Determining Withdrawal Rates Using Historical Data

by William P. Bengen

Editor's note: In honor of the Journal of Financial Planning's 25th anniversary, during

2004 we will reprint what we consider some of the best content of the Journal. This month,

outlive their money. This article utilizes historical investment data as a rational basis for these recommendations.

It employs graphical interpretations of the data to determine the maximum safe withdrawal rate (as a percentage

of initial portfolio value), and establishes a range of stock and bond asset allocations that is optimal for virtually all

retirement portfolios. Finally, it provides guidance on "mid-retirement" changes of asset allocation and withdrawal

rate.

William P. Bengen, CFP®, is a sole practitioner in El Cajon, California, specializing in investment management.

The year is 2004. You have done a creditable job of building your financial planning practice over the last ten

years. Your retirement clients are particularly well satisfied. You have demonstrated to them the virtue of a

diversified portfolio of investments to provide income during retirement. The markets have been kind, if not overly

generous; your clients' portfolios have enjoyed returns well in excess of bank savings accounts and certificates of

rates of withdrawal based on average rates of returns experienced by the markets over the years, and that the

markets will recover. However, you cannot help feeling a gnawing concern that you have overlooked something...

It is 2009. True to your forecast, the stock market has recovered nicely during the last three years, and most

clients' portfolios have regained almost all their lost nominal value. However, your clients have a new complaint:

they cannot live on the withdrawals they have been making. Inflation, averaging eight percent over the last five

years, has so eroded their purchasing power that they must substantially increase their withdrawals

—or face a

drastically reduced quality of life. When you compute the effect on your clients' portfolios of these much higher

levels of withdrawals, you are shocked: many clients will deplete their assets in less than ten years, even though

As Larry Bierwirth pointed out in his excellent article in the

January 1994 issue of this publication ("Investing for

Retirement: Using the Past to Model the Future"), it pays to look not just at averages, but at what actually has

happened, year-by-year, to investment returns and inflation in the past. He demonstrated that the long-term

effects of certain financial catastrophes, such as the Depression or the 1973–1974 recession, can overwhelm the

averages. Such "events" cannot be ignored, and the client should be made aware of them.

In this article, I will build on Bierwirth's work, approaching it from a slightly different tack. Using the concept of

To begin with, let's see how our hypothetical planner got into trouble. By referring to the Ibbotson data (which we

will assume had not changed significantly by 2004), our planner learned that common stocks had returned 10.3

percent compounded over the years, and intermediate-term Treasuries had returned 5.1 percent. Inflation

averaged 3 percent over the same period. Therefore, a client with a portfolio consisting of 60-percent stocks and

40-percent bonds could expect an average compounded return of 8.2 percent, assuming continual rebalancing.

The "real" return, adjusted for inflation, would be almost 5.1 percent.

This planner's clients wanted to spend as much as possible each year from their retirement accounts, while

maintaining a consistent lifestyle throughout retirement. Given the above analysis, it seemed to the planner that

the clients could safely withdraw all the "real return" each year, or about five percent, and leave the remainder in

worked well for several years, as investment returns and inflation stayed close to historical averages. The

circumstance that upset the arrangement was an "event," consisting of a severe stock-market downturn and high

inflation. What similar events have actually occurred in the past?

Table 1 lists the three largest stock-market declines since 1926 that have occurred over periods of more than one

year. (The "crash" of 1987 does not appear, as stocks showed a gain for the full year.) Because of my interest in

astronomy, I have nicknamed them, respectively, the "Big Bang," the "Big Dipper," and the "Little Dipper,"

reflecting their relative impact on the value and purchasing power of investors' portfolios. These impacts will be

more precisely quantified in the section below on the portfolios.

● The "Big Bang" of the 1973–74 recession was the most devastating because it occurred during a period of

only half a decade.

● The "Little Dipper," of course, was the early Depression years. It may sound odd to list its impact as only

third behind the previous two events, given the huge decline in stock prices that occurred. However, as

you can see from Table 1, the early years of the Depression was a deflationary period, so the impact of

the decline in stock values was cushioned by an advance in purchasing power for the dollar, as well as by

modestly positive bond returns.

There have been other events of shorter duration, such as in 1946, but the above represent the most significant

financial cataclysms of the last three quarters of this century. As planners, we know such events are likely to

recur in the future. But just how detrimental have these past events been on the long-term performance of a

is easy to explain to my clients, whose primary goal is making it through retirement without exhausting their

funds, and whose secondary goal is accumulating wealth for their heirs. The graphs themselves afford rapid

comparisons between many different investment scenarios. I have made several assumptions in preparing these

graphs.

In Figure l(A), the first vertical bar on the left represents the portfolio of a client who began retirement on Jan. 1,

1926. He made a withdrawal of 3 percent of the portfolio the first year, followed by inflation-adjusted withdrawals

each succeeding year. The next bar represents the portfolio of a client who began retirement on Jan. 1, 1927,

and so on.

As you can see from the graph, the 1926 client was able to make withdrawals from his portfolio in this manner for

50 years. Actually, the portfolio would have lasted much longer than this. I have chosen 50 years arbitrarily as the

Figure l(A) (three-percent withdrawal rate) is as exciting as a crewcut. It shows that all clients, regardless of the

year they began their retirement, were able to enjoy at least 50 years of inflation-adjusted withdrawals from their

portfolios. The graphs become more interesting as we increase the percentage of first-year withdrawal. Figure l

(B), featuring an initial withdrawal of four percent, begins to show the effects of some financial events. However,

these effects are comparably mild; no client enjoys less than about 35 years before his retirement money is used

withdrawals begin many years earlier—as much as 20 or more years earlier! This is a powerful warning

(particularly appropriate for recent retirees) not to increase their rate of withdrawal just because of a few good

years early in retirement. Their "excess returns" early may be needed to balance off weaker returns later.

The "Big Dipper" of 1937–1941 was less severe than the "Big Bang," and affected portfolio longevity for only

about 9 or 10 years prior to the event—about half that of the "Big Bang." Least significant of the three was the

"Little Dipper" of the Depression years, which affected portfolio longevity for only four to five years. This confirms

our earlier observation that it is not a deflationary period like the Depression that is to be truly feared, but rather

an inflationary period that wreaks havoc on purchasing power as well as portfolio values.

I have not included charts for withdrawal amounts of seven percent and higher, as they are too high to be

rates as high as approximately 3.5 percent.) However, most clients would find such a low level of withdrawals

unacceptable.

Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent [Figure l

(B)], followed by inflation-adjusted withdrawals in subsequent years, should be safe. In no past case has it

caused a portfolio to be exhausted before 33 years, and in most cases it will lead to portfolio lives of 50 years or

longer. By comparison, a 4.25-percent first-year withdrawal could exhaust a portfolio in as little as 28 years, were

past conditions to repeat themselves.

Therefore, I counsel my clients to withdraw at no more than a four-percent rate during the early years of

different asset allocation would improve this, but it would still be uncomfortable, in my opinion). This means he

has less than a 40-percent chance to successfully negotiate retirement—not very good odds. If the client

suggests that he can prune back his lifestyle to accommodate a major event should it happen, I make sure he

knows how severe a pruning that may require. Even then, it may be too little to late.

To answer that question, consider Figure 3(A), which shows 4-percent withdrawal rate applied to a portfolio

consisting of 75-percent stocks and 25-percent bonds. Compare this to Figure l(B),which is also drawn for a 4-

percent withdrawal rate, but at a 50/50 stock/bond mix.

Importantly, however, the shortest longevity is still during the "Big Bang" (and this longevity has been unaffected

by the higher stock allocation), so we have not violated our criterion of 30 years minimum portfolio longevity.

As there is a trade-off in moving to stock allocations higher than 50 percent, there is clearly room for client

discretion. However, before a client makes his or her decision, there is one more piece of information to consider: