Financial Independence – What is the safe withdrawal rate?

How much money I need to have in my investments and how much can I withdraw, so that my expenses are taken care of for rest of my life? What is the safe withdrawal rate if I am living entirely off my passive income?

This is one of the fundamental questions one needs to answer while aiming for financial independence.

Enter safe withdrawal rate.

If you need, say Rs. 100,000 every year to survive, what is the savings you need to have & how much can you withdraw (in percentage terms) every year? In other words, what is the safe withdrawal rate that will help you stay financially independent?

Like many other things in financial planning, there is not fixed rule here. However, many financial planners suggest that you can withdraw ~4% of your investments every year if you are living off your investments. This is a very crude way of putting it (however, a good starting point to back-calculate).

Let us look at some numbers.

Financial independence - What is the safe withdrawal rate?

If you ignore growth and inflation, at 4% (of initial capital) safe rate of withdrawal, your corpus will last for 25 years. And then you’ll be out of money. In the above example, if you have Rs. 25 Lac as investment & spend Rs. 1 Lac per annum, you are hitting the safe withdrawal rate.

But,

You can’t just ignore inflation.

Nor can you afford not growing. (Compound interest can work wonders for your growth!)

Nor you may want to be in a situation where you are depleting your initial capital.

For the sake of calculation, let us assume that you have Rs. 100,000 savings, your investments are growing at 8% and your expenses will rise at 4%. Here is what it will look like.

Year Initial Capital at beginning of the year Withdrawal Rate Withdrawal Amount Capital at end of the year @ 8% growth rate
0 1,00,000
1 1,00,000 4% 4,000 1,03,680
2 1,03,680 4% 4,147 1,07,495
3 1,07,495 4% 4,300 1,11,451
4 1,11,451 4% 4,458 1,15,553
5 1,15,553 4% 4,622 1,19,805
6 1,19,805 4% 4,792 1,24,214
7 1,24,214 4% 4,969 1,28,785
8 1,28,785 4% 5,151 1,33,524
9 1,33,524 4% 5,341 1,38,438
10 1,38,438 4% 5,538 1,43,532
11 1,43,532 4% 5,741 1,48,814
12 1,48,814 4% 5,953 1,54,291
13 1,54,291 4% 6,172 1,59,969
14 1,59,969 4% 6,399 1,65,855
15 1,65,855 4% 6,634 1,71,959
16 1,71,959 4% 6,878 1,78,287
17 1,78,287 4% 7,131 1,84,848
18 1,84,848 4% 7,394 1,91,650
19 1,91,650 4% 7,666 1,98,703
20 1,98,703 4% 7,948 2,06,015
21 2,06,015 4% 8,241 2,13,97
22 2,13,597 4% 8,544 2,21,457
23 2,21,457 4% 8,858 2,29,607
24 2,29,607 4% 9,184 2,38,056
25 2,38,056 4% 9,522 2,46,817

 

 

 

 

 

 

The ROI, I have assumed is keeping in mind the average approximate interest rate you can get via PPF, liquid fund, Fixed Deposits (Bank/ Corporate) etc. With equity exposure it may be possible to get even higher returns (but with a downside risk too). However at this stage of life, capital protection will become as important as capital appreciation (or maybe more!) and hence major exposure may be towards debt.

These numbers change if as your assumptions change.

Some key assumptions about above Safe Withdrawal Rate:

  • Return on Investment >/ = Inflation + withdrawal rate. (In reality, returns may be lower or inflation, especially lifestyle inflation may be higher)
  • You are sufficiently insured (health insurance & term life insurance, if you have dependents)
  • You have made provisions for major life expenses. E.g. buying a house (if you don’t have one), kids’ education, wedding, long & expensive travels to “explore” the world etc.
  • You will have control over your behavior & expenses well into your “retirement”.
  • Your assets are cash flow generating ones (e.g. gold or land don’t generate regular cash flow)
  • You don’t want to deplete the initial capital.
  • The amount chosen above is just for calculation. It is unlikely that Rs. 100,000 per annum of expenses (used in above examples) would suffice for anybody!

What this calculation on Safe Withdrawal Rate doesn’t take into account?

  • Major life expenses (which don’t fit into “recurring expenses” category)
  • Any unforeseen emergency (You may want to read – Expenses that can set your financial plans back)
  • Lack of insurance coverage to plan for any setbacks. This might come into play, for example, if you want some long term care as you age. (but not covered under insurance)
  • Scenario where Return on Investment < Inflation + withdrawal rate. In such scenario, while the amount you get keeps on increasing, it is not keeping pace with inflation – a situation you would want to avoid.

Few more thoughts on Safe Withdrawal Rate

  • Doing nothing and living off passive income can be boring, unless you have some some purpose or goal. So, financial independence may not mean not working. It may actually mean, not working with money as the primary motive. This can probably still give enough to “top up” your lifestyle expenses. This becomes more relevant if you are relatively younger (say in your 30s or 40s)
  • If you manage to save and invest even from your passive income, it will lead to more financial independence! (if such a term exists!).

(You may also be interested in – Common misconceptions about financial independence)

My take on Safe Withdrawal Rate

While understanding safe withdrawal rate is a good way to start planning for FIRE – Financial Independence (and/or Early Retirement) one must consider other factors too while arriving at a number. The number 4% for Safe Withdrawal Rate may not hold true if any of the factors like unforeseen emergency, no major life expenses, assumptions about inflation or returns don’t hold true. And life being a roller coaster ride it is, it is unlikely that all assumptions will hold true throughout your life.

So probably, you should be looking at a number lesser than 4% (2%? 3%? – Do your math & figure out. You are the best judge of your life). And/ Or you should be looking to save & invest money from whatever you are withdrawing (especially, if you are following the 4% withdrawal convention)

To top it up one needs to keep doing something hopefully worthwhile (remunerative/ non-remunerative) – It is usually a long life ahead even after one is financially independent.

What are your thoughts?

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