It's probably one of the most important decisions you'll make when you retire - how much to withdraw annually from your retirement assets. Take out too much every year and you may have to seriously reduce your standard of living late in life or even deplete your assets. Take out too little and you may unnecessarily reduce your standard of living so you won't enjoy your retirement.
Several factors need to be considered when calculating your withdrawal rate, including your life expectancy, expected long-term rate of return, expected inflation rate, and how much principal you want remaining at the end of your life. Unfortunately, life expectancies, rates of return, and inflation are difficult to predict over a retirement period that can span decades. Keep these points in mind:
- Your life expectancy.
While it's easy enough to find out your actuarial life expectancy, life expectancies are only averages. Approximately half the population will live longer than those tables suggest. How long close relatives have lived and how healthy you are can help you gauge your life expectancy. Just to be safe, you might want to add five or 10 years to that age. After all, you don't want to run out of money at age 75 or 80, when you might not be able to return to work.
- Rate of return.
Expected rates of return are often derived from historical rates of return and your current investment allocation. Historical rates of return are averages of returns over a period of time. You might want to be more conservative than that, assuming a rate of return lower than long-term averages. Even if you get the average return correct, the pattern of actual returns can significantly affect your portfolio's balance. For instance, if you experience higher returns in the early years of retirement when your portfolio balance is higher and lower returns in the later years when your portfolio's balance is lower, you'll have a higher balance than if the opposite occurred. One of the most devastating scenarios for a retiree is to experience a severe market decline right after retirement.
- Expected inflation.
While inflation has been relatively tame recently (2.5% over the past 10 years), that has not always been the case. Over the past 30 years, inflation has averaged 4.9% (Source: Bureau of Labor Statistics, 2004). Even at tame levels, inflation can have a dramatic impact on your money's purchasing power. For instance, at 2.5% inflation, $1 is worth 78- after 10 years, 61- after 20 years, and 48- after 30 years. Since your retirement is likely to last decades, use an inflation estimate encompassing a long time period.
So what is a reasonable percentage to withdraw on an annual basis? One study looked at that question based on actual market returns from 1926 to 1976. The study concluded that to ensure your assets lasted for 50 years, your initial withdrawal rate should be no higher than 3% to 3.5%, with subsequent withdrawals adjusted for inflation. To ensure assets last 30 years, the initial withdrawal rate could increase to 4%. These withdrawal rates assumed a stock allocation of 50% to 75% of the total portfolio. Due to the possibility of a major market decline soon after retiring, the study did not recommend stock allocations over 75% (Source: Journal of Financial Planning, March 2004).
Another study took a different approach to this question. By adding other asset classes to the portfolio, including international equities and real estate, and establishing fixed rules for rebalancing the portfolio, this study concluded that to last 40 years, the initial withdrawal rate could be 4.4% with a 65% weighting in equities and 5% with an 80% weighting in equities. If the retiree was willing to forego increases in withdrawals in certain circumstances, such as when the portfolio's ending balance is lower than its beginning balance, and cap inflation increases to 6%, withdrawal rates could increase to 5.1% to 5.8% (Source: Journal of Financial Planning, October 2004).
What conclusions can be drawn from these studies?
- Your withdrawal percentage should be modest to ensure you don't deplete your assets.
While the two studies reach different conclusions, they advocate initial withdrawals of modest amounts ranging from 3% to 5.8%. With a $1,000,000 portfolio, that means your initial withdrawal will range between $30,000 and $58,000. You need to carefully look at your assumptions before deciding between the high or low end of these estimates.
- Stocks need to remain a significant component of your portfolio after retirement.
Both studies were based on stock allocations of at least 50% and up to 80% of the total portfolio. With lower allocations to stocks, you would need to decrease your withdrawal percentage even further.
- Review your calculations every year.
This is especially important during your early retirement years. If you're depleting your assets too rapidly, you can make changes to your portfolio, reduce your expenses, or consider going back to work. As you age, your options tend to become more limited.
- Work as long as you can.
Supporting yourself for a retirement that could span 25 or 30 years requires huge sums of money. Consider working at least a couple of years longer than originally planned. During those years, you can continue to build your retirement assets and delay making withdrawals from those assets. Once you do retire, consider working at least part time to reduce withdrawals from your retirement assets.