After we retire, the retirement corpus we have accumulated over the years becomes our most important asset. And assuming that our corpus is adequate in light of our financial needs post retirement, the major challenge that we need to deal with would be to decide on a safe portfolio withdrawal rate through our post retirement years. A safe withdrawal rate is the percentage of our portfolios we can safely withdraw each year so that our retirement corpus provides for our needs effectively over the course of our post retirement lives. This question is even more pertinent to those who have no supplementary sources of income post retirement, and majorly or completely depend upon their portfolios to meet their financial needs. There are a number of theories that propogate thumb rules to decide on a safe withdrawal rate. But these theories and thumb rules carry little relevance, if any. There are a number of considerations that need to be made before we can come up with a withdrawal rate that is optimally suited to meet our needs. Therefore, today I am going to delve deeper into the matter of withdrawal rates. I will start off by showing why arbitrary theories and thumb rules surrounding withdrawal rates are increasingly losing relevance. I will then talk about the considerations that need to be made when trying to come up with an optimal withdrawal rate for our needs. I will also show how withdrawal rates can be recalibrated as per our needs over various phases of our retirement years. I will then conclude by commenting on whether there is a single figure that can universally be used as a safe withdrawal rate by all individuals to meet their needs regardless of other circumstances.
The concept of safe withdrawal rates first gained popularity on the back of a study in America carried out using data on investment returns between 1926-1976. It was carried out again in 1994 by a financial advisor named William Bengen using data between the late 1930s and early 1970s. The essential finding from these studies was that if a retirement corpus worth 25 times our current annual expenses were to be invested in a mix of stocks and bonds with near equal allocation to both (say 50-50 or 60-40), the growth in such a portfolio would allow us to safely withdraw 4% of the corpus each year. And this means that the corpus would last for at least 30 years. Look at the graphic below for a better understanding.
This has given rise to hope in some circles that the 4% withdrawal rate theory would work with similar efficacy in India too. But, this theory cannot enjoy as much relevance in India for a number of reasons. To begin with, the 4% withdrawal rate was propogated in the context of inflation in America. But, inflation rates in India (averaging 6% historically) are significantly higher than those prevalent in America (averaging 3.25% historically). Therefore, a 4% withdrawal rate may prove to be insufficient to meet the needs of Indian individuals. Also, the 4% withdrawal rate is designed to provide for a post retirement period of 30-35 years, with retirement coming at age 60-65. But more and more individuals today in India and the world over aspire and aim to retire anywhere between their late 40s and mid 50s. Constant advancements in medical science and health care has also meant that the average life expectancy of individuals all over the world is likely to increase towards anywhere between 85 and 90 years. This means that the typical post retirement period would be around 40-50 years. Therefore blind adherence to the 4% withdrawal rate would mean that we would run out of money 10-15 years too early.
Assuming our net portfolio return post retirement = inflation rate (meaning that our money does not lose purchasing power to inflation), an optimal withdrawal rate would depend on a few important variables. The first of these is the number of income streams that we would have post retirement. Those of us looking to work part time or get into freelancing post retirement would continue to have a source of earned income. This means that our dependence on our portfolios would be reduced, allowing us to operate with a lower withdrawal rate. Those who would be completely dependent on their portfolios would need to work with a higher withdrawal rate. The next variable is the amount of fixed monthly expenses (for instance food, clothing, utility bills, rent, medical expenses and so on) we would have post retirement. A higher fixed monthly expense burden would indicate the need for a higher withdrawal rate and vice versa. Those of us who are in good health and are expected to enjoy an average life expectancy can work with a lower withdrawal rate. Any of us who may be dealing with lifestyle conditions that could compromise our life expectancy can afford to operate with a slightly higher withdrawal rate. Lastly, those of us who have high annual tax obligations to meet may have to work with a high withdrawal rate, compared to those who have planned their taxes in a way that allows them to work with a lower withdrawal rate.
It may not always be practically possible to stick to a single withdrawal rate all through our retirement years. Take the case of an identically aged couple where the husband wishes to retire at the age of 50 and the wife at the age of 55. Let us further say that each of them will receive a fixed pension from their employers when they each turn 60. And finally, let us assume that they have an adequate retirement corpus when the husband retires at 50, and expect to live until the age of 85. In such a case it would be best to break down the couple’s post retirement years into three distinct phases. Phase 1 would begin from the time the husband retires and last until the wife turns 55. Phase 2 would be between the time the wife retires and both spouses turn 60. During phase 1, the couple’s dependence on the retirement corpus would be relatively lower since the wife would still be bringing earned income into the household which can contribute towards meeting their financial needs to a certain extent. Therefore the portfolio may have a slightly higher allocation to equity relative to debt (say 65-35 or 70-30) withdrawal rate during this phase can be relatively lower. Phase 2 would see both spouses retired and completely dependent on their portfolios to meet their needs. Therefore, the portfolio mix must either be equal or slightly skewed towards safer investments in the debt category (i.e 50-50 or 70-30 leaning towards debt). And the absence of earned income would naturally mean that the withdrawal rate would be significantly higher relative to phase 1. Phase 3 would once again reduce dependence on the retirement portfolio owing to the monthly pension both spouses would receive. This means that the portfolio can again have a slightly higher allocation to equity if necessary (say 60-40) and the withdrawal rate would be slightly lower compared to phase 2. So as can be seen, a single post retirement period may require the use of multiple portfolio mixes and withdrawal rates.
A thumb rule that is sometimes prescribed in India for a safe withdrawal rate is Withdrawal Rate = G Sec Rate (interest rate on long term government bonds) - 1.5%. So if the interest rate on a 30 year government bond is say 7%, the withdrawal rate would be 5.5% (7 - 1.5). But, as we have seen so far, an optimal withdrawal rate is heavily influenced by our individual lifestyles. Therefore, those of us with higher spending needs may find withdrawal rates given by such thumb rules to be insufficient. No two different people can have absolutely identical lifestyles. Portfolio mixes and allocation to various assets may also have to be varied to meet the nuances and specific financial needs in light of our personal circumstances. This naturally means that there is no single withdrawal rate that can be considered universally applicable across individuals, and optimal withdrawal rates post retirement would differ from person to person. Therefore, we would need to analyse our current lifestyles and understand how our financial needs would evolve over the course of our post retirement years in order to come up with a realistic estimate for a safe withdrawal rate post retirement, and adjust our portfolio mix accordingly. If we cannot do this ourselves, we always have the option of seeking professional help at reasonable prices. And given how crucial an effective withdrawal rate is to ensuring that we don’t outlive our money and enjoy a rewarding retirement, it is a decision that must be made with utmost care and discretion.