Do you go to a doctor when you get sick? Of course! Do you take your car to the mechanic? You bet! This makes it interesting why so many people choose to act as their own financial advisor. Having 6 different mutual funds might cause someone to brag about how they are diversifying, or perhaps a recent retiree might say, “Well, I calculated how much I can take out of my portfolio each year, you know there is a rule of thumb.” Your retirement lifestyle will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. Figuring out an appropriate initial withdrawal rate is a key issue in retirement planning and presents many challenges that the do-it-yourselfer likely overlooks.
Why is your withdrawal rate important?
Take out too much too soon, and you might run out of money in your later years. Take out too little, and you might not enjoy your retirement years as much as you could. Your withdrawal rate is especially important in the early years of your retirement; how your portfolio is structured then and how much you take out can have a significant impact on how long your savings will last. No longer do we work until 65 and live another 5 to 10 years. Many people will spend nearly ½ of their lives in retirement, and that is why the simple math just doesn’t work.
So what withdrawal rate should you expect from your retirement savings? The answer: it all depends. One study of annual performance of hypothetical portfolios that are continually rebalanced to achieve a 50-50 mix of the S&P 500 Index and intermediate-term Treasury notes found that a withdrawal rate of slightly more than 4% would have provided inflation-adjusted income for at least 30 years. More recently, similar assumptions show that a higher initial withdrawal rate–closer to 5%–might be possible during the early, active years of retirement if withdrawals in later years grow more slowly than inflation. Of course, adding asset classes such as international stocks, real estate, and commodities helped increase portfolio longevity, but you already know that, right? A withdrawal rate can be fine-tuned from year to year, but one has to start somewhere to find a base to start with. We think the best place to start is with something we call Prosperity Planning®. (Call me and we can talk more about this one.) One retiree might be comfortable with a 75% chance that his or her strategy will permit the portfolio to last throughout retirement; another might need assurance that the portfolio has a 100% chance of lifetime success. Exploring your goals and comfort needs should always begin before crunching numbers.
Inflation is a major consideration
For many people, even a 5% withdrawal rate seems low. 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 a money market account yielding 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. I have heard the story too many times, when someone has said “I need 5% of my money and CDs usually get 5%.” That’s great, but inflation means you need to get at least 8% if it’s going to last. That large cash account should probably be invested in the market in at least some proportion.
Calculating an appropriate withdrawal rate
Your withdrawal rate needs to take into account many factors:
1) Asset Allocation
2) Projected Inflation rate
3) Expected rate of return
4) Annual income targets
5) Time/Investment Horizon
6) Comfort with uncertainty
These are just a few, but I will let you go ahead and get started with that. All you need is a calculator and a few spare days off work. Myself, I tend not to like wandering around for a week feeling awful trying to cure an illness with time and my own ingenuity. My car is probably in much better shape since I only know how to pop the hood, check the oil, and put air in the tires. Exploring our futures and retirement should be a fun and exciting process, and is far too important for guessing games and “rules of thumb”. It is never too early to begin preparing for the future, however; something this important usually requires a professional, so pick up the phone and call a friend, ask around town, or stop by and see us!