What Is a Drawdown Percentage?
A drawdown percentage is the portion of a retirement account that a retiree withdraws each year. If the drawdown percentage is too high, the retiree will outlive her savings and struggle financially at the end of her life.
If the drawdown percentage is too low, the retiree will die with money left over. Many people wish to spend most or all of the money they’ve worked so hard to earn and invest during their lifetimes. Others want to make sure they leave an inheritance for their spouse, children or charities they support.
- A drawdown percentage is the portion of retirement assets that a retiree withdraws each year to pay for their needs and wants expenses.
- The 4% rule states that retirees should withdraw 4% of retirement assets each year to live on so that $1 million would equal $40,000 in annual income.
- The 4% rule has come under fire since other strategies such as guaranteed lifetime annuities can be safer options.
Understanding Drawdown Percentage
Drawdown percentages can be difficult for individuals or couples to calculate accurately. Many financial experts find that it can be easy to over or under calculate how much money one needs to live on through retirement. To combat the difficulty in determining how much you need to live on annually in retirement, a common rule of thumb is to take 4% of the principal amount saved annually, adjusted for inflation. Inflation is the rate at which prices rise in an economy over time.
The 4% rule is supposed to maximize one’s chances of having enough money to last through to the end of one's life and is based on a 1994 study by past financial planner William Bengen. His study used stock market data, and average investment returns to determine that 4% was the highest percentage that an individual could withdraw so that their retirement money could last 30 years. In the study, it's assumed that the individual had invested at least 50% of their savings in stocks.
More specifically, a drawdown percentage of 4% is based on the historical investment performance of a portfolio made up of 50% bonds and 50% stocks, and historical inflation rates. It is expected to ensure that the retiree’s nest egg lasts a minimum of 33 years and a maximum of 50-plus years.
Limitations of the Drawdown Percentage
The 4% rule has come under criticism by academics and financial experts in the years since the Great Recession. While the 4% historical drawdown percentage can be a helpful guide, it may not be entirely accurate for today’s retirees.
For example, critics of the 4% drawdown percentage say many people won’t experience 33 years of retirement because they will work beyond age 65 and/or because of poor health and point out that overall market performance has changed since the rule’s development in 1994. Usually, the best way to calculate the drawdown percentage for your own nest egg is to consult an independent financial planner who can look at your age, your financial needs, and your portfolio to determine a more precise percentage.
Guaranteed lifetime annuities are increasingly popular nowadays as a way to guarantee a steady flow of income for one's life after retirement. While annuities have been criticized in the past for being overly expensive up-front and illiquid, many are now recognizing the benefit of lifetime income that cannot run out or fluctuate with the market.