Determining a safe withdrawal rate is one of the most debated and critical issues in developing a plan for your retirement income. That is, how much can you withdraw without running out of money? Over the last 10 years I have seen an article in a reputable financial planning magazine suggest a 7% annual rate and I've witnessed more and more experts pointing to a number as low as 3%. The answer is much more complicated than a number that applies to everyone. It really comes down to your portfolio and how much buffer you set for inflation.
For example, if your portfolio was all bonds and had a yield of 5% with a mix of investment grade bonds and high-yield, you would not want to draw 5% per year from your portfolio. You could do it, but you would have no inflation protection. So if inflation grew at a rate of 2.5% per year, you would essentially be taking 2.5% less income every year. It would probably be o.k. for the first 5 years or so, but after 10 years, your income would have about 78% of the buying power you had at the beginning. That is a big deal, right?
So you want to assume some number for inflation, probably 2-3%. This is a judgement call, but I believe the Federal Reserve has been fairly diligent to keep inflation under control. If you want to be conservative, then assume 3%. If you want to take a little more risk, you could assume a rate of 2%.
Now how will you determine your future return? You could look at analysts' predictions and use that as your baseline. The problem is, you need to develop a range of return for your specific portfolio. One great place to do this is Portfolio Visualizer:
With a backtest, you need to choose your time period carefully. To be safe, you should start by choosing a start date of 2008 to the present. In this way you can see the total return of the portfolio starting from a very unfortunate date. A second good starting point is 2000. That gives you two different points, right before market corrections.
I ran a backtest with a 60% equity, 40% bond portfolio and found the portfolio delivered a return of 6.89% using the 2008 start, and 8.59% using the 2000 start. So with the inflation adjustment, you have a withdrawal rate of 4.89% to be safe, if you use a 2% inflation rate. Inflation was actually lower in that period, so if you use historical inflation with the historical return you would get something higher, 5.36% using 2008-present.
You will have to be careful, though, with backesting. You can't tinker too much with a portfolio for a specific period just to get better backtested results. You'll just end up with a portfolio that did really well in the past. You need a great portfolio for the future!
Ultimately, your withdrawal rate is going to depend on your portfolio. Build a global portfolio with healthy exposure to small cap stocks, value stocks, international stocks, and emerging markets and you will get more for your money over the long-term. There are periods when you may do better by being concentrated in US large cap growth stocks, as has been the case recently, but over the long-term you will benefit by being more diversified.