How much money you can take out of your investments without running out of money is a critical question when building any financial plan. As a member of the Financial Planning Association I hear from other members and read in the financial press many theories on how to calculate a safe withdrawal rate. Some of the ideas put forth are elegant, some are complicated, and all ultimately fail because they attempt to do the impossible, which is to predict a future event. The future is unknowable, so having any degree of confidence in any method of projecting historic calculations on future events is dubious at best. There is a reason the SEC requires the disclaimer that past results are not indicative of future returns.
The uncertainty of safe withdrawal rates is one of the reasons I advise clients to try to be debt free when they reach retirement age. If your house is paid for and you have no consumer debt, your living expenses can be managed much more easily. You can adjust your lifestyle without too much pain to cope with unexpected events, and adjust withdrawal rates to protect your nest egg.
That said, I do believe having a financial plan gives you a much greater chance of success than not having a plan, and you must select some withdrawal rate that you believe (or maybe hope) to be safe to complete any retirement planning calculations. So here I go with what I believe is as good a way of calculating your safe withdrawal rate as any.
If you've been reading this blog a while you know about estimating your rate of return for a diversified portfolio, and you know how to calculate your real rate of return. My simple if imperfect suggestion for calculating your personal safe withdrawal rate is to use the expected real rate of return of your portfolio. This amount is already adjusted for inflation and you will probably have to make some adjustments along the way anyway. If you can afford to take less, great! Your odds of success are probably improved. Oh, and one other thing, when you reach retirement try to keep one years living expenses allocated to cash, this will help if things get really dismal. Having a large cash reserve will preclude you from having to sell other securities at in opportune times. At least for a year.