When markets fall, withdrawal rates can go up
We’ve previously covered the concept of withdrawal rates, and, in particular, safe withdrawal rates for retirement income seekers.
One significant challenge of the standard safe withdrawal rate research is that, if we apply a fixed rule (e.g. that you should start by withdrawing 3.5% of your retirement portfolio when you retire), then your income in retirement will be heavily dependant on the amount you have invested on the day you retire.
Michael Kitces, the leading financial planning academic in the USA, illustrated this perfectly for us:
“Imagine two clients, the Retirenows and the Notquiteyets, who both have a £1,000,000 portfolio available for retirement. The Retirenows begin retirement immediately, and use an initial withdrawal rate of 3.5% to produce £35,000 a year of real spending (increasing each future year for inflation). The Notquiteyets, on the other hand, decide that they wish to work for one more year, and plan to retire next year instead. Over the ensuing year, a bear market emerges, and at the end of the year both portfolios have experienced 15% market declines. The Notquiteyets, now ready to retire, can only safely spend £29,750 a year (which is 3.5% of their now £850,000 portfolio) adjusted each year for inflation. In the meantime, with a 3% inflation adjustment on their original safe withdrawal amount, the Retirenows are informed that they can safely spend £36,050.
The Retirenows can safely spend almost 21% more than the Notquiteyets, despite the identical investment results. And in fact, the disparity is even more shocking; because the Retirenows also spent money in the first year, the reality is that not only is their safe spending in year two a whopping 21% higher than the Notquiteyets, but their portfolio value is lower. After all, the Retirenows didn’t just experience the market decline; they also took a first-year spending withdrawal!”
This paradox explains why clients who retire after a bear market can start with a higher withdrawal rate than those who retire at the top of the market.
This paradox was confirmed by Professor Wade Pfau (the Professor of Retirement Income, no less!) who looked at several examples from the past proving that withdrawal rates do move inversely to market valuations.
The conclusion from these studies is that you can increase the standard safe withdrawal rate by 0.5% when markets are below their all-time highs, and by 1.0% when markets have fallen sharply.
When markets are plumbing the depths, you can increase your starting withdrawal rate by even more.
After last week’s drop in asset values, the UK stock market is at least 10% lower than its all-time high, so, if you are about to retire, you can safely increase the starting withdrawal rate from your portfolio.
Mr and Mrs Notquiteyet can relax!