After working years to accumulate a nest egg, investors naturally hope to live comfortably off their savings in retirement. So clients often ask us what constitutes a “reasonable” withdrawal rate. You can use historical average returns to arrive at an amount for annual withdrawals, of course, but the detail that’s lost when you use average annual returns can prove critically important.
For example, from 1993 through 2016, the S&P 500 achieved an average annual return of 9.21%. If you invested $500,000 at the end of 1992, made no deposits or withdrawals, and duplicated the S&P 500’s performance, you would have ended last year with a $4+ million portfolio. Along the way, you’d have experienced large annual losses (more than 37% in 2008, for example) and gains (more than 32% in 2013). Despite such volatility, however, given the 9.21% average return you might assume that annually withdrawing 7% of the starting value—$35,000—would not have depleted the portfolio over the 24-year period. And, in fact, you’d be right: The portfolio would’ve survived such withdrawals because of the order in which the annual returns occurred. You could not have known in advance, however, that high returns in the 1990s built a protective cushion against negative returns when the tech bubble burst; or that good performance in the mid-2000s cushioned against losses during the Great Recession. In contrast, think about what would’ve happened had the losses all come in the early years and the gains much later.
We’ve analyzed this situation and others in our recently-updated article, “The Hidden Trap of Average Annualized Returns and The Adaptive 5% Solution.” If the annual returns of the S&P 500 were “shuffled” so that they occurred in low-to-high order, the portfolio would’ve achieved the same 9.21% annualized time weighted return. However, annual withdrawals of $35,000—just 7% of the account’s initial value—would’ve depleted the portfolio in less than six years. When the poorest-performance years come first, the $35,000 annual withdrawals would have been catastrophic. In contrast, when the returns are shuffled high-to-low, the portfolio actually grows in spite of the same withdrawals.
The unknowable nature of future returns has led us to offer the following suggestion, which we call “The Adaptive 5% Solution.” Rather than think of annual withdrawals in fixed dollar terms, think in adaptive percentage terms. If you annually withdraw 5% of the account based on its January 1st value each year (that’s the “adaptive” part), the portfolio will more likely survive good times and bad—no matter what order returns occur. (Depending on returns and your withdrawal rate, the portfolio value may grow or decline.) When performance is good, and the year-over-year value increases, your withdrawal amount will go up (i.e., 5% of a larger number is a larger number). Belt-tightening will be necessary after a down year, however, and you will have to withdraw less. While it may be a bit more difficult to budget, and you may have to scrap hoped-for purchases or vacation plans after poor years, when good performance returns, your portfolio will be there.