Withdrawal Rates Adjusted for Rough Roads

Over the years, I’ve talked about a reasonable withdrawal rate from your investments. This is the amount you can start drawing from your investments that allows the money to last as long as you do. The number I use is 4%. Research puts the number somewhere between 3.5 and 5%, depending on how the study is constructed. When I use 4%, I’m anticipating the investments to last 30 years whether or not you get hit with something as big as the Great Depression—even when taking inflation into account.

But lately many professional publications and bloggers are questioning whether the withdrawal rate is set too high. They are worried because, while the historic long-term average on returns of stocks is around 10% per year, most predictions put the next many years at a 5-8% return. And as you can imagine, less return allows less withdrawals. So their logic is based on the idea that if a 4% draw rate is good with stocks returning 10%, you might need to drop things down to 2-3% if stocks are returning less.

You might remember that I preach diversification. That does help things. But even a nicely balanced portfolio can have a decade-and-a-half long period with an average return close to 1%. So does that make the pundits right? On the contrary, it actually proves my point.

The worrywarts are using a line of reasoning that doesn’t consider how the withdrawal rate is calculated. You see, the withdrawal rates are already adjusted for little things like the Great Depression, the ‘73-‘74 bear market, the crash in October 1987, and other market anomalies, including entire decades where the average return in the stock market was negative.

Things have been bad in the past—actually a lot worse in the past—and yet the nominal withdrawal rates I talk about still worked. Is the current environment that much different?

That’s where quite a few of my professional friends agree with quite a few of my lay friends: both groups expect things to blow past the worst-case scenarios of the past into something quite unimaginable.

So let’s try to imagine it.

Michael Kitces is a leading market historian and researcher. According to him, for us to have a new worst-case, stocks would have to have real returns of less than 1% and bonds have real returns of 0% for the next 15 years. I’m not saying it’s not possible. (Sorry to my English professors for the double negative.) I am saying that it’s more likely Congress will come up with meaningful tax reform, an energy plan, and fully fund the repair of our failing infrastructure.

In other words, not likely.

This article was published in the Wichita Falls Times Record News on September 23, 2011.