What is a ‘Safe’ Income Withdrawal Rate?
It’s Crucial to Ensure You Won’t Run Out of Money in Retirement
What does the phrase “safe income withdrawal rate” mean to you? Most people would answer, “the amount of income you can withdraw from your assets without the fear of running out of income during your lifetime.” This seems cut and dried. But you have to look at what the word “safe” means to different people.
“Safe” to some people might actually mean “safer than something else,” such as you stating that you are “driving safe” because you are going 80 miles per hour while everyone else on the road is driving 90 miles per hour, but the posted speed limit is 65 miles per hour. And then, “safe” to other people might mean the chance of anything negative happening is 0%. In planning for retirement, safe better mean safe, something you can count on for sure. Safe better not mean “kind of safe.”
It Sounds Simple, Right? (But it’s Not!)
When you were working and saving for retirement, you were probably taught, or simply thought, that you could:
- Save up a pile of money by the time you retired.
- Live off the earnings of your pile of assets.
- See your assets continue to grow, or at least stay level, while you were taking income distributions.
- Leave the exact same pile of your money to your kids and grandkids when you passed away.
Doesn’t this sound just perfect? This is exactly what you want to happen with your assets. Save your money, use your assets for income throughout your retirement, and then pass all remaining assets to your kids and grandkids.
Unfortunately, it doesn’t work this way. Do you remember “The Gong Show” from the late 1970s? Remember when someone failed or was wrong the “Gong” was hit and made a loud dismal sound signaling failure. I just hit the “Gong” about what you were taught or thought about how your money would act because what you learned about how you could use your assets to create income is no longer accurate and is no longer a viable planning strategy.
SEE ALSO: Adjusting to Retirement: 8 Helpful Tips
So, What is a ‘Safe’ Income Withdrawal Rate?
For decades the financial industry has used resources such as Morningstar, Ibbotson, and other firms to provide a “safe income withdrawal rate” for retirees. The “safe income withdrawal rate” is typically based on some type of success probability. In the 1980s the industry standard for a “safe income withdrawal rate” was 6%. This meant you had a high probability, typically a 95% chance (for you math eggheads out there, this means within two standard deviations), that you could take out 6% of your assets for income each year and not run out. This also meant you had a 5% chance you would run out of money during your lifetime because your income wasn’t guaranteed. And during retirement, we feel 95% success probability is 5% too low.
If you remember back to the 1980’s you could have earned 8% in the bank, so 6% was not a stretch. But over time, the stock market has changed, interest rates have changed, the economy has changed, and the world has changed, all helping to shape the historical progression of safe income withdrawal rates:
- In the 1980’s it was thought 6% was the “safe income withdrawal rate,” then the Gong was hit signifying that 6% was too high.
- In the 1990’s it was thought 5% was the “safe income withdrawal rate,” then the Gong was hit signifying that 5% was too high.
- In the 2000’s it was thought 4% was the “safe income withdrawal rate,” then the Gong was hit signifying that 4% was too high.
- In the 2010’s it was thought 3% was the “safe income withdrawal rate.”
- Now the Gong may be hit again, as the financial industry is weighing the possibility that the “safe income withdrawal rate” should be reduced to 2.5%, meaning that on $1,000,000 of portfolio assets you shouldn’t take out more than $25,000 per year. In many cases, this may not be enough for you to live on.
How You Can Plan
In planning your retirement income, you must have a high probability for success that your income will never run out, or you will worry every day throughout your retirement. Right now, you may have a high probability your money will run out and just not know it. Or, you may be working with an advisor, or doing the planning by yourself, and you incorrectly have been told, or think, that you can’t be hurt by having a low probability of retirement income success. You cannot let yourself stay in this position.
Here’s an example: If you watched the comedy Dumb and Dumber, you will recall Lloyd played by Jim Carey was interested in Mary, played by Lauren Holly. One of the most memorable scenes has been nicknamed “1 in a million.” In this extremely memorable scene, Lloyd and Mary have the following dialogue:
Lloyd: “What do you think the chances of a guy like you (he was nervous so he called Mary a guy), and a girl like me (again nervous so he calls himself a girl), ending up together?”
Mary replied, “Well Lloyd, that’s difficult to say, and we really don’t…”
Lloyd interrupted: “Hit me with it, just give it to me straight. I came a long way just to see you Mary. Just, the least you can do is level with me. What are my chances?”
Mary replied tentatively: “Not good.”
Lloyd replied after a long pause: “You mean not good like 1 in 100?”
Mary replied: “I’d say more like 1 in a 1,000,000.”
Lloyd replied optimistically: “So you’re telling me there’s a chance, Yeah!”
In matters of the heart, it’s OK to take a chance and not have a high level of probability of success. But in planning income for your retirement years, you must design a plan that has the highest level of potential success rate, with 100% as the goal. A guaranteed 100% is even better.
There are several main reasons the “safe income withdrawal rate” has decreased by 50%, and possibly more, since the 1980s:
- The stock market’s increased volatility.
- Interest rates declined to historic lows.
- Life expectancy has increased.
These changes create necessary modifications to your plans for retirement, as the traditional asset allocation models you have been using may not work any longer to be able to provide you lifelong retirement income success.
If you want to ensure you won’t run out of money in retirement, we can help. Contact us today to learn how we can create a customized retirement plan to meet your goal of financial freedom.