Research suggests that a retirement nest egg that is close to at least 33X the annual expenditure of the first post-retirement year, also known as expenditure cover, is needed.
With this nest egg, withdrawing 3% a year should comfortably cover one’s retirement needs for a 30-year post-retirement period. Of course, these withdrawals will rise each year to keep up with inflation.
But can you retire with less cover and still make your retirement corpus last?
A recent study suggests this is possible, though not without trade-offs. By accepting some volatility in withdrawals (i.e. fluctuations in retirees’ spending power in inflation-adjusted terms), a retiree may be able to retire with less than 33X the first year’s post-retirement expenses.
Now, there are strategies that can smooth out the withdrawals even at a lower retirement cover.
The study is based on Monte Carlo simulations, which run thousands of “what if” scenarios to see how a strategy is likely to hold up under different market conditions. The current study ran 10,000 simulations for each withdrawal strategy, using 24 years of data on the Sensex returns, debt returns (proxied by 1- to 3-year fixed deposit rates), and inflation (based on the Consumer Price Index).
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Here is a look at how three different withdrawal strategies hold up in good and bad markets:
Floor-and-ceiling strategy
William Bengen’s floor-and-ceiling strategy uses a fixed withdrawal rate, but with controls. The withdrawal rate is inflation-adjusted for the beginning of the retirement period, and then it is fixed throughout the retirement years. If the retirement corpus’s size increases due to positive markets, withdrawals also rise. Withdrawals decrease if the markets turn negative.
But there is a safety switch to prevent overspending and underspending in good and bad markets. Withdrawals—in absolute terms—can only be up to 20% more than the first year’s withdrawal or 15% lower than the first year’s withdrawal.
A quick example: Assuming a ₹1 crore portfolio with 4% withdrawal rate, the first year’s withdrawal would be ₹4 lakh. So, the balance at the end of the first year is ₹96 lakh. Next year, the corpus grows by 12%. The new balance is ₹1.07 crore. The second year withdrawal is ₹4.28 lakh, at the 4% rate. In this strategy, withdrawal is allowed up to the fixed upper band of ₹4.8 lakh—20% higher than the first year’s withdrawal.
The Monte Carlo simulations-based study by Ravi Saraogi, a Sebi-registered investment adviser and co-founder of Samasthiti Advisors, showed that a retiree who chooses Bengen’s floor-and-ceiling strategy would need an expenditure cover equal to 27X the first year’s annual expenses.
The study assumes a balanced 50:50 equity and debt retirement portfolio, with a 30-year post-retirement period for all strategies.
Saraogi’s study, ‘Boosting Retirement Income through Dynamic Withdrawals’, provides more details.
“This strategy ensures that the volatility in spending power of the retiree is contained with a cut-off trigger both on upside and downside, and the retiree is prevented from overspending in good years and underspending in bad years,” explained Saraogi.
Remember, no simulation study is foolproof, despite thousands of scenarios simulated. These simulations have a 95% success rate or a 5% failure rate.
The forego-inflation strategy
In the forego-inflation strategy, if the portfolio delivers a negative return in a given year, withdrawal is not adjusted for inflation next year.
However, withdrawals can compress sharply over the years in this strategy. According to the simulations-based study, the last withdrawal in inflation terms—even in good markets—was 37% lower than the first post-retirement year. In bad markets, decline was 58%.
“In the forego-inflation strategy, there is no way for the strategy to catch up after inflation is skipped. Hence, the spending power of the retiree can erode significantly over the years,” Saraogi said.
The forego-inflation strategy has its use cases.
“When a retiree comes with a lower corpus size, we need to control withdrawals. We had a case of a retiree with just ₹2 crore of portfolio. We opted for the forego-inflation strategy with certain tweaks. We reviewed the portfolio every 4th or 5th year and increased the cash flows to the extent the portfolio’s equity returns were above a 12%-threshold,” said Kavitha Menon, founder of Probitus Wealth.
Guardrails
This strategy is slightly more complex. If the effective withdrawal rate is 20% higher than the previous year’s withdrawal rate, withdrawal—in absolute terms—will be 10% lower than the first-year withdrawal. If the withdrawal rate is 20% lower than the previous year, the withdrawal can be 10% higher than the first year’s withdrawal.
The effective withdrawal rate will typically rise when the portfolio size grows with positive returns and decline when it shrinks due to negative returns.
The simulations show that the retiree can start with a retirement cover of 12.8X the first year’s annual expenses. However, the study shows that withdrawal volatility can be much higher than Bengen’s floor-and-ceiling strategy.
“Despite its popularity in global discourse, the guardrails approach can be very volatile for a retiree. We should take the lower corpus requirements under this approach with a pinch of salt as it can lead to a significant cut in withdrawals depending on markets. This is particularly true for an Indian retiree dealing with volatile markets as compared to a developed market retiree,” said Saraogi.
Takeaways
The study shows that one can retire with less expenditure coverage if the retiree is willing to make some trade-offs on withdrawals.
“If there is a willingness to make compromises on post-retirement spending, especially the discretionary spending—take a vacation once every two years, shopping, moderate luxury spending, etc., such withdrawal strategies can help to retire with a lower expenditure cover,” said Vishal Dhawan, founder of Plan Ahead Wealth Advisors.
However, a retiree should choose a strategy that can contain withdrawal volatility to some extent and provide a certain level of predictability.
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