Avoid withdrawing over 3.5% yearly from retirement corpus

Given the many unforeseen developments that can occur over a 30-year-plus span, err on the side of caution

Retirement planning is typically done assuming steady returns. Financial advisors and calculators usually assume an average annual return of, say, 12 per cent. But in reality, returns fluctuate greatly from year to year. Such variability can deplete the retirement corpus much sooner than planned for.

The “sequence of return” risk highlights the fact that besides the quantum of returns, the order in which those returns come is equally critical.

The Covid-19 market crash, for instance, severely affected retirees’ portfolios. Retirees kept withdrawing funds during the downturn. Those withdrawals depleted their portfolios further. The traditional approach, based on constant returns and inflation rates, has thus proven unreliable.

Concept of safe withdrawal rate

Financial advisors in the United States (US) have used the concept of a safe withdrawal rate (SWR) for a considerable period. This rate determines the annual amount that can be withdrawn from a retirement portfolio, accounting for market volatility and inflation changes. (More specifically, the SWR tells how much can be withdrawn in the first year of retirement. For each year that follows, the amount can be enhanced by the inflation rate). In 1994, William Bengen recommended a 4 per cent SWR, based on US market data. This rate has since been used globally, often without additional research to confirm its suitability for other countries.

SWR is lower for India

A recent study titled ‘Balancing Acts: Safe withdrawal rates in the Indian context’ by Rajan Raju, director, Invespar, and Ravi Saraogi, co-founder, Samasthiti Advisors, calculates the SWR for India, taking into account India’s asset returns and inflation rates. The researchers analysed data from 2000 to 2023. They found that the SWR for India is lower.

The duo began with a portfolio invested fully in fixed deposits, which resulted in a very low SWR of under 2 per cent. They then experimented with increasing the equity component. They found that an equity allocation of 40 per cent offered the best SWR of 3 per cent.

“Raising the equity share beyond 40 per cent reduced the withdrawal rate. This outcome is counterintuitive as it is commonly believed that a higher equity share would enhance returns and, consequently, the withdrawal rate. However, doing so introduces significant volatility in the portfolio, diminishing the withdrawal rate,” says Saraogi.

A high equity allocation works in a portfolio in the accumulation stage, but not in a retirement portfolio, which is subject to regular withdrawals.

To improve the SWR, the researchers added gold to the portfolio. They discovered that a mix of 60 per cent debt, 30 per cent equity, and 10 per cent gold raised the SWR to 3.5 per cent.

Get your math right

Imagine someone spends about ~50,000 monthly, or ~6 lakh annually. If this person has a ~1 crore portfolio in fixed deposits offering an interest rate of 6 per cent, they might assume withdrawing ~6 lakh annually is feasible. “However, this implies a withdrawal rate of 6 per cent, which is not sustainable. As the study shows, the SWR should be lower,” says Deepesh Raghaw, a Securities and Exchange Board of India (Sebi) registered investment advisor (RIA).

Avoid addressing the problem of an inadequate corpus by investing excessively in equities. “As the paper highlights, this approach might backfire. Maintain a sensible asset allocation in your post-retirement portfolio,” says Avinash Luthria, a SEBI-RIA and founder, Fiduciaries. Raghaw adds that having too much equity postretirement can also disturb your peace of mind.

The study takes into account taxes, which makes it realistic.

A few caveats

The study recommends an SWR of 3-3.5 per cent with a 95 per cent confidence interval. With this SWR, there is a 5 per cent chance that individuals could deplete their funds within their lifetime. “You don’t want to be in that 5 per cent, so it would be advisable to err on the side of caution,” says Luthria.

The study analysed 24 years of data. “Investors must allow for the possibility that future returns from various assets in India, primarily equities, may not match past performance,” says Luthria.

Investors must adhere to the recommended asset allocation (60:30:10) for the 3.5 per cent SWR to hold true. They should avoid shifting their entire portfolio to fixed income after a significant market downturn.

Investors likely to react this way might benefit from using the bucketing strategy. “Allocate the next five years of expenses solely to secure, fixed-income instruments. This makes navigating market volatility easier,” says Raghaw. The second bucket should consist of a diversified portfolio, including risky assets. Profits made in this bucket should be periodically transferred to the first.

Making the portfolio last longer

Try and delay retirement, if health permits.

Choose the optimal withdrawal strategy. “If equities perform well in a year, withdraw money from equities. If the equity market is down, shift withdrawal to the debt portion. If interest rates are low but gold prices are high, withdraw from gold,” says Saraogi. He also emphasises the need to minimise tax outgo during the withdrawal phase.

Retirees may also engage in belt-tightening in the years when the market is down. Luthria recommends the following alternative approach.

“Every year, divide your remaining corpus by 90 minus your age. For example, at 60, divide the corpus by 30 years and spend that amount. The next year, divide whatever corpus you have by 29, and so on. This method ensures you spend less whenever the market crashes,” he says.