Navigating Rough Waters: Market Cycles and Safe Withdrawal Rates

Written by Annika Cushnie, CFP®, CIMA® on January 1, 2016

Many investors are currently reviewing their financial plans to reevaluate their situation and make sure that they are still on track. For the baby boomers just entering or approaching retirement, the last year or so has introduced unwelcomed anxiety as plans now seem more uncertain. We believe that a central element in proper wealth management is the strategy and structuring of investment portfolios to optimize income in retirement. Some of the factors Brightworth advisors take into consideration include income goals, time horizon, other sources of income, and the desire to leave a legacy. From there we determine how much is needed from the investment portfolio, structure the investment pieces, and perform a series of analyses to test the “retirement readiness” of the portfolio. Key to this process is a concept derived from various well-known industry studies called the “4% Withdrawal Rate Principle.” The premise is that if an investor limits his annual withdrawals to 4% of the starting value of all investment assets at retirement (and adjusts them by infl ation each year going forward), he will have a very high probability of not outliving his assets over a 30-year time frame, regardless of market fluctuations. For example, an investor with a $4,000,000 portfolio at retirement should be able to conservatively withdraw about $160,000 in the fi rst year to meet cash flow needs and pay taxes.

However, market cycles can impact this calculation for the better. Consider a situation where both Investor A and Investor B have $4,000,000 portfolios in October of 2007 (the all time high of the stock market to-date). Investor A retires in 2007, and based on the 4% Principle, he should be able to conservatively withdraw $160,000 inflation-adjusted per year. Investor B continues to work and retires at the end of 2008. At that time, both of the portfolios are down 15%. Does this mean that since Investor B’s “starting investment portfolio value” is lower that he should only be able to conservatively withdraw $136,000 inflation adjusted per year while Investor A can still withdraw $160,000. The short answer is no.

While no one can consistently predict shortterm movements in the market, long-term trends show that the market moves up and down in cycles. The most common measurement used to track the value of the market through these cycles is called the “P/E ratio” of the market, or price-to-earnings ratio of a market index. A recent study showed that the market valuation (adjusted for inflation and business cycles) at the starting point of the portfolio withdrawal period is strongly correlated to “safe withdrawal rates” for a portfolio over a given time period. Basically, when the P/E ratio at the beginning of the time period is low (indicating an undervalued market), higher withdrawal rates can be sustained over time and when the P/E ratio is high (indicating an overvalued market), lower withdrawal rates (closer to the 4%) can be sustained. It is important to note that the P/E ratio used to support these rates is the P/E 10 ratio. The P/E 10 version uses the average inflation-adjusted earnings for the previous ten years. The chart below depicts “safe withdrawal rates” at various market valuation starting points for a balanced portfolio (for simplicity, think of 60% stocks/40% bonds) based on Brightworth and other industry research. There are two key points to be gained from this illustration. First, a 4% withdrawal rate has been sustainable during every 30-year rolling time period in stock market history including the Great Depression and the 1970s bear market, and second, higher withdrawal rates can be sustained in an undervalued market such as today.

Going back to our example, Investor A retired in October of 2007 when the P/E ratio of the market was 27.31 and could conservatively withdraw $160,000 per year (infl ation-adjusted) from a $4,000,000 portfolio. Investor B retired at the end of 2008 with a portfolio of $3,400,000. Based on a P/E ratio of the market of 15.37, Investor B should be able to conservatively withdraw at least 4.6%, or $156,400 per year (inflation-adjusted) over his lifetime.

While the 4% Withdrawal Principle has held up through some tough times in the market, after a year like 2008 many investors may be seeking peace of mind about their own personal situation. Withdrawal rates must be carefully monitored in good years and bad to ensure that you stay on track and out of trouble — no matter how much money you have. The good news is that recent studies confirm that if you started into this downturn with a prudent withdrawal rate and have maintained a solid investment discipline, your “safe” rate has gone up as the P/E of the market has come down.

1“Resolving the Paradox — Is the Safe Withdrawal Rate Sometimes Too Safe?”, The Kitces Report,, May 2008