How to Apply The Method of Safe Withdrawal Rate (SWR)

The safe withdrawal rate (SWR) method is a spending strategy designed to help retirees draw down their portfolios while minimizing the risk of depleting their funds. Although not perfect, the SWR provides a useful guideline for managing retirement spending.

Balancing a portfolio according to the safe withdrawal rate requires careful planning. Retirees and financial advisors often construct portfolios with lower-risk assets, such as bonds, to ensure longevity using the SWR method. However, retirees also typically include some growth assets, like stocks, to achieve modest returns. By creating a lower-risk portfolio, retirees can help secure their income for the long term, though it’s important to continuously monitor investments and spending.

The safe withdrawal rate (SWR) is the percentage of funds retirees can withdraw from their retirement accounts each year while minimizing the risk of depleting their savings before the end of their lives. The goal is to make the investment portfolio sustain the retiree’s lifestyle for as long as possible, so the SWR is typically a small percentage of the total portfolio.

After years of saving in tax-advantaged accounts such as a 401(k) or Roth IRA, retirees can apply the SWR method to draw from these investments. Although some retirees may have pensions or Social Security, the SWR method generally focuses on maximizing the discretionary portfolio, excluding these income sources. If a retiree can avoid tapping into their investment portfolio, they can extend its longevity.

Retirees usually shift to a lower-risk portfolio compared to their working years but often retain some stock allocation, typically around 40 to 50 percent. This stock allocation provides growth potential over time. The remaining assets are usually placed in income-producing investments like CDs or bonds. This combination creates a relatively low-risk portfolio that can support a higher safe withdrawal rate.

Maintaining a balanced portfolio with growth opportunities enhances the likelihood that retirees can avoid the risk of running out of money.

Calculating the safe withdrawal rate (SWR) can be straightforward with the 4 percent rule, a common guideline used by financial planners. The 4 percent rule involves withdrawing 4 percent of your portfolio’s balance in the first year of retirement, based on its value at retirement. In subsequent years, you adjust the withdrawals for inflation.

It’s crucial to understand that the longevity of your portfolio, assuming no growth, is the inverse of your withdrawal rate. For instance, a 4 percent withdrawal rate would deplete the portfolio in 25 years. A 3 percent rate would extend it to 33.3 years, while a 2 percent rate would make it last 50 years. This allows you to tailor your withdrawal rate based on your desired asset longevity.

In theory, a 4 percent withdrawal rate could deplete your portfolio in 25 years. For example, withdrawing $30,000 annually from a portfolio would last until the retiree is 90, assuming no growth. However, retirees often maintain investments in income-producing or growth assets, meaning their money could last longer if the market grows. While not guaranteed, the SWR method generally yields favorable outcomes.

For a more conservative approach, you can lower your withdrawal rate to extend your portfolio’s lifespan and increase the likelihood of not outliving your income. Considering the stock market’s potential for prolonged declines, some retirees opt for a 3 percent rule to further mitigate risk.

A 3 percent withdrawal rate is more suitable for larger portfolios. For example, this rate would mean withdrawing $22,500 annually from a $750,000 portfolio. In this scenario, additional income sources like Social Security might be necessary to supplement your retirement funds.

Alternatively, if you know your yearly expenses, you can calculate your safe withdrawal rate by dividing your annual expenses by your portfolio balance. For example, if your annual expenses are $25,000 and you have a portfolio worth $750,000, your withdrawal rate would be:

$25,000 / $750,000 = 0.033

This results in a 3.3 percent withdrawal rate. Assuming no growth, you can withdraw 3.3 percent per year, though inflation will erode its purchasing power over time. However, if your investments include growth assets, you can sustain a 3.3 percent withdrawal rate with minimal risk.

The more conservative your withdrawal rate or the lower your required expenses, the more likely your portfolio will last throughout your lifetime.

The safe withdrawal rate (SWR) method offers several advantages that make it worth considering:

1. Simple to calculate: The SWR method involves straightforward math. With a calculator, you can easily determine your withdrawal rate by dividing your portfolio balance by the desired longevity of your portfolio.

2. Reduces risk: By adhering to the withdrawal limits set by the SWR method, you minimize the risk of depleting your funds before the end of your life.

3. Predictable income: Since you calculate your withdrawal rate at the start of retirement, it typically provides a consistent income throughout your retirement years.

While useful, the SWR method has its limitations. Here are some drawbacks to consider:

Fails to account for market volatility: The simplicity of the SWR method is also a limitation. For instance, during extended recessionary periods, retirees may face an increased risk of depleting their funds.

Doesn’t account for life changes: While minimizing expenses is possible, unexpected costs can arise, especially healthcare expenses that can escalate significantly. A basic SWR method usually doesn’t factor in these potential increases.

Doesn’t eliminate all risk: Although the SWR method reduces the likelihood of running out of money, it offers no guarantees. Economic downturns and rising expenses, such as inflation, can still lead to financial shortfalls despite adhering to the SWR method.

The SWR method can help retirees minimize the risk of outliving their portfolio. The widely used 4 percent rule helps limit withdrawals, but it may not account for risks like rising healthcare costs and economic recessions. Some retirees mitigate these risks by opting for a lower withdrawal rate or periodically adjusting their withdrawals. However, the most effective strategy remains saving sufficiently for retirement.