About four years ago, I authored an article for Financial Advisor in which I examined risks to the “4.5% safe withdrawal rule,” which I had developed over many years of research. At that time, my conclusion was that the rule was still viable. But when you consider the case of the person who retired on January 1, 2000 (someone who had to contend with not just one but an unprecedented two huge stock market declines within 10 years), the rule was under slight duress. I opined that the rule’s survival depended on the avoidance of a sustained bout of double-digit inflation in the near future, the kind of inflation the U.S. endured in the 1970s, which was a key element giving rise to the 4.5% rule in the first place.
In this article, we’ll examine the evolution of “SAFEMAX” (the historically lowest safe withdrawal rate) from the late 1920s to the present, to establish a frame of reference. We will then revisit the “sustainability” prospects for people who retired in either 2000 or 2008. In both years, people entered retirement on the cusp of major stock market declines, which in the past have been associated with low safe withdrawal rates.
Four years ago, there just wasn’t enough data to draw any conclusions about withdrawal sustainability for the 2008 retiree; now clearer indications are available.
To look at the evolution of SAFEMAX, we begin with a walk through history. Recently I ruminated, “The 4.5% rule was derived from the experience of the January 1, 1969, retiree. In 1993, when I began my research, that represented the ‘worst case scenario.’ But what if I had conducted my research 10, 20 or even 30 years earlier? What would SAFEMAX have been at those times?”
To answer that question, I fired up my trusty spreadsheets. Since I use the Morningstar Ibbotson database, which begins in 1926, and postulated a minimum of 30 years of portfolio longevity, it would have been at least the mid-’50s before the first SAFEMAX could have been identified. As per Figure 1, which records the evolution of SAFEMAX (given a fixed allocation of 35% large company stocks, 20% small company stocks and 45% intermediate-term government bonds), the first retiree to experience failure was he or she who retired on October 1, 1928. Such a person would have been limited to a 5.85% withdrawal rate, which seems very generous compared with the 4.5% rule in use today (especially considering the Great Depression that followed his or her retirement).
As you can see, the SAFEMAX percentage had to be lowered from its initial value eight times, during events that happened in three clusters. The first cluster includes retirees in 1928 and 1929, just before the 1929 stock market crash and the ensuing depression. Another event, an isolated one, took place in 1937, around the time of a huge stock market decline. (Large company stocks lost 35% that year, while small company stocks lost 58%, a real drubbing.) The last grouping occurred in the late 1960s and preceded a lengthy period of weak stock market returns and high inflation that decimated investor portfolios.
A few conclusions can be derived from Figure 1. First, and most important, safe withdrawal rates have changed over time, and in fact have declined substantially from the late 1920s. This suggests that at some future time, they could decline again. The current 4.5% rule has been in effect for almost 50 years, the longest period of applicability yet seen. Are we perhaps ripe for a change? Wade Pfau and Wade Dokken have convincingly made the case in recent years that there is nothing sacred about 4.5%. (See the article, “Why 4% Could Fail,” in the September 1, 2015, issue of Financial Advisor magazine.)
Second, you will note that previously I identified the January 1, 1969, retiree as the one having the worst portfolio experience in retirement. In Figure 1, I have changed the date to October 1, 1968 (one calendar quarter earlier), although the actual SAFEMAX value (about 4.47%) is little affected (it was almost a dead heat between people retiring on the two different dates).
To explain why I made this change, in my past research I considered only the portfolios of those investors who retired on January 1 of each year (for a total of 61 portfolios of 30-year duration between the years of 1926 and 1986). In preparation for this article, I enhanced my worksheets to analyze quarterly retirement statistics for the portfolios of individuals who retired on the first day of each quarter, from January 1, 1926, through January 1, 1986, looking at a total of 241 retirees. This is about four times as many as before. The finer mesh allowed me to identify new SAFEMAX candidates I had overlooked before.
One may argue that this sizable expansion of the database (all derived from Morningstar Ibbotson statistics, God bless them) is in part illusory, since there is a substantial overlap of data for many retirees. For example, over a 50-year time horizon, the April 1968 retiree and the October 1968 retiree share 594 months of data in common; the data differs for only six months. However, at an initial withdrawal rate of about 4.5%, the portfolio of the April 1968 retiree will almost certainly last 50 years, while the portfolio of the October 1968 retiree was exhausted in just 30 years! I believe such differences are worth noting. Given the volatile backdrop of markets and inflation, two individuals retiring a short time apart can experience vastly different outcomes, although it’s likely the October 1968 retiree might alter his spending.
Lastly, as can be seen from the final cluster of five retirees from the late 1960s, SAFEMAX can decline considerably in only a few years. The April 1, 1966, retiree was “safe” at just under 5%, but only two and one half years later, the October 1, 1968, retiree was forced to withdraw half a percent less. In fact, if the 1968 retiree had adopted the SAFEMAX derived from the experience of the 1966 retiree, his portfolio would have expired in 21 years, not 30. That is a bit uncomfortable to acknowledge, to say the least.
So let’s update the withdrawal performance of the 2000 and 2008 retirees to see if they have anything to worry about. The simplest way to do this is probably through comparisons of the “current withdrawal rate,” which is the amount withdrawn at the end of each year divided by the portfolio balance at the start of that year. Figure 2 updates a similar figure in my earlier article.
The January 1, 2000, retiree now has 16 years under his belt, and what a wild 16 years they have been in the markets! Two 50% declines in the S&P 500 index, followed by vigorous recoveries, particularly since 2009. In my earlier article, I noted that during retirement an increase in the current withdrawal rate of about 25% from the initial withdrawal rate (of about 4.5%) signaled danger, and by year’s end 2009, the 2000 retiree had exceeded that threshold. However, I also observed that the trend in 2010 and 2011 had turned favorable, as the current withdrawal rate declined those two years.
From 2012 to 2015, that trend of declining current withdrawal rates continued for the 2000 retiree, sending him or her well below the “danger threshold.” At year-end 2015, the retiree’s current withdrawal rate was 5.4%, admittedly elevated above the initial withdrawal rate of 4.5%, but well below the peak of 6.5%. Compared with the 1969 retiree (to facilitate comparisons with the 2012 charts, I will not substitute the October 1, 1968, retiree at this time), the 2000 retiree is in very good shape indeed, with current withdrawal rates 60% lower than that “worst case” scenario. My conclusion for the 2000 retiree is that although he may be subject to portfolio shrinkage over the remaining 14 years of his time horizon, he need not make any adjustments to his strategy. His money should last the full 30 years, barring some cataclysm.
The January 1, 2008, retiree, if anything, is in even better shape than the 2000 retiree was at that same stage of retirement, eight years in. Despite an even larger stock market decline, his current withdrawal rates have been consistently lower than those of the 2008 retiree, and at the end of 2015, his current withdrawal rate of 4.4% was below his initial withdrawal rate of 4.5%. This is a favorable development and argues that, for this retiree as well, no immediate strategy changes seem required.