You’ve worked hard your entire life and you’ve saved diligently to make sure you’d have financial freedom in retirement. Now that you are either in retirement or getting close to it, you need to make sure your finances, i.e. what you have in your retirement portfolio, lasts the rest of your life and possibly that of your spouse. And that may not be easy. As we have seen in the very near past, The Great Recession and subsequent recovery, the financial markets can be extremely volatile.

No individual can control the financial markets but there are actions we can take to manage or control the markets impacts on our portfolios. A key control mechanism is managing how much we withdraw from our portfolio each month to pay for expenses. This, in financial planning jargon, is called the “sustainable withdrawal rate”.


What is a sustainable withdrawal rate?

A withdrawal rate is the percentage that is withdrawn each year from an investment portfolio. If you take $20,000 from a $1 million portfolio, your withdrawal rate that year is two percent ($20,000 divided by $1 million).

However, in retirement income planning, what’s important is not just your withdrawal rate, but your sustainable withdrawal rate. A sustainable withdrawal rate represents the maximum percentage that can be withdrawn from an investment portfolio each year to provide income with reasonable certainty that the income provided can be sustained as long as it’s needed (for example, throughout your lifetime).


Why is having a sustainable withdrawal rate important?

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 withdrawal rate is a key factor in retirement planning. However, this presents many challenges and requires multifaceted analysis of many aspects of your retirement income plan. After all, it’s getting more and more common for retirement to last 30 years or more, and a lot can happen during that time. Drawing too heavily on your investment portfolio, especially in the early years, could mean running out of money too soon. Take too little, and you might needlessly deny yourself the ability to enjoy your money. You want to find a rate of withdrawal that gives you the best chance to maximize income over your entire retirement period.

A sustainable withdrawal rate is critical to retirement planning, but it can apply to any investment portfolio that is managed with a defined time frame in mind. It’s also fundamental to certain types of mutual funds that are managed to provide regular payments over a specific time period. For example, some so-called distribution funds, which are often used to provide retirees with ongoing income, are designed to distribute all of an investor’s assets by the time the fund reaches its targeted time horizon. As a result, the fund must calculate how much money can be distributed from the fund each year without exhausting its resources before that target date is reached.

Tip: Each distribution fund has a unique way of addressing the question of a sustainable withdrawal rate. Before investing in one, obtain its prospectus (available from the fund), and read it so you can carefully consider its investment objectives, risks, charges, and expenses before investing.


What determines whether a withdrawal rate is sustainable?

  • Your time horizon: The longer you will need your portfolio to last, the lower the initial withdrawal rate should be. The converse is also true (e.g., you may have health problems that suggest you will not need to plan for a lengthy retirement, allowing you to manage a higher withdrawal rate).
  • Anticipated and historical returns from the various asset classes in your retirement portfolio, as well as its anticipated average annual return: Though past performance is no guarantee of future results, the way in which you invest your retirement nest egg will play a large role in determining your portfolio’s performance, both in terms of its volatility and its overall return. That, in turn, will affect how much you can take out of the portfolio each year without jeopardizing its longevity.
  • Assumptions about market volatility: A financial downturn that reduces a portfolio’s value, especially during the early years of withdrawal, could increase the need to use part of the principal for income. It could also require the sale of some assets, draining the portfolio of any future income those assets might have provided. Either of those factors could ultimately affect the sustainability of a portfolio’s withdrawal rate.
  • Anticipated inflation rates: Determining a sustainable withdrawal rate means making an assumption about changes in the cost of living, which will likely increase the amount you’ll need the portfolio to provide each year to meet your expenses.
  • The amounts you withdraw each year: When planning your retirement income, your anticipated expenses will obviously affect what you need to withdraw from your retirement portfolio, and therefore affect its sustainability. However, because this is one aspect over which you have at least some control, you may find that you must adjust your anticipated retirement spending in order to make your withdrawal rate sustainable over time.
  • Any sources of relatively predictable income, such as Social Security, pension payments, or some types of annuity benefits: Having some stability from other resources may allow greater flexibility in planning withdrawals from your portfolio.
  • Your individual comfort level with your plan’s probability of success.

As with most components of retirement income planning, each of these factors affects the others. For example, projecting a longer lifespan will increase your need to reduce your withdrawals, boost your returns, or both, in order to make your withdrawal rate sustainable. And of course, if you set too high a withdrawal rate during the early retirement years, you may face greater uncertainty about whether you will outlive your savings.

Example(s): Mary’s financial professional tells her that given her current withdrawal rate and asset allocation strategy, there is an 80 percent chance that her retirement savings will last until she’s 95 years old. Mary has several choices. If she wants to increase her confidence level–maybe she prefers a 95 percent chance of success–she might reduce her yearly spending, try to increase her portfolio’s return by changing her asset allocation, direct a portion of her portfolio into an investment that offers a guaranteed lifetime income, or some combination. On the other hand, if she’s a risk taker and is comfortable with having only a 75 percent chance that her portfolio will last throughout her lifetime, she might decide to go ahead and spend a bit more now. (This is a hypothetical illustration only, not financial advice).

Estimating lifespan

In general, life expectancies have been increasing over the last century. Life probabilities at any age are listed on the Social Security Administration’s Period Life Table, available under the Actuarial Publications section of its web site.

Tip: Regularly updated longevity estimates are published in the National Center for Health Statistics’ National Vital Statistics Reports.

However, be aware that averages are not necessarily the best guide when determining how long an individual portfolio may need to last. By definition, many people will live beyond the average life expectancy for their age group, particularly those who have a family history of longevity. Also, average life expectancies don’t remain static over an individual’s lifetime; a 30-year-old may have an average life expectancy of 76, while a 76-year-old may have a life expectancy of 85.

Couples will need to consider both individuals’ life expectancies when planning a sustainable withdrawal rate.

The impact of inflation

An initial withdrawal rate of, say, four percent may seem relatively low, particularly if you have a large portfolio. However, if your initial withdrawal rate is too high, it can increase the chance that your portfolio will be exhausted too quickly. That’s because you’ll need to withdraw a greater amount of money each year from your portfolio just to keep up with inflation and preserve the same purchasing power over time. For a retirement portfolio, that can become problematic, since the amount withdrawn is no longer available to generate income in future years. An appropriate initial withdrawal rate takes into account that inflation will require higher withdrawals in later years.

Example(s): Jean has a $1 million portfolio invested in a money market account that yields five percent. That gives her $50,000 of income that year. However, inflation pushes up prices by three percent over the course of the year. That means Jean will need more income–$51,500–the next year just to cover the same expenses ($50,000 x.03=$1,500). Since the account provides only $50,000 of income, the additional $1,500 must be withdrawn from the principal. That principal reduction, in turn, reduces the portfolio’s ability to produce income the following year. In a straight linear model, principal reductions accelerate, ultimately resulting in a zero portfolio balance after 25 to 27 years, depending on the timing of the withdrawals. (This example is a hypothetical illustration and does not account for the impact of any taxes.)

Inflation is one reason you can’t simply base your retirement income planning on the expenses you expect to have when you first retire. Costs for the same items will most likely continue to increase over your retirement years, and your initial withdrawal rate needs to take that into account to be sustainable.

Financial Literacy for CouplesThere’s another inflation-related factor that can affect your planning. Seniors can be affected somewhat differently from the average person by inflation. That’s because costs for some services that may represent a disproportionate share of a senior’s budget, such as health care and food, have risen more dramatically than the Consumer Price Index (CPI)–the basic inflation measure–for several years. As a result, seniors may experience higher inflation costs than younger people, and therefore might need to keep initial withdrawal rates relatively modest.

Market volatility and portfolio longevity

When setting an initial withdrawal rate, it’s important to take a portfolio’s volatility into account. The need for a relatively predictable income stream in retirement isn’t the only reason for this. According to several studies in the late 1990s 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 assets 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. And a steep market downturn, or having to sell assets to meet unexpected expenses during the early years of retirement, could magnify the impact of either event on your portfolio’s longevity because the number of years over which those investments could potentially have produced income would be greater.

Withdrawal rates and tax considerations

When calculating a withdrawal rate, don’t forget the tax impact of those withdrawals. For example, your withdrawal rates may need to cover any taxes owed on that money. Depending on your strategy for providing income, you could owe capital gains taxes or ordinary income taxes. Also, if you are selling investments to maintain a uniform withdrawal rate, the tax impact of those sales could affect your withdrawal strategy. Minimizing the tax consequences of securities sales or withdrawals from tax-advantaged retirement savings plans could also help your portfolio last longer.

Yet another twist in determining the withdrawal rate is determining when to switch to the Required Minimum Distribution (RMD) as required by the Internal Revenue Service. The withdrawal rate you come up with can be trumped by RMD rules and regulations.

What is a RMD? A RMD is the annual minimum amount a retirement plan account owner must withdraw beginning in the year he or she reaches 70 ½. By far, most retirement accounts are subject to this rule. Funds held in a Roth IRA are not subject to the rules so long as the account holder is alive and funds held in a non-qualified annuity that is NOT held in an IRA are exempt from the RMD rule. However, funds held in a Roth 401(k), 403(b) and 457(b) plans are all subject to RMD’s as are annuities held in an IRA. The penalty for ignoring the RMD is quite severe. In general, the RMD is taxable in the year it is taken. If you decide not to take the RMD, the amount not withdrawn is subject to a 50% tax.



As mentioned earlier, you control how much you take from your investment portfolio each and every year. That amount will change over time due to life events. The more aggressively one spends from their retirement savings, the greater the risk they outlive their finances. The more conservative one is, the more likely it is they will be able to survive market volatility and live comfortably to the end of their lives. If this seems daunting and complex, talk to a financial advisor such as Mackey Advisors.


Continue on to read part 2