There are many factors to consider when deciding how much you should withdraw from your retirement portfolio annually. You need to think about life expectancy, the rate of return on your investments, inflation and your personal goals for your assets in addition to your income needs.
In the case of a married couple who retires at age 65, there is a good chance that one of them will live for more than thirty years in retirement. According to life expectancy tables from the Social Security Administration, a 65 year old male today has a life expectancy of 17.57 years and a 65 year old female has a life expectancy of 20.20 years. The average age difference between married couples in the US is about 3.5 years, with the male being typically the older partner. That means that women are likely to spend a few years in widowhood as they are normally younger than their male partners and also live longer.
You also have to estimate the rate of return you’ll earn on your retirement portfolio. Using historical averages is the most common approach, but you also may want to consider alternative scenarios, like a prolonged bear market in stocks or low interest rates lasting for many years. In a normal interest rate environment, a retiree with $1 million saved could expect to get an income of $45,000 to $50,000 per year by investing in ten year US Treasury bonds without risking principal if held until maturity. Today, that same million bucks will only get you about $25,000 per year. Of course, US Treasury bonds are backed by the full faith and credit of the United States government and are considered to be amongst the safest investments in the world.
The rate of inflation is another calculation where you should use long term averages, but also consider the effects of what could happen in either a deflationary environment or if you have to live through a period of rapidly rising inflation. If your investments don’t keep pace with inflation, you’ll lose purchasing power over time.
Another very important consideration is your personal goals for the funds. Do you have children or charities that you wish to leave your money to? If so, you might want to just spend the income and try to never touch the principal. If you don’t wish to leave the principal to some beneficiaries, you might want to consider a plan were you use the principal also and spend the account down based on your life expectancy.
You’ll also have to plan your budget and the amount of the distributions you’ll be taking from your retirement portfolio. One approach is to shift towards income producing investments in retirement and simply take the income from your account and leave the principal. An often cited rule that you may have heard of is the 4% rule. The rule comes from the Trinity Study which was done in 1998. The way the rule works is fairly simple. In your first year of retirement you withdraw 4% of your portfolio. If you have $1 million saved, that equates to $40,000. The next year you take out the 4% again, plus an inflation adjuster. If inflation runs at 3%, in year two you’d withdraw $41,200, you’d add the inflation rate to your 4% withdrawal rate. The conclusion of the Trinity study was that if you have a 50/50 stock and bond portfolio and you take out 4% per year with an inflation adjustment, you have 95% probability that your funds will last at least thirty years. In my next column we’ll take a closer look at the 4% rule and see if it makes sense for your situation.
Kenneth Roberts is a Truckee-based Registered Investment Advisor. Information is at his blog at www.sellacalloption.com or 775-657-8065. The mention of securities should not be considered an offer to sell or solicitation to buy investments mentioned. Consult your investment professional to understand the risks and/or how the purchase or sale of these investments may be implemented to meet your investment goals. Past performance is no guarantee of future results.