Thursday, 27 October 2011

Early Retirement : Safe Withdrawal Rate (SWR)

Safe Withdrawal Rate or SWR, in the context of retirement (early or otherwise), was a term coined by William Bengen.  Bill wrote about SWR in the Journal of Financial Planning in October 1994.  He proposed that once you have accumulated your retirement corpus, you should withdraw only 4% of the corpus for your expenses on a yearly basis (adjusted for inflation of course).  As long as you maintain the 4% withdrawal rate, you will never run out of money throughout your retirement years.  If you increase your withdrawal rate to 5%, you have a high probability that your money will run out before you die. 

This is a very fundamental thought that every retiree has to go through.  How much can I afford to withdraw every year for my living expenses?  If I withdraw too much, I run the risk of running out of money soon.  If I withdraw too little, I am forcing myself to live a more frugal lifestyle than I can afford, and will not be able to live my retired years to their fullest potential. 

Bill based his analysis on historical return rates of stocks and bonds, and looked at real scenarios over the last 75 years.  He analyzed different withdrawal rates, and back tested the probability of your initial retirement corpus running out, across various time-frames over the last 75 years to prove his hypothesis.  This is a seminal piece of work, and if you have the interest, you should read the original article by William Bengen. 

Amazingly enough, financial planners in India, almost never quote or even refer to Safe Withdrawal Rates.  The entire concept seems to be alien to wealth managers here.  Typically a simple mathematical formula assuming a 6% or 8% inflation rate is used to figure out how your expenses in retirement will increase.  The effect of compounding is then typically used to frighten the lay person with the large numbers that invariably result from the long 30-40year retirement scenarios.  Finally a 12-15% rate of return is assumed on your invested corpus to figure out how long your corpus will last, or how much you will need to save up to last through your retirement years.

Of course the SWR will vary from country to country based on the historical data, current inflation scenario, future GDP growth prospects etc.  Currently financial planners in India seem to take these into account in a ad hoc manner, and are in general oblivious to SWR in the Indian context.

I recently came across a study done in Japan, that attempts to determine the SWR in emerging markets.  I have contacted the authors to understand their thesis a little better, and seek permission from them to share their results with you. 

In the meantime, I will publish a couple of more articles describing how SWR works in the coming days, with some examples and illustrations.

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