Addendum: Adjusting Retirement Withdrawals for Inflation
After my article “Taking Retirement Withdrawals From a Fund Portfolio” was originally published in the May 2013 AAII Journal, I was asked to recalculate the numbers with the initial amount withdrawn adjusted upward for inflation. Under this scenario, 4% was withdrawn from the 2008 ending balance of $115,129. The initial withdrawal amount of $4,605 then served as the basis for determining all future withdrawal amounts. Adhering to this method ensures the annual withdrawals always rise, as long as inflation persists and the savings are not drained.
The math for calculating these withdrawals is simple. During the second year of retirement, the initial withdrawal amount is increased for the rate of inflation. In 1989, the CPI (U.S. Consumer Price Index) ran at 4.6%. The second-year withdrawal was therefore calculated as $4,605 × (1 + 0.046) = $4,817. The withdrawal amount for the third year is the second year’s withdrawal rate increased by the third year’s rate of inflation. Using the 1990 CPI of 6.3%, the math is $4,817 × (1 + 0.063) = $5,120.
Since the dollar amount of the withdrawal itself is increased, the total amount withdrawn over the 25-year period did not change, regardless of whether rebalancing was employed or not. The total withdrawal amount was also unaffected whether the withdrawals were evenly split across all funds or the pro rata method was used.
None of the four hypothetical portfolios ran out of money, and neither did any of the funds used. This is unlike the non-rebalanced pro rata portfolio. The cumulative dollar amount withdrawn explains why. When the initial withdrawal amount was adjusted upward, $167,716 was withdrawn under all four scenarios. When the withdrawal rate was adjusted for inflation, the cumulative amount withdrawn from the non-rebalanced pro rata portfolio was $307,410. Adjusting the withdrawal rate results in an increasing proportion of the portfolio’s value being taken out, which drains savings faster. Adjusting the withdrawal amount instead of the withdrawal rate will give you less in annual income, but will better ensure you do not outlive your savings.
The upper limit of what could safely be withdrawn when the withdrawal amount is adjusted for inflation seemed to be slightly above 5% for the period studied. When a 6% withdrawal rate was used with the non-rebalanced pro rata portfolio, the international fund ran out of money in 2012. I did not test higher rates, but I suspect they would cause problems. Higher overall rates of inflation would have impacted these findings, a factor that should be taken into consideration.
A few members commented about the period studied. I used a 25-year period to encompass a variety of market conditions. Had the analysis started in 2000 instead of 1988, the portfolios would have declined in value because of the allocation used. A more conservative allocation with a larger portion in bonds would have likely fared better, given the rise in bond prices.
(Added May 30, 2013)