On Withdrawal Rates

In a recent Barron’s interview, Ray Dalio discusses financial deleveraging and makes an interesting point about the relationship between nominal interest rates and nominal growth rates in the economy.  

According to Dalio, the key to successful deleveraging is keeping nominal interest rates below nominal economic growth rates.

There are similar attempts in world of financial planning and retirement income to define some sort of fundamental rule on withdrawal rates.  For example, much is made of the “safe” or “rule of thumb” withdrawal rate of 4 percent.

One could suggest that a more appropriate starting point for anyone who intends to generate income from their savings would be the relationship between their withdrawal rate and the rate on the 10 year Treasury bond.

The 10 year Treasury rate is a reasonable consideration because it is a generally accepted proxy for a discount rate.

The withdrawal rate is generally defined as the relationship between a desired level of spending and the funds that are available to support the spending needs.  For example, a person who desires $25,000 per year in retirement income and has $500,000 in retirement savings has a desired withdrawal rate of 5 percent.

An ordinary annuity payout effectively illustrates the relationship between withdrawal rates and discount rates.  This is because ordinary annuity payments are a sort of financial “proof” of how long a lump sum of money will last.

In any ordinary annuity illustration, what is clear is the fact that any withdrawal rate in excess of the discount rate is subject to longevity risk.  In other words, the annuity payments are finite.  On the other hand, any withdrawal rate that is less than or equal to the discount rate will last forever.

So what does it take to produce an infinite withdrawal rate in our current interest rate environment?  Well, the current 10 year Treasury rate is 1.53 percent.  This means that the person with the $500,000 portfolio could withdraw a whopping $7,650 per year with no risk of running out of money. This assumes, of course, that interest rates and the $500,000 portfolio remain static.

Adding inflation to the picture makes things even more bewildering.  It can be argued that inflation is currently running at about 2 percent annually.  This means that the real yields on the 10 year Treasury are negative.  

Do negative real yields mean that all withdrawal rates are subject to longevity risk?

In any event, there is no avoiding the fact that historically low interest rates equate to historically low levels of retirement income and spending.

Source: Barron's