most people actually take stock of how ready they are for retirement. A good way for one to do this would be to calculate their Initial Withdrawal Rate (IWR). The IWR is normally used to assess the adequacy of an available corpus at and after the point of retirement. But it can also be used to gain useful insights during the decade before retirement. And in today's post I will throw light on the insights offered by the IWR. I will also show how specific values of the IWR should be interpreted.

Understanding Initial Withdrawal Rates

An Initial Withdrawal Rate (IWR) expresses our annual expenses during the first year of retirement as a percentage of our liquid net worth at retirement. In other words it shows us what portion of our corpus we would withdraw during the first year of retirement. It is expressed as a percentage. A low IWR is considered to be favourable. It implies a lower risk of running out of money post retirement. The IWR can be calculated as follows :

Initial Withdrawal Rate = [(Annual Expenses - Annual Post Tax Pensions (if any))/Liquid Net Worth At Retirement] × 100

Assume a retiree has annual expenses worth Rs 12 lakh, annual post tax pensions worth Rs 6 lakh and a liquid net worth of Rs 300 lakh at retirement. The Initial Withdrawal Rate in this case may be given as follows :

Initial Withdrawal Rate = [(12 - 6)/ 300] * 100

= [6/300] * 100

= 0.02 * 100

= 2%

This means that the retiree is likely to withdraw 2% of their liquid net worth during the first year of retirement. The liquid net worth is therefore likely to last for 50 years post retirement. For normal retirement at age 55, the post retirement period would be 35 years. Therefore the ideal IWR to ensure that the corpus lasts for 35 years is 2.85% (100/35 = 2.85). So the IWR of 2% in this case shows that the retiree is very likely to have a comfortable retirement.

The above example shows the IWR works when calculated at retirement. But this metric can also be used during the last decade before retirement. It would show whether or not whether the individual is on track to retire at the age they intend to. The individual must assume that they are retiring at present and interpret the results accordingly. Let us now understand what various values of the IWR imply during the decade before retirement. For the purpose of this discussion, I am assuming that all calculations are being done at the age of 45.

Case 1 : Initial Withdrawal Rate Is 5% Or More

This represents the worst case scenario. It implies that the available liquid net worth would last for 20 years or less post retirement. There is therefore a very high risk of the individual running out of money post retirement. An IWR of 5% or more usually has a few common implications.

It mainly means that the individual has not been investing enough for retirement until now. It may also mean that they may have started investing for retirement later than they could afford to. Finally it may mean that they have not been investing enough in equity until now. One or more of these factors is likely to have resulted in the corpus not growing enough until now. The high IWR is simply a natural consequence of this.

There are solutions available to such a situation. But they definitely aren't palatable ones. Firstly the individual would have to invest twice or thrice the amount they currently are for retirement. They would most likely also have to bring down their lifestyle spending drastically. They may also have to increase their allocation to equity. As a last resort, the individual may need to retire later than originally intended. Needless to say, none of these are easy to do.

Case 2 : Initial Withdrawal Rate Is More Than 3.5% But Less Than 5%

This is an acceptable position to be in. But it is not entirely comfortable. It implies that the individual is on track to retire at the age that they intend to. But some course correction may still be required. The individual may need to invest more than they currently are for retirement. Their asset allocation may need to be reviewed and corrected. Better product choices may need to be made within individual asset classes. But all in all, they should be able to build enough money for their retirement. Seeking professional help for an objective assessment and course correction may be of value.

Case 3 : Initial Withdrawal Rate Is 3.5% Or Less

Represents the best case scenario. This implies that the individual is investing enough for retirement at this point. They may even be investing more than they need to for retirement. Allocations to various asset classes in the portfolio are also likely to be ideal. An IWR of 3.5% or less gives them a reasonable chance of achieving the ideal IWR of 2.85% at age 55. This would give them the flexibility to choose their desired portfolio management strategy post retirement. A full fledged bucket strategy may also be considered. The only thing they need to do is to keep doing what they have been doing so far until they retire.

The Parting Shot

Using the IWR for an assessment too early would make no sense. The earliest it can be used for a realistic assessment is anytime between the ages of 40 and 45. Around age 45, there are usually 10 to 15 years left until retirement. Using the IWR at this point would give us clarity on what needs to be done on the path ahead. There would also be enough time available for a reasonable degree of course correction. This would reduce the probability of us waking up to rude shocks at point of retirement.