Once upon a time, Canadian retirees used their nest egg to fund particular expenses such as a new car, home renovation or a special trip. Some people will still be able to make irregular withdrawals like that, but it is more likely that today’s (and future) retirees will be relying on their own investments for a good part of their retirement cash flow needs.
The challenge now is figuring out how much is a safe withdrawal rate that will last you for life. A high withdrawal rate early on can quickly deplete your savings, especially if the stock market goes down and stays down for several years.
What is a safe withdrawal rate?
A commonly accepted rule of thumb is the “4% withdrawal rule” which has been used for a while as a convenient way to draw down assets. It was developed in the 1994 by William Bengen and based on long-term capital market assumptions for a model portfolio of 50% stocks and 50% bonds. The reasoning is that if you retire at 65, the 4 percent rule should provide 30 – 35 years of income and continues to be a benchmark.
There are two different ways to make the calculations:
- Constant Dollar, inflation adjusted (the original): Determine 4% of your retirement savings balance (that is, in your first year of retirement) and withdraw that amount. The next year, draw the same amount but include inflation. e.g. If you have $500,000 saved you would withdraw $20,000 the first year. The second year you would take out $20,400 (assuming 2% inflation), the third year, $20,808, and so on.
The drawback here is the built in assumptions may no longer apply. Bond yields have been low. A steep market decline could deplete your savings too early. People tend to make terrible investment decisions and not even get market returns. You may not enjoy the growth you need to fund 30+ years of spending.
- Constant Percentage: With the second method you withdraw 4% of your portfolio balance annually.
The disadvantage is the uncertainty about how much income you will have each year as it depends on your portfolio balance.
While the 4% safe withdrawal rate can be a good starting point, no simple financial rule can take into account all the variances and complexities of real life. If you retire early, especially before you are eligible to collect pension benefits, you need to be much more conservative in your withdrawal levels.
Consider Cindy (53) and Martin (58). Martin was recently let go from his sales job and has had difficulty finding comparable work. Discouraged, he decided he might as well take early retirement and will begin to collect reduced CPP at age 60. Cindy works part time in a small boutique and will continue working until age 65, then collect her CPP. They want to have $6,000 of income a month.
You can see from this diagram that, with not much income coming from other sources, the majority has to come from their savings (in blue). They will burn through their savings by two-thirds or more within the first ten years if they are not willing to scale back.
Spending in retirement
Statistics Canada studies have shown that the average 65 year old spends about 25% more than the average 80 year old. In fact, the average retiree can expect three phases of retirement and it’s logical to assume that spending patterns will also change:
- Early years – a period of travel, hobbies and adventure and spending more freely
- Middle years – some activities, more socializing and relaxation
- Later years – a time of winding down, discretionary expenses fall significantly, may be restricted to spending most days at home.
Selecting a long-term strategy for withdrawing retirement assets can be a daunting task. It is unreasonable to believe that your initial strategy will still fit circumstances in later years.
You need to have a plan that fits you and your specific lifestyle needs to ensure your retirement years will be everything you want them to be. Careful planning will safeguard your future.
Because the future is based on assumptions (and your life may not turn out to be “average”), you should monitor the performance of your portfolio closely and think about what you will have to do if your investments lag behind your expectations. No one knows where interest rates, house prices, stock market returns or inflation are headed.
Be flexible and reassess your plan at least annually, or as circumstances change, to ensure your savings are not dwindling beyond a reasonable amount too quickly.