What Are Safe Savings Withdrawal Rates In Retirement?

By: Boris_Dzhingarov

Throughout most of my working life, I assumed I had my retirement sorted. I’d been building my own savings from the day I started working, as well as contributing to a retirement fund with automatic deductions from my salary.

However, as I got older, a lot of questions started to gnaw at my peace of mind. The amount I had saved seemed like enough, and still had time to grow. But I started to worry that I couldn’t truly know if I had enough available. After all, taking inflation into account, the amount I would need for my day-to-day needs would constantly increase.

Of course, inflation was accounted for by the investment of my funds, but that would all change once I started actually living off them. They couldn’t keep growing at the same rate while I continually withdrew money from my accounts.

It was in this context that I learnt about safe withdrawal rates. The subject of safe withdrawal rates is a crucial one for retirees (and those approaching retirement) to consider. If you're as concerned as I was about how my retirement savings would last, this discussion is going to be extremely pertinent.

As we end 2022 and enter 2023, it is more relevant than ever. Inflation is not sticking to the rules and this is having an impact on retirement savings. Let’s take a look at the concept of safe withdrawal rates, the figures touted by experts, and whose advice you should take.

What are safe withdrawal rates?

The discussion of safe withdrawal rates is really a question of how much of your retirement savings you can afford to spend at any one time. Every year, you are going to withdraw and use a proportion of your retirement funds. Since they need to last you for the rest of your life, you need to know how much you should withdraw. The answer you come to is known as your safe withdrawal rate (SWR).

This is not the same as taking the sum total of your retirement savings and dividing it by the number of years you think you have left. As I’ve mentioned, the amount you need to spend on your daily needs is continually rising due to inflation. The amount of money you can get by with today isn’t going to be anywhere near enough thirty years from now.

If you're not a maths whizz, you may well be wondering how we can ever pinpoint a fixed SWR. This is where the equation becomes a whole lot more complicated. A SWR needs to be an amount that allows your fund to keep growing at a relatively high rate. As each year passes, the SWR you have chosen will be worth slightly more than the year before.

The theory is that we can get to a specific SWR that remains relevant and accurate as the decades go by. The boffins who crunch the numbers will tell you that this does, somehow, work. However, they do argue on what that rate is and whether it is truly universal.

The 4% Rule

When I started down this rabbithole, I came across what is called the 4% rule. The 4% rule is exactly as it sounds. It contends that, as a rule of thumb, 4% is a safe withdrawal rate across the board.

This idea sprouted in the US. It infiltrated the discussion of safe withdrawal rates in Canada too, with many experts there contending that 4% is the magic number. Over time, it has made its way to the UK.

There are two challenges we need to put to the 4% rule:

1. Does it work?
2. If so, does it apply in the UK?

Let’s start with the first challenge.

Does the 4% rule work?

The 4% rule is not a new concept. It was first brought to widespread attention by financial planner Bill Bengen in 1994. He demonstrated that 4% would have been a safe withdrawal rate across any thirty-year-period in modern market history.

It has been almost thirty years since, which makes it almost the perfect time to ask the question of whether the 4% rule works. The good news, for Bill Bengen at least, is that the 4% rule has proven effective. In fact, some contend that 4% was playing it too safe.

The bad news is that the past efficacy of the 4% rule does not necessarily predict whether it will work in future. Economic conditions are different today than at any period over the past thirty years. A confluence of low starting bond yields, relatively high equity valuations, and high inflation have created a perfect storm to put our retirement funds at risk.

That being said, the time periods over which the 4% rule has been tested have at some points had vastly different economic contexts. The theory is that the ups and downs are smoothed out over time and 4% is a safe withdrawal rate in the long run.

Is the 4% rule universal?

As I mentioned, the 4% rule has spread its wings and made its way across the pond. Many British retirees are using 4% as a SWR. But is it wise to assume a rule that works in the US should work in the UK?

There are reasons to push back against the 4% rule in the UK. Our inflation rate is not the same as the US’s rate. In fact, there is usually at least one percentage point separating the two, with inflation here almost always higher.

This does not automatically mean that 4% will not be a safe withdrawal rate in the UK. However, it does mean that we cannot take it as fact. While it has worked elsewhere, experts in the UK have come up with their own calculations to determine a SWR specific to our shores.

What is a SWR in the UK?

The 4% rule was given credence in the UK for a long time, before experts began to weigh in. After doing some studies, they came to the conclusion that 4% was not a safe withdrawal rate for British retirees.

They came up with their own figures. The most conservative figure was 2.5% with others contending that 3% was a good rate. Many more take the middle ground and put the SWR in the UK at 2.7%.

The question remains as to whether you can rely on a rule of thumb, considering our current economic context. Many people saw their retirement savings drop significantly at the end of 2021 and beginning of 2022 due to markets falling.

There’s no simple answer to this. Theoretically, the SWR of 2.7% should still apply, considering that the number was calculated by taking the worst case scenario into account. The thirty year periods over which it was applied included times during which financial markets were in a worse condition than they are today.

Nonetheless, there is always going to be some doubt regarding how future proof a SWR is, simply because unprecedented events do occur. We expect our world to recover, but there is always a worst-case-scenario that everything falls apart. We can’t live our lives based on that worst-case-scenario, though, so choosing a SWR should not fail you.

What if you retire early?

I’ve consistently used the timeframe of 30 years, which has been the basis for the calculation of SWRs in most cases. The US’s 4% rule and the UK’s 2.7% rule were calculated using that timeframe. This makes sense, considering that this is the expected lifespan of retirees.

But what if you retire early? The earlier you retire, the less likely the 2.7% rule is to be effective. By adding on more years to the calculation, your SWR gets smaller. The flipside is that most early retirees have reasons to be optimistic about their financial security. Few people retire early with nothing more than hope that they’ll be able to make ends meet.

There is another question that is more difficult to answer. What if we start living much longer than we once did? Life expectancy has been rising consistently, with only the pandemic causing an aberration. If people start living healthy lives years after they have hit 100, they will run out of retirement savings.

Of course, this is part of a much greater discussion, which includes whether people need to start retiring at a later age, and the impact this would have on our economy.

There is no guaranteed safe withdrawal rate, but the 2.7% rule in the UK and the 4% rule in the US and elsewhere do seem to work. That said, we can’t predict the future, especially considering how things have changed over the last few years.

By Boris Dzhingarov

© 2022 Copyright Boris Dzhingarov - All Rights Reserved

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