Saving up for retirement is hard work. It can take a lifetime to accumulate a large enough nest egg to live on (see How Much Money Do You Need To Retire), and once you finally do retire, you want to make sure your money never runs out before you pass away. What happens to your savings in retirement depends chiefly on one factor: how your withdrawal rate compares to your investment return.
Now when I say withdrawal rate, I am referring to the withdrawal rate in your first year of retirement, similar to how the 4% rule works. After the first year, I’m assuming that you are withdrawing the same amount (not percentage) to maintain your current lifestyle.
With this is mind, there are essentially only three possible scenarios for the year you retire:
- Your withdrawal rate is less than your investment return.
- Your withdrawal rate is equal to your investment return.
- Your withdrawal rate is greater than your investment return.
This can be summed up in the following graph comparing how retirement savings is affected by withdrawal rate and investment return from retirement at age 65 until age 100.
1. We’ll start with the ideal scenario, when your withdrawal rate is less than your investment return. This means that you are taking less money out than you are making each year, so your savings continue to grow even as you live off of them. You can see this illustrated above as the green line. You’ll notice the exponential curve. Since your investments are still growing each year, that means compounding is still in play. This is the safe scenario for retirement because your savings are not diminishing each year. You don’t have to worry about using up all your money before you go, and you are able to leave the most money behind for your family. In fact, the longer you live, the more money you’ll have to pass on.
2. The next scenario, when your withdrawal rate is equal to your investment return, still allows you to retire comfortably knowing your money won’t run out; however, it will not continue to grow, and if the rates are not exactly equal, you could quickly run into problems. In this scenario, you are taking out exactly as much money as your investments will earn each year. You have money to live on, and your savings are stable. The problem with this scenario is that it is practically impossible to achieve. Though your portfolio may average a certain percentage return each year, this is not constant from year to year. Theoretically, I suppose you could keep your savings at the same number each year, only taking out any earnings, but then in a down year, you’d actually have to add money to your savings in order to keep the amount unchanged. It’s simply not practical. Regardless, if you were able to achieve this, your savings would look like the black line in the graph above: flat.
3. The last scenario, when your withdrawal rate is greater than your investment return, is one you do not want to find yourself facing. This occurs when you are withdrawing more money from your savings than you are earning each year, and as you might expect, this results in your savings diminishing quickly, as you can see illustrated by the red line above. This means that they may be relatively stable for a while (depending on how close you are to the second scenario) but then decline rapidly. Before you know it, you’ll be out of money. Now, to be fair, you can certainly retire under these conditions. However, it can be quite risky. If you end up living longer than you expect, you may find yourself with no money left to live on.
Clearly, how your withdrawal rate at retirement compares to your investment returns can make a big difference. If you withdraw too much, you may quickly end up without any savings at all. How can you prevent that from happening? It’s quite simple. Your initial withdrawal from your savings when you retire should be a lower percentage than your anticipated investment returns. To be safe, and because investment returns can vary so much from year to year, your initial withdrawal rate should actually be much lower. That’s why experts generally recommend withdrawing no more than 3-4% in your first year of retirement, even if you’re expecting 9% annual returns. You never know what the future might bring, so it’s better to be safe.