Withdrawal rates
Lets say you reach your goal of retirement. You quit your job sit on your sailboat and eat pineapples all day. The wind is in your hair, you are relaxed and carefree, and you have pineapple breath. All because you have a formidable nest egg and can live comfortably off your investment earnings.
But how do you know how much of your nest egg you can withdraw and spend each year?
How to calculate your withdrawal rate
Step 1
Calculate how much you spend each year. This step requires actual effort so people often don't bother. But this step is the key to retiring early and the key to retiring at all. Happily there are online tools to help you. I of course will recommend Networthify. But CashBaseHQ and Mint are great as well.
Step 2
Divide your annual spending by the size of your nest egg. Thats your withdrawal rate.
\[ \begin{aligned} NestEgg \times WithdrawalRate & = AnnualSpending \\ WithdrawalRate & = \frac{ AnnualSpending }{ NestEgg } \\ \end{aligned} \]
But...
But there is a problem. Your withdrawal rate could change dramatically each year depending on the size of your nest egg each year. For example:
A happy scenario
Your $1 million nest egg earns 10% returns this year.
Your withdrawal rate could be as high as $100,000.
A sad scenario
Your $1 million nest egg earns 1% returns this year.
Your withdrawal rate could be as high as $10,000.
Those are radically different outcomes. Living off $10,000 for a year will not get you to the pineapple breath you were hoping for. Now consider how big a difference it makes if you have 15 good years when you first retire vs if you happen to get 15 bad years. It is massive.
If you are starting your career and trying to plan for retirement, all the calculators out there ask you to input a withdrawal rate. What you now know is that is impossible to know. It will depend on market conditions, inflation, and changes to tax law. And none of those is knowable.
Solution
If you are already retired this means you need to be flexible when considering your withdrawal rate. Each year will be different and you must be especially careful in your first 10 years of retirement.
But what do you do if you are starting your career and trying to plan your retirement? Basically we guess. But we do an educated guess.
Researchers like Wade Pfau have discovered that a nest egg that uses a constant withdrawal rate of 4% survives any period of US stock market history -- including the Great Depression. This is why all of networthify's calculators default to a 4% withdrawal rate.
That sounds like good news, but remember that past performance doesn't predict future performance. Most worrying Wade Pfau also ran the numbers using European historical stock market data and found that in some countries there were periods when a withdrawal rate of 0 would not preserve your nest egg.
More reading
If you want to learn more, here is a fun introduction to withdrawal rates written by Mr Money Mustache.
But the definitive article on withdrawal rates is this one (its long) at FinancialMentor.com. It is awesome and fascinating and I highly recommend it.