Retirement Spending: The 4% Solution

by Rande Spiegelman, CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research
August 29, 2006

Reprinted from the August 17, 2006 issue of Schwab Investing Insights®, a monthly publication for Schwab clients.

Younger investors saving for retirement often ask: "How big does my portfolio have to be before I can retire?" Those nearer to or in the very early stages of retirement might ask: "How much can I safely withdraw from my retirement portfolio?" The two questions are really different ways of approaching the same critical issue.

Based on our research, we believe that if you are a conservative-to-moderate investor at retirement who wants a very high level of confidence you can maintain your standard of living and keep pace with inflation for a retirement lasting 30 years, you can follow a basic rule of thumb. The rule is this: You should shoot for a retirement portfolio approximately 25 times as large as your first-year withdrawal. This roughly translates into a 4% withdrawal rate in the first year of retirement.

CHART

First-year vs. per-year approach
A first-year withdrawal target of 4% doesn't mean you will withdraw 4% of your portfolio's value each year. If you did, your cash flows would be all over the map, up in some years and down in others, as your portfolio fluctuated over the short term. The key is to strike a balance between not running out of money prematurely and maintaining a reliable standard of living, adjusted for inflation, from one year to the next. The 4% withdrawal rate applies to the first year only. Then, grow the first-year dollar amount for inflation each year throughout your retirement.

Residual wealth
Based on a Monte Carlo analysis that runs thousands of simulations of market scenarios, we believe that a 4% first-year withdrawal rate should allow you to grow that dollar amount for inflation each year with about a 90% probability your money will last 30 years. To put that in perspective, in 89% of the probable outcomes, there would be more than $0 at the end of 30 years. In the remaining 10% of probable outcomes, you would run out of money earlier.

Here's an illustration of what ending wealth might look like at various confidence levels, using as an example a first-year withdrawal of $50,000 from a $1,250,000 portfolio¹:

CHART

As you can see, there's a very slim (one-in-ten) chance the portfolio might be worth at least $6,445,000, a 50/50 chance of ending up with $2,340,000, and so on. By the way, at a 95% confidence level, the portfolio runs out of money at some point during the 27th year. Also, keep in mind that these are future dollars. Assuming a 2.6% compound rate of inflation, $1,000,000 30 years from now has a present value of about $463,000. Of course, the first-year withdrawal amount of $50,000 would grow to almost $108,000 in terms of future dollars. You might assume higher inflation, but that would also correspond to higher expected nominal investment returns.

No magic here
There's nothing magical about a 90% probability, though we think it's a reasonable goal to shoot for. Anything less than 75% would probably be undesirable for most, with 50% not much more than a coin flip, but you may be okay with an 80% or 85% probability. And your retirement may not last 30 years. If that's the case, maybe you could get by with a portfolio less than 25 times your first-year withdrawal. Every situation is different.

As for what constitutes a "safe" withdrawal rate, a lot depends on the return assumptions, time horizon and probability levels used. Using realistic assumptions—we estimate a long-term return of 7% for a moderate portfolio of 60% stocks and 40% bonds and cash—a first-year withdrawal of 3% to 5% seems reasonable. Anything less than that would require either an extraordinarily large portfolio or drastically reduced spending, while anything much over that would likely result in an unacceptable confidence level.

Stay flexible
Remember, too, that in the real world, future returns and inflation rates are unknowable in the here and now, at least with absolute certainty. That's why it's a good idea to stay flexible, and why you should view retirement planning as an ongoing process and not a one-time event. A Schwab consultant can help you design your own plan, using realistic assumptions based on your own unique situation.

Important Disclosures:
The retirement strategies discussed herein are guidelines to consider but are not intended to be predictive of future results and do not represent individualized advice.

1. Based on 1,000 Monte Carlo simulations assuming a moderately conservative asset allocation (25% large-cap stocks, 5% small-cap stocks, 10% international stocks, 50% bonds, 10% cash) using the following capital market expectations: large-cap stocks 8.6%, small-cap stocks 10.3%, international stocks 8.6%, bonds 4.4%, cash 2.9%, inflation 2.6%.

Although the information contained herein is obtained from sources believed to be reliable, its accuracy or completeness is not guaranteed. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security. Schwab does not assess the suitability or the potential value of any particular investment. All expressions of opinion are subject to change without notice. No portion of this report may be copied in any manner or form, nor redistributed, without the prior written consent of Schwab. All charts and research have been compiled from publicly available, proprietary and/or licensed data. Past results are not indicative of future performance. Diversification and asset allocation do not eliminate the risk of investment losses.

This report contains viewpoints and opinions on the economy, the markets, and specific companies and securities. From time to time, certain of them may differ from each other. Additionally, Schwab or its affiliates may publish or otherwise express other viewpoints or opinions that may be different from certain of the viewpoints or opinions expressed in these materials. Investment funds and/or separate accounts managed by Schwab or its affiliates may take positions contrary to the information contained in these materials.

This information is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, Schwab recommends consultation with a qualified tax advisor, CPA, Financial Planner or Investment Manager.

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