The MRA's Variable Percent Withdrawal Calculation
You've worked hard and saved and invested money for your retirement. Now you're retired and want to enjoy the fruits of your labour. You want to know how much of your savings you can spend to supplement your pensions. You want to spend to enjoy your retirement years, but you are afraid you'll run out of savings too quickly. How much can you spend safely?
You've probably heard of the 4% rule. Academics have run simulations that show you can safely withdraw 4% of your portfolio at retirement. It works like this. At retirement, you calculate 4% of your savings. So if you have a million dollars in your investment accounts, you can withdraw $40,000. You never revisit that calculation. Every year, you increase the amount originally calculated by inflation. So if inflation is 3%, you would then withdraw $41,200. (A common misconception of the 4% rule is that you would withdraw 4% of the value of the portfolio every year, but that is not what the rule says to do).
The 4% rule is simple, to the point of being overly simplistic. It is a very general rule of thumb that does not consider many factors. And there are many factors you could consider. Among the big ones are: How long is your retirement expected to be? What if the markets crash? What are the tax implications? So there have been many studies and new strategies proposed to help you determine how much money you can withdraw from your portfolio.
One of these is called the Variable Percent Withdrawal Calculation. It is very popular with Canadians as it is championed in the Canadian financial wiki finiki . I get asked about it a lot. Many MoneyReady App users have used it, and want to understand the differences between it and the MoneyReady App.
The finiki says The Variable percentage withdrawal (VPW) is a method which adapts portfolio withdrawal amounts to the retiree's retirement horizon, asset allocation, and portfolio returns during retirement. It combines the best ideas of the constant-dollar, constant-percentage, and 1/N withdrawal methods to allow the retiree to spend most of the portfolio using return-adjusted withdrawals. By adapting withdrawals to market returns, VPW will never prematurely deplete the portfolio
To use the method, you recalculate the amount you can withdraw from your portfolio every year. The calculation involves knowing the current value of the portfolio, its asset allocation, and the long-term rates of growth expected for each of the asset classes. Sounds complicated, but the authors make a free spreadsheet available you can use https://www.finiki.org/wiki/Variable_percentage_withdrawal#VPW_Accumulation_And_Retirement_Worksheet.
How it works is it makes a die-broke calculation, set to you dying at age 100 with your portfolio entirely depleted with a constant annual withdrawal amount until then. This is a simple Time Value of Money problem. You can use the TVM calculator in MRA or the PMT function of a spreadsheet to calculate it. you would enter:
| Present value (PV): | - portfolio value (the minus sign is important) |
|---|---|
| Future value (FV): | 0 (die broke) |
| Nominal annual rate%: | The expected long term return of the portfolio. This is the weighted average of the expected return of each asset class, with the weights being the percentage contribution of the asset class to the portfolio. |
| N: | 100 - your age. This is the number of years before the portfolio is depleted)) |
| BGN: | True (or Mode = BGN on a calculator) as you are taking the payment immediately |
Solve for PMT, that is how much you can withdraw. If you enter -1 for the PV and solve forPMT again, it will show you the withdrawal rate that corresponds to.
You are meant to redo this calculation about once a year since your portfolio will probably not have grown exactly at that long-term expected rate of return a year from now and your withdrawals may not have followed the recommendation exactly.
The amount to withdraw is pre-tax. How much you get to spend after tax depends on the account types you are withdrawing from. The VPW does not consider account types and taxes. It doesn't tell you how much to withdraw from each account that you have.
The MoneyReady App's CHOOSE YOUR LEGACY tool is similar in spirit to VPW but much more flexible and informative.
- You don't have to be retired to run it, that is you could still be accumulating to accounts and contributing to pension plans.
- It allows you to vary your planned consumption from year to year.
- It considers taxes, minimum and maximal withdrawals mandate by legislation, and all other factors considered by the MoneyReady App TIME MACHINE
- It doesn't use a simple TMV formula. It relies on a recursive algorithm to get to the solution. This is also why it is much, much slower than VPW.
- It tells you how much you can increase or decrease your EXPENSES to leave the legacy you choose at the year of death you choose.
- This tells you how much you can spend now. Like the TVM, you should rerun it every year to adapt the plan to the change in your portfolio's value since the last year.
- The TIME MACHINE will show you the before-tax withdrawals that are necessary to satisfy the after-tax consumption on top of any other income you may have.
- For the years after retirement, you can use the WITHDRAWAL OPTIMIZER tool that will optimize from where to make account withdrawals.
I strongly recommend using CHOOSE YOUR LEGACY over VPW. But as I said, many users love VPW because they see it as a "Safe" withdrawal rate. So for them, I implemented it in the MoneyReady App.
Now it's my take on it, so it uses my opinionated views instead of the official VPW opinionated views. Here's how the MRA's VPW works:
It gets the total value of the investments you've entered. This ignores Cash investments, MOCK accounts, RESPs and RDSPS of dependents, and CCPC investment accounts. It also gets the asset allocations of the investments, and the long-term rate of return for asset classes used is those recommended by FP Canada. That total expected return of the total portfolio is reduced by 1% as an estimate of all investing fees (Brokerage fees, MERS, TERS, and advisor fees). This makes the FP-recommended rates a little safer. The number of years to deplete the portfolio is the number of years until you set your death (or the last to die if you have a spouse) in the TIME MACHINE plus 10 years. 100 is the default if you haven't run a TIME MACHINE. That's all we need to solve for the safe withdrawal rate and amount, just as above. Again, the result is a single pre-tax amount of the amount on top of any other income that you can withdraw and spend on expenses and taxes.
This is the MoneyReady App so we go further. First, we make any required withdrawals from RRIFS, LIFs, and IRAs. You must make sure to have entered last year's balance and the amount previously withdrawn for each of these accounts. You can do so by 'Edit Account Properties' for such accounts. We then use your current year Withdrawal PRIORITIES to make any additional withdrawal(s) required. You should see all the withdrawals made, and these should add up to the safe withdrawal amount calculated above. To that we add all your INCOMEs for the year, including estimated public pensions, then reduce it by all your entered EXPENSES, LOAN payments, and INSURANCE PREMIUMS. AUTOMATIC SAVINGS/WITHDRAWALS to/from accounts included in your portfolio are ignored. Then we run the tax calculation to approximate the total tax payable this year.
The MRA's VPW tool returns the amount you can spend after tax. It shows you what your total entered EXPENSES for the current year, and how much you can add to that. If that last number is negative, that indicates you should potentially reduce expenses for this year. If you also have money in Cash investments, remember that we ignored those for the safe withdrawal amount calculation, but they are also available for spending. We show you that cash balance separately. So this calculator shows you both how much you can safely withdraw and how much to adjust your spending for the current year. It should only be used once you are retired, which for these purposes means that you will not be increasing total savings or contributing to pension plans. It should only be used if you are planning a near-constant withdrawal amounts from your accounts. There should not be any planned future increased or decreased spending in your scenario.
The results could be a safer adjustment to EXPENSES for this year than given by the CHOOSE YOUR LEGACY tool. That will depend on the expected rates of return that you have set for your investments and the amount of the LEGACY you set for the CHOOSE your legacy tool.
If you want to make the CHOOSE YOUR LEGACY tool and TIME MACHINE safer, make sure to set the TIME MACHINE to use long-term rates (You can do that in RATES/YIELDS/CURRENCIES), you can also increase the size of the LEGACY to have more of a cushion, or delay the age of death.