Wednesday, 14 September 2016

Safe Withdrawal Rates - with respect to inflation ...

The subject of Safe Withdrawal Rates is cropping up again regularly on the blogs, so I thought I'd take a quick look at it myself.

The general acceptance criterion seems to be a drawdown rate at which an initial capital sum would last for 30 years without becoming depleted, after the withdrawn amount is increased annually in line with inflation.

Instead of trying to predict any particular safe withdrawal rate, I decided to take a slightly different approach and examine what the annual investment growth rate would need to be to sustain a 4% rate of withdrawal, and with reference to the assumed inflation rate.  4% is the oft-quoted safe withdrawal 'rule'.

So I set up a simple spreadsheet based on a £100k pot from which an inflation-adjusted amount is withdrawn each year, and then I played around with various input values.

The spreadsheet also assumes that the full annual drawdown is taken in a single tranch and at the very beginning of each year.  Taking all or part of the drawdown later in the year should only improve the situation.

Click on the Table for a larger image.

In the above example I've just used 2% as an inflation rate, i.e. the government's CPI target.

The conclusion is that a 4% withdrawal would appear to be safe if you could grow the investment pot by 1.5% per annum above the prevailing inflation rate, e.g. in a 2% inflation environment you'd need to grow your pot annually by 3.5%.

This 1.5% growth above inflation holds true for inflation rates <15%, above which it breaks down and 4% withdrawal becomes too much.   At extremely low levels of inflation, i.e. <2%, an investment growth rate of only around 1.33% above inflation would be required.

This is a very simplistic approach using a fixed inflation rate and there are many other factors to consider, such as the effects of a market crash in the early years, but it gives a useful indication of a minimum investment growth target.

Update 15-Sep-16

I've added a graph of the capital depletion from the above example Table, with start-of-year capital plotted against time.  It shows how easy it is to be fooled into thinking you're doing OK following such a drawdown strategy, and why very close monitoring of the situation would be essential.

Without considering this curve, after 10 years into drawdown you'd probably be celebrating that you still have 90% of your original capital sum, and even after 23 years over half of it remains untouched, but the steadily increasing gradient of the curve will get you in the end.

So if you're even very slightly below the curve at any time, you're stacking up major problems for the future.

What was it that Hemingway wrote about going bankrupt ?  "Gradually and then suddenly..."

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