Retirement Income Planning: Why an Appropriate Withdrawal Rate Matters
Accumulating enough assets for retirement may be the top priority for most investors. However, the amount that is withdrawn from a portfolio each year during retirement is what may ultimately determine how long retirement assets will last. Calculating the annual withdrawal rate from personal savings and investments is critical for retirees and people about to retire. It is also a helpful exercise for younger investors who would like to gauge how much they will need to provide adequate income during retirement.
Something to Consider
Several factors will influence an appropriate withdrawal rate. These include your age and health, the potential impact of inflation on assets and cost of living, and the likely variability of investment returns. If you plan to leave a legacy to your heirs, this should also be factored into the withdrawal rate decision.
Age and Health
Although it cannot be predicted for certain how long you will live, an estimate can be made. However, basing the estimate on average life expectancy for age and sex may be unwise, particularly if you are healthy. Be sure to take into account the risk of living longer than a life expectancy table would indicate. As a rule of thumb, plan on a retirement portfolio needing to generate income for 30 years.
As you think about inflation, bear in mind that inflation affects the real return on your assets as well as the cost of goods and services. For long-term planning purposes, it can be assumed that consumer price inflation will continue at its historical average of 4% a year. But also keep in mind that year-to-year variations in inflation may also dramatically impact your plans. Should inflation flare up above the level you assumed after retirement, you would need to revisit your withdrawal rate along with the inflation-adjusted return potential of your investment portfolio.
When considering how much your investments may return over the course of retirement, you might think you could base your assumptions on historical averages, just as you may have done when projecting your retirement savings goal. But once you start taking income from your portfolio, you no longer have the luxury of time to recover from possible market losses.
Just imagine how long it would take to restore the value of a portfolio if it suffered a large loss as a result of a market downturn. For example, if a portfolio worth $250,000 incurred successive annual declines of 12% and 7% during the first and second years, its value would be reduced to $204,600. To restore its value to $250,000, it would require a gain of nearly 23% in the third year. When a retiree’s need for annual withdrawals is added to poor performance, the result can be a much earlier depletion of assets than would have occurred if portfolio returns had not declined.
COMING TO A DECISION
Although it is possible your portfolio will not experience any losses, it is likely that it will at some point. For this reason, it may be safer to assume some setbacks will occur. Although past performance can never ensure future results, market history may give some insight into setting an appropriate withdrawal rate. For example, an analysis by Standard & Poor’s found that 5.5% was the maximum annual withdrawal rate that could be sustained from a balanced portfolio during all 30-year holding periods between 1926 and 2005. The portfolios, which were adjusted for actual consumer price inflation, were composed of 60% stocks represented by the Standard & Poor 500 and 40% long-term Treasury bonds. During the period studied, sustainable withdrawal rates for the respective 30-year portfolios ranged from just over 3% to as high as 8%.
In view of the variability of investment returns and inflation as well as the risk of living beyond your average life expectancy, you may want to err on the side of caution and choose a conservative annual withdrawal rate. The goal, after all, is to crack your nest egg in such a way that it will provide a reliable stream of income for as long as you live. That may mean taking out less in the early years of retirement in the hope of having sufficient income in the later years.
This article is not intended to provide specific investment or tax advice for any individual.
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Scott Kleiman is the president of Apollonia Financial Services in Fort Washington, Pennsylvania. Questions and comments about this article or Apollonia’s services can be directed to him at 1-877-490-6785 or firstname.lastname@example.org.