How Much Should Retirees Withdraw Annually? The Market P/E Ratio Is Your Guide

Retirees have long struggled with a key question: How much can they afford to withdraw each year?

Retirees have long struggled with a key question: How much can they afford to withdraw each year? The right answer is a fixed number—such as 4 percent of assets annually—according to some retirement software. But recent studies suggest that retirees may need to rethink their withdrawal plans.

The idea of setting a rate was proposed by Bill Bengen, an investment advisor in El Cajon, California. In a 1994 article in the Journal of Financial Planning, Bengen examined historical return data of stocks and bonds. He tested how retirees would have fared if they used various withdrawal rates—such as 5 percent or 6 percent. For the study, Bengen looked at how a portfolio would have performed in rolling 30-year periods such as the period starting in 1930, 1931 and so on. In the Bengen system, a retiree with $1 million could withdraw $50,000 the first year. Most often, retirees could take withdrawals and not exhaust savings.

While many advisors adopted fixed withdrawals of 4 percent or 5 percent, the approach had some flaws. Under most scenarios, a retiree who stuck to 4 percent would not come close to exhausting the nest egg. In fact, by limiting withdrawals, the investor might be scrimping needlessly. On the other hand, there would be a few scenarios when 5-percent withdrawals would exhaust the assets. For example, someone who retired before the Great Depression or the 1970s bear market could have gone broke in less than 30 years.

To overcome the problems, some advisors have simply decided to fly by the seat of their pants. For clients with plenty of money, the advisors suggest withdrawing 6 percent or more of assets the first year. If the markets drop, the withdrawal rate must later be reduced.

The flexible approach may be appealing, but researchers argue that taking excessive withdrawals in good times could lead to harsh belt-tightening later on. To maintain a disciplined approach, consider whether the market is undervalued, says Michael Kitces, a CFP and director of financial planning for Pinnacle Advisory Group in Columbia, Maryland. Examining historical data, Kitces found that during certain 30-year periods, retirees could have taken big withdrawals. Someone retiring in 1950 could have withdrawn 10 percent and not run into trouble. But, most often, such a big withdrawal would result in bankruptcy. Kitces noted that the greatest risk of bankruptcy occurred for people who retired when the price/earnings ratio of the market was high. At such times, the future market returns were low. When the market was relatively cheap, returns going forward were high. To account for different valuations, Kitces devised a formula. If the P/E of the market is more than 20, then retirees should not take more than 4.5 percent of assets annually. If the multiple is below 12, the retiree can start by withdrawing 5.7 percent.

No matter what formula advisors use, the greatest problem may be persuading clients to follow the advice. Studies by Fidelity Investments found that typical retirement clients take annual withdrawals of more than 9 percent. For many investors, that could be a recipe for disaster.

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