“Will I run out of money?” For people at or near retirement, this is a hot topic. And understandably so since retirement can last 30, 40 or even 50 years. The focus should shift away from maximizing returns to making sure our money will last. The magic number that lets us withdraw just enough to live comfortably, while allowing our portfolio to last, is the “sustainability rate.”
Finding the sustainability rate that’s just right for you is like trying to hit a moving target. Spending needs change, market returns vary, and resources ebb and flow. As you age, you may find you’re actually spending more money – not less — since you have more time to travel, support your favorite causes or develop new interests. Your income sources may also change, as you get mandatory payouts from pension and retirement accounts, or sell the family home.
The 4% “Rule”
What can your portfolio comfortably afford to pay you? A lot of planners say 4% annually. That number is based on analysis done by William P. Bengen, a financial advisor and planner, who in 1994 published an article titled “Determining Withdrawal Rates Using Historical Data” (Oct. 1994 ,Journal of Financial Planning).
First, let’s clarify what the 4% refers to: The idea is to withdraw 4% of your portfolio the first year of retirement. Each year after that, you take out the first-year fixed dollar amount plus the rate of inflation. So if you’re starting retirement with a $1 million portfolio in 2015, you’d take out $40,000 this year and then $40,800 in 2016 ($40,000 plus 2% inflation), and so on.
The 4% rule works if you keep your portfolio invested — in a mix of stocks, bonds, cash, etc. — and the growth rate over time more than compensates for the 4% withdrawals.
Here’s the catch: with the 4% rule, your withdrawals may be too high if your investment returns stall or decline during the first few years of retirement.
Withdraw Less Initially
Given the current market environment – low yields, rising volatility and global uncertainty — some experts argue that the 4% rule is just too high, assuming a 30-year retirement. Instead, it’s probably wiser to withdraw less than 4% in the beginning of retirement. How much less?
I often advise clients to budget for around a 2% withdrawal rate if possible, during the first few years of retirement. Then, over a 10-year period, slowly increase to 4%. This improves the likelihood that the portfolio can support the withdrawal rate for three decades plus, while staying ahead of inflation.
Withdraw a Fixed Percentage
Another approach is to base your withdrawal rates on how well your portfolio is doing. Take out less during down markets and potentially more when markets are strong. Let’s say you opt to withdraw 4% annually. If your portfolio value drops by 20% — from $1 million down to $800,000 – you’d get $32,000 that year instead of $40,000. Using this approach, you’re not likely to run out of money. But when the markets are down, you’ll have less to spend.
If you aren’t comfortable with dramatic fluctuations in your spending levels, consider a hybrid approach: (1) set a minimum and maximum withdrawal amount that suits your needs over time; (2) within that range, vary your withdrawals annually based on how well your portfolio is performing.
These are just some of the ways you can set parameters around retirement spending. Keep in mind, however, that these are general guidelines, and much more care is required to make sure your actual spending is in line with your specific situation.
At LNWM, we start with each client’s lifestyle, needs and goals. Then we take into account assets and liabilities, future funding and spending — including healthcare — as well as expected rates of return. Only then do we feel comfortable advising on what’s sustainable cash flow for the next 30+ years, and we continuously update these targets as market projections and client circumstances change.