Safe Withdrawal Rate

In the previous post, we took a look at an hypothetical equity portfolio of $550,000, generating a cool $55,000 per year at 10% return on average. Here we have assumed yearly rate of return to be 10%. There is only one problem with this assumption: this return is on average. On average. On average. I think I made my point quite clear here. So why am I putting such an emphasis? Well, there might be will be certain years where the real rate of return is less than 10%. In that case what would you do? Simply, you might reduce the amount of withdrawal to match the return%, say 5%. But that would mean you have to drastically reduce your lifestyle (by half, in this case) for an year. Worse, what is your investments yield negative returns?

So we have to make sure that we are able to safely withdraw a defined percentage of money from our total portfolio so that our retirement kitty is able to sustain us over a long period of time after factoring in market highs/lows, inflation and other adjustments. This rate of withdrawal is defined as “Safe Withdrawal Rate” or SWR hereafter. Our portfolio is a success if it is able to sustain us throughout our retirement (..till death do us..), a failure otherwise. For the US demographic, there have been many studies conducted to find the optimal SWR, most famously, the Trinity Study, benchmarking the SWR at 4% in 1998. Of course, we have seen at least 2 boom-bust cycles in the stock market, and now people are clamoring over 3% or even the ultra conservative 2% as SWR.

What does this mean:

If I know my yearly expenses are $55,000^#1, SWR at 3% says that I should have a minimum portfolio size from which I can withdraw 3% every year throughout our retirement so that my portfolio doesn’t run out of money. This would mean

$55,000 = X/3%  or X = $1.83 million.
At 4% SWR, we would need = X = $1.38 million
At 5% SWR, we would need = X = $1.1 million
and at 10% SWR, it would be exactly $550,000, our original amount.

Now if I had saved $150,000 so far, I can calculate my “Freedom Days” at 3% SWR by the following formula

Freedom Days = Current Portfolio * SWR / ADW
where ADW = Average Daily Withdrawal = Average Yearly Withdrawal / 366

In this scenario, ADW = $55,000/366 ≅ $150
and that gives 30 Freedom Days ( $150,000 * 0.03 / $150 )

If you happen to be in this position, congratulations! You are financially independent for one whole month in an year for the next 50 years^{on average}. Keep up your progress!

You now have 2 questions to ask yourself, and only you can know the answers for them:

1. What are/would be my yearly expenses?
2. What SWR is applicable to MY stock market?

Kindly note that the initial study and subsequent updates on Trinity Study are based on the USA stock market performance over the last 90 years. Based on this past performance, there is an awesome online retirement calculator firecalc that will run simulations based on your inputs on Portfolio Size, Yearly Withdrawal and number of years of retirement. Since there is no such thing as 100% success rate in real life, especially in statistical analysis, consider anything above 95% success rate as success for your portfolio. Again, this firecalc tool pertains only to the USA stock market.

However, it is not really that big a leap to apply it to one’s individual stock markets. Let’s assume your average length of retirement is 20 years. Take past 20 year returns of your domestic stock market, start with a lump portfolio sum and make a SWR withdrawal WHILE ADJUSTING FOR INFLATION every year to check whether your portfolio is able to stand the test of time. One caveat here is past performance is not never a predictor of future performance of the market. (If you take 21 years, you get two “20 year periods” to analyze. Needless to say, the longer you look back, the more data you get to analyze and hence, be more confident in your data points). For USA, you will see that for the scenarios calculated using firecalc, a 3% SWR would give almost 100% success rate over a period of 50 years.

Now it is absolutely subjective, and it SHOULD be, to choose your portfolio size and a proper SWR. Everyone of us is different, and each of us has unique traits, tastes and needs that would severely alter the composition of our expenses; everyone’s would be unique like a snowflake. So while calculating, always arrive at your portfolio size through your expenses and not through your income.

#1 Always calculate your portfolio required based on your expenses rather than your income. it will give a realistic idea of your needs and wastefulness.