The magic withdrawal number in retirement: 2.8% with low rates
February 7, 2013 by Darla Mercado
If you’re planning for low interest rates to last, you might want to take a second look at your clients’ withdrawal rates in retirement.
It seems that a 2.8% withdrawal rate over a retirement period of 30 years, with a 40% allocation to stocks, is the recipe for a 90% success rate — if interest rates continue to stay low, according to a recent study by David Blanchett, head of retirement research at Morningstar Inc.’s investment management division.
Michael Finke, a professor at Texas Tech University, and Wade D. Pfau, an incoming professor at The American College, were co-authors.
In the analysis, the writers assumed an initial interest rate of 2.5%, based on today’s rates and approximately the same yield on the Barclays Aggregate Bond Index as of Jan. 1. Rates were assumed to rise to normal after a five- to 10-year period. The researchers used 30-day Treasury bills as a proxy for cash, the Ibbotson Intermediate-Term Government Bond Index to stand in for bonds, and the S&P 500 to represent stocks.
Over a 30-year period, the model assumes a 3.02% return on cash, a 5.14% return on bonds, bond yields at 5.01%, stock returns at 9.89% and inflation at 3.14%. The study also assumes a 1% fee to account for the cost of the investments and fees for the adviser.
Based on those assumptions, the tried-and-true 4% initial retirement withdrawal rate over 30 years, with a 40% allocation to stocks, will only lead to a 48.2% success rate, the researchers found.
The first five to 10 years are extremely important for retirees because low rates erode returns on the bonds. However, rising rates will consume the value of the bonds, Mr. Finke said.
“When it comes to shortfall risk, those first five to 10 years are extremely important,” he said. “It’s been suggested that one way to achieve higher yields is to raise the duration of the bond holdings, but that only exposes you to greater interest rate risk. There is no easy solution for this problem.”
In the end, building the appropriate base for sustainable income in retirement will require clients to save more money, according to the paper.
“While the difference between a 3% initial withdrawal rate and a 5% initial withdrawal rate may not seem material,” the researchers wrote, “the 3% initial withdrawal rate requires 66.7% more savings than the 5% to produce the same annual income.”
Raising the allocation to equities only makes a small difference in the withdrawal rate, so the greater risk doesn’t necessarily pay off with a higher withdrawal rate. If a client has a 30-year time horizon and 80% of his or her portfolio is allocated to equities, the individual can withdraw income at an initial rate of 2.6%, according to the study.
The use of longevity insurance could help make up for the increased risk that a client will run out of money, Mr. Finke said. Mr. Pfau has done research that shows the value of income annuities as opposed to bonds because the former has the added benefit of mortality risk pooling.
However, advisers also may want to talk to clients about their expectations for life in retirement.
“The bottom line is that a client needs to have more modest expectations about how much income they can withdraw safely each year from the retirement portfolio,” Mr. Finke said. “If the client doesn’t think that’s enough money to live on, then they need to consider other options, such as delaying retirement or supplementing their income to maintain their lifestyle.”