We say to retire once you reach 25 times your annual spending, meaning a 4% annual withdrawal, because that's reasonably safe. But it's not completely safe.
We face a risk with the rather florid name "Sequence Of Returns Risk". This means that if you get very unlucky and soon after you retire there's a combination of a stock market crash and high inflation, you could find youself drawing your 4% from a pot which has a much lower value than when you began.
The 4% withdrawal we talk about is an initial 4% of your pot. But from there, the size of your pot fluctuates, and that means that the percentage you're withdrawing fluctuates. Let's call this your Actual Withdrawal Rate.
If a crash wipes a third off your pot size, this pushes your withdrawal rate up to 6%. We hope that's just for a brief period.
Investment pots are designed to take this. Their total price will dip sometimes, and that's okay. We just need them not to hit zero at any point, as we'd be broke.
If this year our spending means that we actually pull 6% from the pot whilst it's down, and then the recovery is slow to come, the following year we may be pulling another 6% out. Our sequence of returns has been bad. We'd quite like a good return right about now to bounce the investment pot back up. Otherwise we are doing damage; we're pulling an outsized chunk out, and that's leaving less in there to bounce back up when the recovery eventually comes.
If we get some "normal" years after retiring, we'd hope to see about 7% growth after inflation, and we'd be withdrawing 4% to spend. This leaves a nice gap of 3% real growth in there. This growth is really useful. It nudges our pot up in size year by year, and edges us toward safety.
Example
To use an example, let's say I retired with a £500k pot and £20k annual spending, so that's a 4% withdrawal rate. To keep things simple I'll ignore inflation for this example. I get 7% growth in year one, so my pot grows to £535k. I withdraw £20k for my living costs. I'm left with £515k - my original £500k stake and a further £15k growth.
For year two I get the same typical growth. The £515k pot grows to £551k. I withdraw £20k. I'm left with £531k.
If we measure my withdrawal, £20k from £531k is 3.766%. As the pot grows, my Actual Withdrawal Rate diminishes.
We want to encourage this! Because when we said you could retire safely at a 4% withdrawal rate, we cheated slightly. The historic ultrasafe level may be more like 3.5%. And in future something even worse may happen - so a 3% WR would let us sleep really soundly at night.
These things are unlikely to happen. It's not worth working for more years to guard against this very slight chance. Instead, we'll keep an eye on that Actual Withdrawal Rate. We'll try to encourage it downwards.
About five years of "normal" investing conditions after retiring should be enough to get us past the Danger Zone - for our WR to diminish to about 3.5%.
Assist Your Investment Pot
How can you help it along? Be aware of your Actual Withdrawal Rate, and try to take steps to stop it going above 4%. There are two ways to do this.
You can reduce your spending when the market is down, so that your now-lower withdrawal stays at (or below) an actual rate of 4%. This is known as flexible spending, and works best where you have catered some luxury spending which could be cut. Holidays and new cars. It's harder to do if you have retired on a bare-bones budget.
The second method is Coasting. CoastFI is where you have traded your full-time career job for something which pays less but is either more fun or takes fewer hours. You get your life back, but still do a little work. This pays for some of your lifestyle spending, and means that you're pulling a lower amount from your investment pot to cover the rest of your spending.
Between these two methods you should be sorted. It should take very little of this extra help to get you to safety.
The Opposite Problem
Later on, as our WR diminishes even further, we may want to think about actually raising our spending so that we don't build up an impossibly large excess. Unless you have a large family to cater for, there's little point building up tens of millions in later life - surely you would be better off spending and enjoying it. My solution to this is to adopt a Minimum Withdrawal Rate. If it drops below 2.5% I'll be finding ways to spend the excess. This may be on travel or gifting.
Want to read more of my ideas? I have a new book out - Build Your Retirement, 5 ways to improve your wealth in retirement. Or other books here.