You have built a nest egg of money by saving and investing. Now you want to retire from formal work and just live off the nest egg. How much can you safely withdraw?
The first assumption we are going to make is that we are going be invested in 60% stocks and 40% bonds for the rest of our life. Over the long run this portfolio has given around 9% annual return.
Let us say we have $1,000,000 ( 1 million dollars) as our nest egg:
1. You may think that since our portfolio has a long-term average return of 9%, we could easily withdraw 7% each year. But remember, that this is a long-term average and we could easily run out of money if the stock market tanks for the next few years. Therefore this is a strategy that one should never use. We should never use investment averages to decide how much money we can prudently withdraw from our retirement accounts.
2. William Bernstein says: 2% is bullet proof, 3% is probably safe, 4% is pushing it and if you take 5% there is a 50% chance you will run out of money. So if you have $1,000,000 as your nest egg:
- $20000 per year is safe
- $30000 per year is probably safe
- $40000 per year is pushing it
- $50000 per year means there is a 50% chance you will run out of money.
This again shows that if you can spend less, you are more likely to be okay. That is why spending less is so important. So 2-4% withdrawal per year from your nest egg is okay. When we say withdrawal per year, it means the initial percentage( say 3%) which is inflation adjusted.
3. Okay, you say that 4% is not enough. What else can you do? You can withdraw 4.15% of your nest egg during the first year of your retirement. During the later years, you can take the following amount:
Previous year withdrawal+ inflation rate x previous year’s withdrawal
So with the 1 million nest egg you can take 41,500 dollars the first year. If the inflation rate during the 2nd year was 3% then you can take: 41500 +1245 dollars. You can squeeze a liitle more from your nest egg by modifying the 4% rule to consider inflation.
4. If you want to get more money each year, you can take into account the valuation of the stock market:
|10 year P/E ratio||Safe withdrawal rate|
|12 to 20||5%|
5. To squeeze your money the hardest, you can take into account market conditions on the date of your withdrawals. What does this mean? The assumption is the long-term average return is around 9%. Withdrawals are taken at the beginning of each year. The basic amount you withdraw each year is 5% of the nest egg.
- If the market return over the previous year on the date of withdrawal has been greater than the long-term average you can take 25% more. i.e= 5% + 25% of 5%= 6.25%
- If the market return over the previous year on the date of withdrawal has been lesser than the long-term average you take 25% less. i.e= 5% -25% of 5%= 3.75%
The above are guidelines which you can use. But remember you can adjust things upward or downward if the need comes. The key thing to remember is that if you can spend less, then you can live worry-free for a long time.