When it comes to retirement income planning, it’s important to find a withdrawal rate that provides income for as long as it’s needed.
Your retirement lifestyle will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. But establishing an appropriate withdrawal rate presents many challenges and requires analysis of many aspects of your retirement income plan.
It’s becoming more common for retirement to last 30 years or more, and a lot can happen during that time. Drawing too heavily on your investment portfolio, especially in the early years, could mean running out of money too soon. Take too little, and you might needlessly deny yourself the ability to retire comfortably. You want to find a rate of withdrawal that gives you the best chance to maximize income over your entire retirement period.
In retirement income planning, it’s important to ensure your withdrawal rate is sustainable, and represents the maximum percentage that can be withdrawn from an investment portfolio each year to provide income that can, with reasonable certainty, be available for as long as it’s needed.
A number of factors need to be taken into consideration as you develop your withdrawal strategy:
- Your time horizon. The longer you will need your portfolio to last, the lower the initial withdrawal rate should be. The converse is also true (e.g., you may have health problems that suggest you will not need to plan for a lengthy retirement, allowing you to manage a higher withdrawal rate).
- Anticipated and historical returns. Though past performance is no guarantee of future results, the way in which you invest your retirement nest egg will play a large role in determining your portfolio’s performance, both in terms of its volatility and its overall return. That, in turn, will affect how much you can take out of the portfolio each year without jeopardizing its longevity.
- Assumptions about market volatility. A financial downturn that reduces a portfolio’s value, especially during the early years of withdrawal, could increase the need to use part of the principal for income. It could also require the sale of some assets, draining the portfolio of any future income those assets might have provided. Either of those factors could ultimately affect the sustainability of a portfolio’s withdrawal rate.
- Anticipated inflation rates. Determining a sustainable withdrawal rate means making assumptions about changes in the cost of living, which will likely increase the amount you’ll need the portfolio to provide each year to meet expenses.
- Annual withdrawal totals. When planning your retirement income, your anticipated expenses will obviously affect what you need to withdraw from your retirement portfolio, and therefore, affect its sustainability. However, because this is one aspect over which you have at least some control, you may find that you must adjust your anticipated retirement spending in order to make your withdrawal rate sustainable over time.
- Additional sources of predictable income. Having some stability from other resources (such as Social Security, pension payments or some types of annuity benefits) may allow greater flexibility in planning withdrawals from your portfolio.
As with most components of retirement income planning, each of these factors affects the others. For example, projecting a longer lifespan will increase your need to reduce your withdrawals, boost your returns, or both, in order to make your withdrawal rate sustainable. Of course, if you set too high a withdrawal rate during the early retirement years, you may face greater uncertainty about whether you will outlive your savings. Ultimately, your individual comfort level with your plan’s probability of success will be the deciding factor.
Types of Withdrawal Rates
The process of determining an appropriate withdrawal rate continues to evolve. As baby boomers retire and individual savings increasingly represent a larger share of retirement income, more research is being done on how best to calculate withdrawal rates. Needless to say, there are a number of approaches to establishing a sustainable withdrawal rate, depending on needs and circumstances.
- Fixed percentage. Perhaps the most well-known approach is to withdraw a specific percentage of your portfolio each year. In order to be sustainable, the percentage must be based on assumptions about the future, such as how long you’ll need your portfolio to last, your rate of return and other factors. It also must take into account the effect of inflation.
- Performance-based. With this approach, an initial withdrawal rate is established. However, if you prefer flexibility to a fixed rate, you might vary that percentage from year to year, depending on your portfolio’s performance. Each year, you would set a withdrawal percentage based on the previous year’s performance that would determine the upcoming year’s withdrawal. In years of poor performance, a portfolio’s return might be lower than your target withdrawal rate. In that case, you would reduce the amount you take out of the portfolio the following year. Conversely, in a year when the portfolio exceeds expectations and performance is above average, you can withdraw a larger amount.
- Age-dependent. Some strategies assume that expenses in the later years of retirement will be lower as a retiree becomes less active. They are designed to provide a higher income while a retiree is healthy and able to do more. Other strategies take the opposite approach, and assume that costs such as healthcare will be higher in the later retirement years. These set an initial withdrawal rate that is deliberately low to give the portfolio more flexibility later. The risk, of course, is that a retiree who dies early will leave a larger portion of his or her retirement savings unused.
Income-Only or Income-and-Principal
Many people plan to withdraw only the income from their portfolios, intending not to touch the principal unless absolutely necessary. This is certainly a valid strategy, and clearly enhances a portfolio’s sustainability. However, for most people, this approach requires a substantial initial amount. If your portfolio can’t produce enough income to meet necessary expenses, an income-only strategy could mean that you might needlessly deprive yourself of enjoying your retirement years as much as you could have done.
A sustainable withdrawal rate can balance the need for both immediate and future income by relying heavily on the portfolio’s earnings during the early years of retirement, and gradually increasing use of the principal over time in order to preserve the portfolio’s earning power for as long as possible.
Planning to use both income and principal requires careful attention. In establishing your strategy, you should consider whether you want to use up all of your retirement savings yourself or plan to leave money to heirs. If you want to ensure that you leave an estate, you will need to adjust your withdrawal rate accordingly.
Your decision about income versus income-plus-principal should balance the need for your portfolio to earn a return high enough to sustain withdrawals with the need for immediate income.
Once you’ve established an initial withdrawal rate, you probably should revisit it from time to time to see whether your initial assumptions about rates of return, lifespan, inflation and expenses are still accurate, and whether your strategy needs to be updated. iBi
Marty Roth is a certified financial planner and director with McGladrey Wealth Management LLC in Peoria. Original article prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2013.