The Lifestyle Stress Test™

Withdrawal rate is a measurement we use to evaluate whether a client’s portfolio distribution needs are sustainable over a long timeframe such as retirement.  It is calculated by dividing total annual withdrawals by the value of the portfolio.  A portfolio with a lower withdrawal rate is more sustainable than one with a higher withdrawal rate. 

For example:  Assume an average annual growth rate of 8% for a portfolio.  Then, subtract 3% to account for the average annual inflation rate that erodes the purchasing power of the portfolio.  Theoretically, this leaves 4% - 5% which can be used to fund distribution needs.  Withdrawal rates of 5% or greater may begin to erode principal and cause depletion of the account.  Hence, the financial planning community commonly considers a 4% or lower withdrawal rate to be sustainable.  We utilize the chart below to illustrate the concept of withdrawal rate. 

The Lifestyle Stress Test ™

  the-withdrawel-stress-test

Why understanding the rate of withdrawal is important

Assuming future growth rates for equities and bonds are similar to their historical averages, a lower withdrawal rate allows for more flexibility in terms of asset allocation.  For a portfolio with 1% - 2% withdrawal rates, market volatility is less impactful and little growth is needed to sustain distribution needs.  Therefore, the allocation can range from conservative to aggressive depending upon the client’s risk temperament.

  • In contrast, an average withdrawal rate of 3% - 5% requires more substantial equity exposure.  Equities have a history of higher growth than bonds.  Hence, some equity exposure is necessary in order to sustain the portfolio while distributions are taken and to keep pace with inflation. 
  • With higher withdrawal rates of 6%+, there is less flexibility in terms of allocation.  Stock market volatility has the potential to negatively affect a portfolio’s value and its ability to sustain distribution needs.  In order to mitigate this risk, a lower equity/higher bond allocation is prudent.  It is important to note that we would expect a portfolio to deplete under this scenario.