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Finding the Right Withdrawal Rate: One Key to Portfolio Sustainability

by Maria Crawford Scott

Finding The Right Withdrawal Rate: One Key To
Portfolio Sustainability Splash image

Like all investors, individuals who are living off of their retirement savings need a blueprint to construct a successful portfolio.

But the blueprint that works for the typical investor who is saving for retirement won’t work for those who are living off of their retirement savings.

That’s because the goals of these two types of investors are not quite the same.

All investors want maximum returns on their savings. But those living off of their retirement savings are also “savings consumers” who use their savings to support themselves. These investors typically have two goals:

  • Goal One—Savings That Last: One goal is that your savings need to provide you with your living needs throughout your entire lifetime. In other words, your savings need to last at least as long as you do, through all kinds of market conditions—both bull and bear.
  • Goal Two—Savings That Provide Large Annual Paychecks: The other goal is that your savings should provide you with enough financial resources so you can do the things you want to do during retirement. In other words, you want your retirement savings to provide you with as large an annual paycheck as possible.

Unfortunately, this presents individuals living off of their retirement savings with a dilemma: Their two savings goals are actually working against each other.

If you are living off of your savings, how do you balance those goals? To be more specific: How do you find the point at which you can spend the maximum amount of your retirement savings each year, and still be sure that you will have enough savings to support you for the rest of your life?

There are three key elements that will help you keep these goals in balance and allow you to maintain a successful retirement portfolio—one that you can comfortably live off of, and that can survive during bull and bear markets:

  • You need an appropriate systematic withdrawal approach that focuses on realistic rates of withdrawal.
  • You need an appropriate asset allocation that includes diversification among the three major asset classes (stocks, bonds and cash) and diversification within the most volatile categories (particularly stocks).
  • You need an appropriate monitoring system that includes: 1) Rules regarding annual spending amount increases and decreases to help ensure that you stay on course; and 2) Periodic reassessments of your asset allocation and rebalancing.

This article focuses on the first key, and helps you answer the question: How much of your retirement savings can you “safely” withdraw each year?

Your Withdrawal Approach

To answer this question, you first have to settle on the approach you are going to use to determine your annual withdrawal amount. The approach that you choose is critical, because it will have a big impact not only on the obvious issues of how much you can withdraw each year and on protecting your savings so they last your lifetime, but also on your asset allocation strategy.

For example, one relatively popular rule-of-thumb is to withdraw only the income generated from your investments. This approach is popular because it seems like a good way of “protecting” your principal value—after all, you’re spending only the income.

However, the typical impulse is to maximize income by putting a large amount in higher-yielding investments, such as bonds. The downside to this approach is that, over the long term, both your savings and the income it generates may not be able to grow in real terms to keep pace with inflation, and eventually you may be forced into a lower standard of living. In other words, you will be consuming current income at the expense of future growth.

One way around this problem would be to simply invest your assets for maximum return and live off of your portfolio’s real rate of return each year. This approach encourages a heavier stock commitment, which maximizes long-term growth.

However, the returns over the last few years illustrate perfectly the havoc this approach can wreak to your income: Using this approach, your income tends to fluctuate wildly year-to-year. It does not produce a steady source of income.

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A more useful approach—the one that is used by most financial advisers today—is to basically create an immediate annuity out of your savings portfolio. To do that, you:

  • Total up all of your investable assets, estimate your life expectancy, and determine a “first-year” withdrawal rate for that portfolio. The withdrawal rate takes into consideration all of the earnings that will be received on all amounts of your remaining invested savings until the portfolio is exhausted, and it divides everything up equally over the time horizon. This basically allows you to withdraw both principal—your original savings—as well as earnings on that principal amount, over your lifetime.
  • That first-year withdrawal rate is translated into a dollar amount, which becomes your first-year “income”—the actual dollar amount that you can withdraw from your portfolio.
  • The next year, you are allowed to withdraw your prior-year dollar amount increased by the rate of inflation.

Under this approach, in your first year of retirement, a first-year “withdrawal rate” is determined that is a percentage of your first-year investment portfolio; that percentage rate translates into a specific dollar amount that becomes your first-year withdrawal. That first-year dollar amount then becomes your annual withdrawal amount—although typically the dollar amount is increased each year by the rate of inflation. Note that, in subsequent years, your withdrawals as a percentage of your portfolio value will vary, depending on your portfolio’s performance.

For instance, if you have a $1 million portfolio in your first year of retirement, and your first-year spending rate is 4%, your first-year withdrawal would be $40,000. The next year you would increase $40,000 by the rate of inflation and withdraw that dollar amount.

Now, if several years down the road your portfolio has had significant losses, your annual spending rate in those years may be greater than 4% of that year’s portfolio value; if your portfolio has had significant gains, your annual spending rate in those years may be less than 4% of that year’s portfolio value.

Withdrawal Rate Clarification

It should be emphasized that the rate I am talking about in terms of the withdrawal rate approach is a rate that applies to your first-year withdrawal only.

You should also be aware that the withdrawal amount I am talking about in using this approach is a “gross income” type of figure. This gross amount, along with any other sources of income, is what is used to pay your annual living expenses—and by that I mean all expenses, including taxes. The withdrawal amount does not take into consideration taxes due based on the source of the withdrawal. So, two individuals may have the same initial withdrawal amount, but one may have a much higher tax bill—and therefore less to spend on everything else—than the other individual, depending on how they are withdrawing from their savings.

Lastly, please be aware that the withdrawal rate discussed in this article has nothing to do with “required” minimum withdrawals from retirement accounts.

The advantage to this approach is that it allows you to separate your asset allocation decision from your withdrawal needs, so that you are not focusing too much on one particular need at the expense of another. This tends to encourage you to invest for the long term, since the withdrawal rate does not depend on any income component. Therefore, higher-growth potential investments such as stocks are less likely to be pushed aside in favor of higher-income but lower long-term growth investments.

Adapting the Approach to the Real World

Before you get worried about “annuity formulas” and “how to figure out the percentage rate,” we’ll take a look at how this approach has been adapted to the real world—and you’ll see that you don’t need to worry about working through any formulas.

If you were to use a strict annuity approach, you would plug your assumed long-term average annual rate of return on your portfolio into an annuity formula and you would come up with a withdrawal rate. But that withdrawal rate would probably be a much higher rate than is warranted. That’s because that average annual rate of return over your time horizon comes from actual returns that in the real world vary tremendously year-to-year: One year your return may be up 15%; the next year, it could be down 45%.

The annuity formula would work fine if you were to make no changes to your portfolio—if you neither added money to nor withdrew money from your portfolio: The sequence of returns makes no difference to your ending amount for any given long-term rate of return. But if you are making withdrawals from a portfolio—as anyone living off of their retirement savings would be—the timing and sequence of the returns that you receive make a big difference on your ending portfolio value: If you receive higher returns in the earlier years, when your savings are at their highest level, your risk of outliving your assets is much lower than if you receive higher returns toward the end of your life, when you have less savings because of all your withdrawals.

Unfortunately, investors have no control over return sequences. Fiddling with your asset allocation by substantially increasing your commitment to low-volatility assets won’t solve the problem because that substantially lowers your average long-term rate of return.

So…the solution still uses the annuity concept, but not the actual formula—and that concept has been adopted very carefully by the financial planning community and financial academics.

Instead of relying on one annuity formula, they have been testing the concept using various rates of withdrawals and different asset allocations over real market conditions—with lots of different return sequences—to see which withdrawal rates and portfolio combinations are actually safest. In other words, they examine a portfolio’s “success rate,” which is the percentage of times that a portfolio is able to sustain the given payout over the entire time period without running out of assets prematurely.

Withdrawal “Success Rates”

Figure 1 is from an article that appeared in the AAII Journal way back in February of 1998 written by three finance professors from Trinity University in Texas. This study is frequently quoted—it was one of the first and, I think, one of the best because of the long time period it covered. For that reason, I think it is still valid, even though it may appear to be a bit dated.

This figure shows the portfolio “success rates” of various stock and bond combinations—the top grouping is a portfolio consisting solely of U.S. large-cap stocks; the second group is a portfolio of 75% stocks and 25% bonds, and so on.

* Assumes inflation-adjusted withdrawals in subsequent years. Source: "Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable," by Philip L. Cooley, Carl M. Hubbard, and Daniel T. Walz, AAII Journal, February 1998.

These success rates were determined based on the actual annual sequence of returns from 1926 to 1995 for varying rates of withdrawal (the vertical columns, starting with 4%), and payout periods (the leftmost column covering 15 years, 20 years, 25 years and 30 years of payouts).

The success rate is the number of times a portfolio was able to make annual withdrawals without running out of assets over the time period relative to the number of total scenarios. The annual withdrawals are determined in the same way I described earlier—an initial spending rate is determined, converted into a dollar amount and then increased for inflation in subsequent years.

For instance, if your portfolio were invested 75% in stocks and 25% in bonds, and your withdrawal rate was 4% of the initial portfolio value with inflation increases in the following years, your investment portfolio would have completely supported you for 98% of all 30-year time periods from 1926 to 1995.

In other words, there would have been a 2% chance you would have run out of money if you lived off of your portfolio for any 30-year time period between 1926 and 1995.

In contrast, if you withdrew 6% of the initial portfolio value with inflation increases in the following years, your investment portfolio would have completely supported you for only 68% of all 30-year time periods.

Interestingly, the professors originally set out to study the importance of asset allocation in a withdrawal portfolio (a portfolio from which withdrawals are being made annually). Certainly, the study did show that asset allocation was an important aspect.

However, the most important conclusion they came to—and that more recent studies support—is that the primary way to ensure your own investment portfolio’s success rate is to establish a realistic initial withdrawal rate of not more than 4% to 5% of your investment portfolio assets.

You can clearly see from the table that withdrawing at higher rates will significantly increase your risk of outliving your assets, especially for longer payout periods.

More Recent Studies

Figure 2 shows a more recent study based on returns that ran through 2005. It only considered a 30-year payout period, but used a wide range of withdrawal rates and a wide variety of stock and bond allocations. The curved lines represent various withdrawal rates, with a 3% rate running along the bottom, close to the horizontal axis.

Simulated return sequences were determined by randomly selecting 30 one-year real returns from 1926 to 2005 for each 30-year period. A total of 10,000 separate 30-year sequences were calculated, so you can see they are using a slightly different methodology than the Trinity study.

Source: “Guidelines for Withdrawal Rates and Portfolio Safety During Retirement,” by John J. Spitzer, Jeffrey C. Streiter and Sandeep Singh, Journal of Financial Planning, October 2007.

This chart shows “runout percentage,” which is the opposite of survival rates—it indicates the percentage of times a portfolio was unable to sustain all of the payouts.

This study is shown because it includes returns from a more recent time period. But its results are strikingly similar to that of the first study: For an investment horizon of 30 years, a 3% withdrawal rate would keep you safe under almost any scenario, but that’s an exceptionally low withdrawal rate. As you can see in the chart, if you want to remain at 10% or under in terms of shortfall risk, you need to keep your annual withdrawal rate low, at around 4%.

(To put a shortfall risk into perspective, remember that the actual chance this will occur is combined with the chance that you or you and your spouse will survive over that entire time period.)

Keep in mind, too, that in all of these studies, the stock portfolios were diversified, typically by using a major market index, and the asset allocations were held steady—there was no attempt to time the markets.

The Bottom Line: Realistic Withdrawal Rates

The bottom line from these studies is that you don’t need a rock-bottom withdrawal rate to be safe. However, you do need to keep the withdrawal rate realistic—and in these studies, that meant taking not more than 4% each year if you want your portfolio to survive throughout retirement.

Keep in mind that this doesn’t mean you can select a realistic withdrawal rate and then put your portfolio on “autopilot.” You still need the other elements of portfolio management: a proper asset allocation that includes commitments to all three major asset classes, and a portfolio monitoring system that includes spending adjustments—midcourse corrections—to ensure that you stay on track.

But setting a realistic withdrawal rate is the first step toward reaching your ultimate goal of striking the fine line between spending the maximum amount of your retirement savings each year and being assured you will have enough savings to support you for the rest of your life.

The Withdrawal Rate Approach

These are the major points to keep in mind:

  • The advantage of a withdrawal rate approach is that it allows you to separate your asset allocation decision from your immediate withdrawal needs so that they do not drive your asset allocation decision.
  • This encourages you to invest for the long term, since the withdrawal rate does not depend on any income component.
  • Annuity tables assume unvarying return rates each year, but your return rates will vary significantly year-to-year.
  • For that reason, base your withdrawal rate on studies of portfolio success rates. You can use the tables here to help you determine an appropriate initial withdrawal rate. This withdrawal rate only applies to your first-year withdrawal; after that, you can withdraw the same dollar amount as the prior year adjusted for inflation. This is a pretax amount that does not take into consideration what type of account your withdrawals are made from (taxable or tax-deferred).
  • Make sure you use a realistic spending rate—not more than 4% of the initial portfolio value.
  • This approach is not an “autopilot” approach. You still need to develop an appropriate asset allocation strategy and a portfolio monitoring system that allows for midcourse adjustments to ensure that your portfolio remains on track.
Maria Crawford Scott is the former editor of the AAII Journal.


Discussion

Bernard Biltek from FL posted over 2 years ago:

This discussion does not consider that currently bond yields are at historical lows. Will the average bond yields be much lower over the next 30 years than they were over the 1926-1995 time periods. If so that will have a major effect on using this data to determine withdrawal rates.


H Padden from NJ posted over 2 years ago:

So, you must pay taxes from your 4% and you (very luckily) make 15% on your investments the first year. Your combined tax bracket is, say, 40%. You must, therefore pay 6% (15% X 40%) from your 4%. So, you are required to live on -2% in your luck year. Who will pay you that money?

You simply cannot use this simple rule inflexibly, but only as a very rough guideline for your overall planning.


Robert Brooks from AZ posted over 2 years ago:

30 year averages are a bit unrealistic. For the first time since 1920, there is a 10 year period (1998-2008) in which investments in the S&P index would have produced a net loss!
Most of us over 65 are concerned that another precipitous drop in the market would essentially wipe our our stock investments in that a 50% decline would require a 100% increase to just break even.
It is very difficult to maintain a "relatively safe" return of over 4% in order to be able to withdraw at that same rate.
I have decided to anuitize a good portion of saving into a single life, no beneficiary, annuity (actually, diverifying among the top rated insurance companies). I can receive a 7.8% return of investment and principal for life. If there is money left over in early retirement, then those dollars can be reinvested into "riskier" assets.
The key, as you pointed out, is to maintain enought fluidity for emergencies and potential investments if the market really takes another dive.
We can thank Mr. Greenspan and his guru, Ayn Rand, for starting this lowest interest rate paradigm which has lasted for over 10 years now. It has had a major negative effect on retirement incomes and all of the retirement portfolios of major agencies (i.e. STRS).
I believe interest rates will rise again (cycles tend to repeat) and hopefully I will have enough cash to reinvest at a higher rate. Now is the time not to invest in bond funds as the upside potential is minimal and the downside risk is horrendous.

Bob Brooks
Prescott, AZ


James Stewart from MA posted over 2 years ago:

Seems that you would only pay 40% taxes on any money you withdraw from IRA type accounts, or 4%X40%=1.6%, for example, plus taxes on dividends, capital gains,other income,etc.


Robert Krisch from PA posted over 2 years ago:

An alternative approach bases the withdrawal rate for each upcoming year on the current value of the portfolio at the beginning of the year, along with the retiree's life expectancy at that same time. This gives a substantially more irregular rate of annual return than the Bengen model that you outline, but has NO risk of running out of money before you die and takes automatic account of fluctuations in the year to year value of the portfolio. This observation is not a revelation. This is the basic principle on which the German retirement system and numerous other large governmental and private retirement systems work. It is also the dominant principle behind the US Social Security System, with various political tinkering around the edges to decrease the short term risk to the annuitant, but with no guarantee that these modifications are permanent.
I understand that this approach to withdrawal from retirement accounts has never been popular with financial planners because it has never been popular with their clients, who generally want a fixed lifelong stream of inflation protected income. I have always believed that with some effort to carefully explain this approach to people in parallel, the risk benefit tradeoff compared to the accepted Bengen approach would look much more attractive. Running out of money at an advanced age without any remaining earning power seems to me to be a much more serious risk than is a significantly fluctuating annual income. As a bonus, this approach also automatically eliminates the long term risk of taking out too little money if the investment markets do unexpectedly well over an extended period. As another bonus, it is very easy for intelligent individuals to apply to their own retirement accounts. Life expectancy tables are widely available on the internet, including multiple tables from the Social Security Administration.
In summary, I feel strongly that this general model should always be offered in parallel as a serious alternative approach to retirement withdrawal, both by financial planners in individual sessions and in articles such as this one, whenever the Bengen approach is presented as a "reasonable" one and that the Bengen approach should never be presented without serious discussion of alternatives such as this.


Robert Krisch from PA posted over 2 years ago:

ADDENDUM to my post above. I apologize, but I somehow forgot to include an important, familiar and classic example of the alternative withdrawal plan discussed above. It is a fairly pure example and is widely used by many prosperous retirees in the US, including I am certain, many readers of this Journal. It is the minimum required annual withdrawal plan laid out by the Federal Government for retirees over 70.5 who own IRAs and/or any other lump sum tax sheltered retirement accounts. With these accounts, you generally don't even have to figure out the required withdrawal amount each year, since the managing institution will almost always do it for you, mail your checks to you regularly and do all of the required record keeping. The life expectancies used are generally for two joint lives, giving a lower than necessary withdrawal rate for single people, but you are always allowed to take out more than this minimum.


Steve Laube from GA posted over 2 years ago:

The classic 4-5% adjusted for inflation approach to withdrawal is flawed in several ways:computr modelsthat run "10,000" simulations usingrandomly selected returns remove the bjsiness cycle from the data, bastardizing the data to the point that one can say it is invalid. More importantly, these secnarios typically assume ALL withdrawals come from the stock portion of the portfolio, even though the asset allocation contains typically 50% bonds and cash. Why use this "safe" allocation and then not use it correctly to withdraw from the non stock portion when the market/portfolio is not at a high water mark. Selliong stocks when the market is down 30 or more per cent results in a double whammy wher ein more tock must be sold to raise money andthen that stock is gone forever when the recovery comes. Last, for many of us, the 3% inflation assumption is way overstated. Unless you are living a minimal lifestyle, age will take care of the gym membership, country club membership, travel and entertanment expenses, mortgage payment, big home/utility bills/taxes, and even the transportation as one goes from two or more cars to one and then none. Also, it is very easy in real life to use a combination wherein the 4% guideline is combined with the ability to cut spending via "substitution" and denial for a year or two if the portfolio is trashed and you are concerned; the withdrawal models assume no adjustment to withdrawals, even as one sees the approaching freight train of running out of money.


Richard Abbott from FL posted over 2 years ago:

I HAVE 115 MINUS MY AGE IN CONSERVATIVE BALANCED MUTUAL FUNDS AND THE REST IN SHORT AND MEDIUM TERM CORPOARTE BOND MUTUAL FUNDS. I HAVE HAD A AN AVERAGE ANNUAL RETURN OF 6% USING THIS RATIO FOR THE PAST 12 YEARS.


Michael Frey from OH posted over 2 years ago:

No way can one take out 4% (in real terms) and expect to maintain the value of the account over time. It's a pipe dream. I've seen this flawed argument over and over from people who should know better.


John Borrows from FL posted over 2 years ago:

Too much attention to what I cannot control and not enough to what I can.

During my 69 yrs. I've lived high on the hog and eaten pigs feet. Can't say that there was a lot of difference in the happiness and satisfaction at either end.

So, the first step is to decide on a minimally acceptable life style, and its annual price. Using whatever conservative estimate you want to decide if you can afford it. If you can't -- resume' time. But you probably can with quite a bit of cushion. Proceed to live that way and watch for truly valuable things to spend the excess on. If all is well with the reserves (money not needed to maintain the minimum acceptable) spend for it and enjoy. If things are going south with your reserves, add the thing to your bucket list.

What is different here is that it seems if you calculate your income first with the idea that you will then do your budget to match, you'll find a way to budget to the income.

I see too many people who spend hours of work and lots of worry on maximizing or estimating their incomes without having a clue of how much they are spending on stuff that really isn't all that important to them. Until you figure out what you really want, you won't know anything about what you have.

Back to managing income, what I would really like to see is a plan for what to withdraw. Building up these assets I had this wonderful plan of steady, equal, investments leading to dollar cost averaging. An assurance that I was buying more at the lows and less at the highs.

The financial planners have not provided me with any way to cash in my investments that is better than a constant percentage rate assuring long term average recovery. If I take out a set amount each year (as suggested here) I get dollar cost average in reverse, assuring below average returns in the long run. I would not want to try to make my living selling that "plan" to paying clients.


Robert Franzen from MO posted over 2 years ago:

What I recommend is tracking your draw rate on a monthly basis using the following process:

1. Create a paper account and credit it with 4% (divided by 12) of your 12 month average portfolio value

2. Reduce the account by your actual draw for the month

3. Monitor the account balance and make adjustments as desired or required

The benefit to using a 12 month average is that values do not suddenly change radically due to market volatility.

If the account builds a surplus value over time, you may decide to reward yourself with an unplanned vacation. If the account builds a deficit value over time, you know it is necessary to reduce spending.

The two most important things one can do to reduce the risk of running out of money are:

1. Setup a disciplined process to manage and monitor as described above

2. Maintain a diversified portfolio containing as many asset classes as you feel comfortable with and rebalance regularly.


James Johnston from NV posted over 2 years ago:

The more I read about this subject the more confused I get.This is my first year in retirement, (lost my business) I'm 61.
Is there a good program that would help me determine a withdrawel amount showing diferent examples?.


Robert Krisch from PA posted over 2 years ago:

In response to Mr. Johnston's post, I agree that this is a somewhat confusing subject, but hopefully the following comments will be of some use to you. My two adjoining posts from yesterday briefly discussed the easy, do it yourself program of treating your accumulated retirement assets as if they were in an IRA and calculating your regular annual withdrawals as if they were your required minimum withdrawals from the IRA. These are calculated very simply. The only information you need is the current market value of the accumulated assets and your current life expectancy or the joint current life expectancy of yourself and your wife. You then divide the market value by your life expectancy and that gives you the amount to be withdrawn for the upcoming year. It can be withdrawn either as a lump sum or in monthly or quarterly installments. At the beginning of the next year you repeat this procedure with the updated value of your accumulation and your updated life expectancy. Individual and joint life expectancy tables are readily available on the internet. For example, the IRS provides several such tables with their instructions for IRAs. Your age is below the starting age of 70.5 for mandatory IRA withdrawals, but I believe that they have data for younger ages for single lives but not joint lives. Those could easily be found at other websites or in a reference library. For more detailed information and for examples of typical scenarios, you just need to look at the section on withdrawals in a few books on IRAs. There are many such books in every public library. Remember, some major advantages of this approach are: 1) You can't ever run out of money if you follow theses rules, although as with any approach where you can't run out of money, if your assets continually produce a low rate of return your annual withdrawals will eventually become lower. As I described in the earlier posts this method is officially endorsed by the US government for IRAs and by a number of other governments for corresponding retirement accounts. 2) It is pretty easy to do it yourself, with no fees and a minimum investment of time and energy, as described above and detailed in numerous other sources on IRAs. 3) It works as advertised, without any fiddling, no matter how you have invested the accumulation, although as noted above, the size of the annual withdrawals will eventually depend on the rate of return. Accordingly, this approach does not alter the need for diversification between and within asset classes or the need to keep a large fraction of the assets in equities. 4) Unlike the Bengen 4% approach, if your investments do unexpectedly well for any extended period, this approach automatically adjusts your annual income upward without any effort on your part.
The major disadvantage of this approach is that your income will not be certain from year to year because it will be calculated from the total value of your accumulation at the beginning of that year, which may fluctuate a little or a lot, depending on how you have it invested and on what the markets did during the previous year. This would be less of a negative once you start collecting additional stable, inflation protected income from social security, but it seems to me that even in the absence of social security, the likely degree of unavoidable annual fluctuation would be a small price to pay for eliminating even a small probability (say 5% as in many of the Bengen type models) of entirely running out of money at an age when you are unable to work.


Alan Thelen from MI posted over 2 years ago:

Because of the impact and difficulty of predicting the sequence of (good) market year returns I have been considering allocating at least the percentage recommended for bonds to an index annuity. I would then forgo any bond investments with my remaining funds. Any thoughts, comments, or dirty looks?


William Porter from IL posted over 2 years ago:

I've been retired "officially" only since the beginning of February, but I think the actual situation for most retirees is a whole lot more complicated than simplistic rules, such as a "4% initial rate" or the IRA distribution rule suggest. Some us lucky few do get to collect traditional pensions, which others might need to create for themselves by purchasing an annuity from an insurance company (or companies!). This income, plus whatever Social Security pays you, provides a guaranteed minimum annual income -- which is something most retirees desire most of all. But if you have other investments in stocks, bonds, whatever, inside or outside of IRAs, 401k plans, etc., in addition to the amount set aside for annuitization, a more flexible approach can be adopted for those additional funds. Yes, your income will fluctuate if you use the IRA withdrawal rate as a guide, but if this is in addition to a fixed annuity-style income (and not instead of a fixed, annuity-style income) derived from Social Security, traditional pension or an actual annuity, then such fluctuation should be tolerable. Indeed, with a proper mix of investments, the IRA-withdrawal model can provide a growing income stream, part of which can be invested outside of tax-deferred accounts, to continue to grow in net asset value, so that the fraction invested in equities becomes ever larger as you age.

It's important to look at ALL of your investable funds, whether in an IRA, 401k plan, or taxable accounts, and calculate the maximum allowable withdrawal based on this total. If you have too much in tax-derferred accounts, and are forced to withdraw more than this calculated value to satisfy IRS requirements, re-invest the difference in a taxable account.


Warren Flick from GA posted over 2 years ago:

For Mr. James Johnston, and others: at laterlivingblog dot com, I advocate a 4% rule, but without automatic inflation adjustments. Withdraw 4% of your initial total investments in the first year, then again in the second, then again in the third. Over that period, read about other approaches, and experiment with a calculator or a computer and spreadsheet (if you program one to model your investments). If your diversified portfolio is heading south, withdraw less. If your portfolio is bounding upward, cautiously increase your withdrawal by an inflation adjustment—maybe to 4.1% of your initial total investments—then hold that steady for some years.

Another factor not yet discussed is the asset allocation of the portfolio. In studies, authors often use the S&P 500 index along with a long series of bond returns, such as long-term, high-grade corporate bonds, or U.S. Government Bonds. Long data series are available for that data.

But keep in mind that a long-term data series is not a real investment. At laterlivingblog dot com, I’m writing about a real portfolio of four assets: domestic stocks, international stocks, bonds, and REITs. I use Vanguard index funds and trace portfolio performance over the most recent 11-year period, from the end of 2000 through 2011.

It turns out that a well-rounded portfolio having approximately 50% exposure to bond or bond-like assets and 50% exposure to stock and stock-like assets performed reasonably well over the 11-year period. I used a 4% rule—withdraw 4% of the initial value of the portfolio, then keep that amount constant. I also report results for an inflation-adjusted withdrawal, using 2.5% as the inflation rate. The approach is simple, and the results show that it would have worked well, even during the turbulence of the past 11 years. Of course no one can guarantee future performance. You might take a look at the blog posts—there are several about investments and withdrawals.

This coming Tuesday I’ll write about putting a human face on managing your investments, such as dealing with rebounding children or other relatives who need help.


Kenneth Dillman from CO posted over 2 years ago:

I've been retired for 20 years running a portfolio of 60% equities and 40% fixed income. My expenses are covered by social security, a small pension and withdrawal from savings. The savings are in a tax defered IRA, ROTH IRA and taxable brokerage account. I have more in savings now than when I started 20 years ago even with the 2007-2008 major downturn. If your going to manage your own portfolio and withdrawal rates you need to understand tax law, tax brackets and how RMD's are calculated. Everyone is different and one size does not fit all. Most retirement plans tell you to withdraw from taxable accounts first before using tax deferred accounts. This may keep your tax rate low in the beginning but your RMD may increase the rate later in life. What worked for me was to control my spending (stick to a budget)and take more out of my tax deferred accounts when the market was up but only enough to keep me in the same tax bracket. This reduces your RMD when you reach 701/2 and increases your taxable account that you can withdraw from and not increase your tax rate. Again, any standard withdrawal rate maybe a starting point but will probably not benefit most people. There is no substitute for knowing the tax law, having a deversified portfolio and controlling spending.


Clifford Wyble from PA posted over 2 years ago:

Warren - Sounds like the best advise to date.


Dave Gilmer from WA posted over 2 years ago:

Alan, stay away from the indexed annuities, until you can read and understand all the fine print. Once you do you will see there are much better options you can do yourself.

Warren,
I like your approach of keeping the 4% constant for a few years and then adjusting.
Also like your term "bond like" investments. For me 2 pensions and one SS are all bond like income streams so I really don't need any other "real" bonds, especially in this interest rate environment. For my income I use a stock dividend portfolio, which has it's own built in growth of income. Since my "yield to cost" is of main concern, if any one of the dividends goes down, I just replace it with my large pool of money from my bucket 2 growth pool. Right now there are more companies with 25+ years of dividend growth than I even need.


Ted Nicholas from CA posted over 2 years ago:

There are a number of articles on withdrawl rates during retirement but nearly all are too complex for quick review or too simplistic to be accurate. AAII has a chart in their Investor Classroom under Step 3 of Fund Mechanics investing and redeeming article. The X axis has the % annual withdrawl rate of capital (from 5 to 16%) and the Y axis has the % annual asset growth (from 1 to 12 %). You simply match the two variables and their intersection tells you how many years your savings will last. Here is the link: http://www.aaii.com/classroom/article/fund-mechanics-investing-redeeming?page=3
I'm surprised at two things:
1. that the chart isn't at least referenced in every general article like this one.
2. that the chart starts at 5% withdrawl rate rather than the ubiquitously recommended 4% (or less).
It is without doubt the best single chart I've seen on managing retirement savings. Why? finances can change literally overnight. A quick glance at the chart with the new figure allows instant determination of a new withdrawl rate and/or time frame.


obie ephyhm from MN posted over 2 years ago:

man, i wish the investment world would stop pumping this bilge out year after year just because it was the paradigm 45 years ago.

it doesn't work today. people live longer, save less, work longer, have had their savings eaten by inflation . . . on and on and on.

if you're smart enough to invest your own money, you should be smart enough to build a dividend income growth portfolio and then live within your means. no need for bonds. no need for stupid annuities.

articles like this are making me question why i became a life-time member of aaii. this is just standard financial "advice" designed to move products, part seniors from their money without providing any real security and it does not deal with the real world.


Curt Peterson from GA posted over 2 years ago:

I like Warren Flick's approach. Ted Nicholas' recommendation also is valuable. Unfortunately, market performance during the last decade and currently, doesn't mimic past performance cited in many of these withdrawal studies, and there is no way to know with any certainty that future peroformance will behave similarly to past performance. Monitoring spending and making sure your portfolio includes opportunity for growth of principal over time are two ways to insure that you do not run out of funds. This approach requires discipline and courage during Bear markets and other unexpected downturns.


Dennis Roubal from MI posted over 2 years ago:

I have subscribed to the 4% rule, with corrections, for a long time. Ultimate success requires some reasonable investment returns to maintain purchasing power. Most withdrawal programs are set up using historical returns as a guide. Future returns may be a real problem for income maintenance.
Research looking at past financial crises, like we are experiencing, indicate a very long period of low interest rates and under-performing equities.
Rheinhart and Rogoff and several other studies show results similar to Japan's current malaise. Their stock market peaked in 1989 and is about 80% lower. Their Treasuries are at about 1.6% yield.
If the U.S. follows this same path, and I think we will, a 4% withdrawal rate may be difficult to maintain.


J Morlock from NJ posted over 2 years ago:

I would like to thank to everyone for sharing their insightful comments.

Here is an article worth reading if you are looking for other retirement income planning tools and ideas.

http://financialkownledge.com/index.php?option=com_content&view=article&id=9145:2011-09-28-21-16-11&catid=51:financial-advice&Itemid=103

Jim Otars's website is one of the best I have found for retirement income planning considerations.

http://www.retirementoptimizer.com/

I also like the consumption smoothing approach incorporated into the ESP financial planning software.

http://www.esplanner.com/

I would love to see AAII publish interviews with the owners of these two websites.


David Brenner from AK posted over 2 years ago:

I agree with Mr. Roubal that a 4% withdrawl rate is hard to count on in the long-term downtrend we find ourselves. A year-by-year approach of 4-5% max understanding that such may mean decreasing gross withdrawl amounts and a committment to try for a lower 3-4% goal may make a big difference going forward, especially considering the tandem of European problems and poor growth in the US. Hopefully the eventual recovery, when it arrives, will signal a return to the likelihood of success with the fixed (x% + inflation) withdrawl strategies discussed. As always, asset allocation will matter!


Charles Hinners from WI posted over 2 years ago:

Annuities
The discussion below is limited to vanilla income annuities in which an insurance company pays a fixed amount for life in return for a lump sum now.
The central problem of financial planning is converting a lump sum to an inflation adjusted lifetime income

Nearly all annuities carry sales commissions of 3 to 5% that translate to a proportional decrease in benefit.
Annuities are priced of bond yields with durations matching life expectancy.

Berkshire Hathaway Life offers a no commission annuity in a limited number of states.
Their crediting rates for income annuities is 2.55% today 8/3/12.

It pays to shop carriers.
Incomesolutions.com offers lower commission alternatives.

They deal with several companies and more information can be gained by talking to Drew Hueler at 866-297-9835


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