How much money can you safely withdraw from your investments once you retire?
This is a subject of wide debate in the financial planning world as our country’s 78 million baby boomers start turning 65 this year. This “withdrawal rate” simply refers to how much you can tap from your investment assets to avoid running out of money before you die. The approach is designed to allow you to withdraw money each year while leaving your principal intact.
For example, if you start with $1,000,000 at retirement and withdraw 4% per year ($40,000), you skim a $40,000 annual gain off the top of your $1 million investment portfolio and always have the $1,000,000 principal until the end of your life. This implies the $1 million keeps growing by 4.2% each year (you need more than a 4% increase to return to $1 million).
Being able to live off interest while retaining your $1 million principal is valuable even if the purchasing power of your principal declines each year with inflation. In other words, your $1 million initial retirement account might only be worth the equivalent of $300,000 after 30 years, but having the equivalent of $300,000 is still a great financial cushion to help keep you from running out of money.
Unfortunately, we don’t live in the predictable world that facilitates an automatic 4% withdrawal rate because markets move up and down, tax rates change, your financial needs change and investments sometimes disappoint. You no longer can simply set the dial at e.g. “4% withdrawal per year” and be assured you won’t run out of money in 30 years.
Here are some things to consider, based upon recent research:
- People are living longer and longer. It’s not overkill to assume you easily can live another 30 years if you retire at age 65.
- You can’t control where markets will land the year you retire and begin tapping your investment nest egg. If you had a few bad years before you turn 65, you might start retirement with $900,000 instead of the $1 million you intended. How much you have at retirement also depends upon your portfolio mix in the years leading up to retirement. You should consult with a financial planner or investment specialist to determine your optimal mix.
- Once you retire, you need to adjust your withdrawal rate “as you go” – depending upon how markets did the previous 3 years. The Wall Street Journal refers to this strategy as “the accordian strategy.” If the market hits a bear market bottom (note: this may not always be obvious), you trim your withdrawal amount by 25% for the coming 3 years. Michael Kitces, a planning strategist, recommends tracking the S&P 500 P/E (price earnings ratio) to determine if the market is overvalued, fairly valued or undervalued. On that basis, he increases or decreases recommended withdrawal rates within a 4.5% to 5.5% range. This approach has been effective in recent years when tested with a 60% stocks, 40% bonds portfolio.
- Some specialists recommend an even lower withdrawal rate (as low as 2.5% for a moderately conservative 40% stocks/60% bonds portfolio). This means you withdraw $25,000 per year (2.5%) instead of $40,000 per year (4%). Of course we’re talking about pre-tax amounts.
- One strategy at retirement is to set aside 3 years of cash reserves (what you otherwise would draw from your investments) so you always can suspend your annual withdrawals from your $1 million if markets hit the skids.
We haven’t discussed the fact that you need to pay taxes on what you withdraw (ordinary income tax rates if it comes from an IRA, or capital gains tax if funds come from an after-tax account). You may need significant other sources of income (social security, pensions, savings) to fund retirement. And then there’s the corrosive power of inflation; you need to withdraw more and more each year in order to keep pace with purchasing power. Finally, our example of $1 million doesn’t go very far toward covering retirement in more expensive parts of the country – you may need multiples of $1 million in addition to social security and a pension (if you’re lucky enough to have one).
As you can see, determining your ideal withdrawal rate is no trivial matter. If you’re calculations indicate you may be coming up “short,” alternatives include retiring later, adjusting your portfolio over time or spending less in retirement. It’s best to seek professional advice if you have doubts or concerns!