I think one of the most frequently asked questions I get from new (and existing) retired clients is “how much money can I take out of my account without depleting my principle?” Not only is this question frequently asked, the answer to it is often debated.
There are a multitude of factors that go into determining one’s withdrawal rate. As we have stated many times, every investor is unique. With that in mind, one could understand how the appropriate withdrawal percentage would differ between individual investors who have individual and unique goals, means, and circumstances. Although there is no set ‘rule of thumb’ there are some factors that come into play such as, the amount of money saved, age at the time of retirement, other sources of income, like a pension or Social Security, and annual living expenses. In addition, when determining your withdrawal rate, your asset allocation, projected inflation rate, expected rate of return, investment time horizon, and comfort with uncertainty (risk tolerance) will need to be considered.
So, what rate should you expect to get? Short answer, it’s complicated. The long answer, the seminal study on withdrawal rates for tax-deferred retirement accounts (William P. Bengen, “Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning, October 1994) looked at the annual performance of hypothetical portfolios that are continually rebalanced to achieve a 50-50 mix of large-cap (S&P 500 Index) common stocks and intermediate-term Treasury notes. The study considered the potential impact of major financial events such as the early Depression years, the stock decline of 1937-1941, and the 1973-1974 recession. It found that a withdrawal rate of slightly more than 4% would have provided inflation-adjusted income for at least 30 years. So, I typically use 4% as a nice starting point. Essentially, the younger you start tapping your retirement savings, the lower the annual withdrawal percentage must be for savings to last.
As an example: if you will retire at age 60, it’s probably smart to dial back your withdrawal rate to 2 or 3%. Retiring at age 70, by contrast, may let you pull out 6 or 7% of your money each year.
When setting an initial withdrawal rate, it’s important to take a portfolio’s ups and downs into account. According to several studies done in the late 1990s and updated in 2011 by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz, the more dramatic a portfolio’s fluctuations, the greater the odds that the portfolio might not last as long as needed. If it becomes necessary during market downturns to sell some securities in order to continue to meet a fixed withdrawal rate, selling at an inopportune time could affect a portfolio’s ability to generate future income. A more aggressive portfolio may produce higher returns but might also be subject to a higher degree of loss. A more conservative portfolio might produce steadier returns at a lower rate, but could lose purchasing power to inflation, which leads me into my next point of why inflation is a major consideration.
To better understand why suggested initial withdrawal rates aren’t higher, it’s essential to think about how inflation can affect your retirement income. Here’s a hypothetical illustration; to keep it simple, it does not account for the impact of any taxes. If a $1 million portfolio is invested in an account that yields 5%, it provides $50,000 of annual income. But if annual inflation pushes prices up by 3%, more income, $51,500, would be needed next year to preserve purchasing power. Since the account provides only $50,000 income, an additional $1,500 must be withdrawn from the principal to meet expenses. That principal reduction, in turn, reduces the portfolio’s ability to produce income the following year.
In summary, your withdrawal rate can be the most important factor in minimizing the likelihood of outliving your money. As most of you know, if you take out too much too soon you might run out of money in your later years. On the contrary, if you take out too little you might not enjoy your retirement years as much as you could. As we all know, retirement isn’t merely about preserving a nest egg but using hard-earned savings to live life to the fullest.
If you have any questions regarding your current, or future, withdrawal rate, please give us a call. We will be happy to review your unique situation.
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