Once you retire, how much can you annually withdraw from your retirement
savings with the least risk of running out of money?
It's one of the biggest financial decisions you'll ever have to
make, but there's no easy answer to this question -- especially
since you may be depending on your money for some 20 to 40 years.
Plus, it's hard to plan when there's no way to know what investment
returns or the cost of living will be in the future.
That's why financial experts have been busy studying ways to help
you figure out how much you can withdraw, along with ways to make
your money last longer. Although the exact amount you can take out
each year depends on many factors specific to your situation, recent
studies do offer some guidelines.
What the studies say
Over the past ten years, the Journal of Financial Planning* has
published a series of studies to explore how much you can safely
withdraw from your savings. Their conclusions:
In general, if you want to be fairly confident that your savings
will last for at least 30 to 40 years, through both good and bad
economic times, you should limit your initial or fixed withdrawal
rate to about 4% or 5%.
For instance, one method the studies recommend is to initially withdraw
about 4% from a portfolio of stocks and bonds, and then annually
increase that dollar amount for the general rate of inflation.
Another study suggests that you can increase this initial withdrawal
rate to more than 5%, if you're willing to follow a set of strict
rules. Specifically, in years with negative investment returns you
would not increase the amount you withdraw, and similarly in years
of high inflation you would cap your withdrawal amount. Furthermore,
you would follow detailed rules for generating spending money from
your portfolio.
Alternatively, another study concludes that you can tap your savings
by withdrawing a fixed 5% each year - but with limits. Specifically,
in years when investment returns are either exceptionally good or
extremely bad, you would cap the dollar amount you withdraw by a
designated ceiling or floor percentage.
Your actual withdrawal rate
Of course, how much you can actually withdraw from your savings
depends on many things. Among the most important: your other sources
of income, how much money you have and how it's invested, how long
you think you'll live, and if you're part of a couple, your spouse's
or partner's estimated life expectancy.
It also depends on how much you want to leave to your heirs, how
much life insurance you have, and whether the majority of your money
is in taxable accounts or retirement plans.
Additional important factors include how you'd cover possible uninsured
medical and long-term care expenses, how willing and able you are
to reduce your withdrawals if your investment returns are poor,
and how large of a cash cushion you have to fall back on.
For example, if you have a significant portion of your income coming
in from pension and Social Security retirement benefits, you're
less dependent on your savings. Similarly, if you have significant
assets, your wealth may allow you to spend more freely.
On the other hand, if you're relying on your savings as your major
means of support, you have to be more cautious. And if your nest
egg is modest, that's all the more reason to rein in your spending.
Furthermore, if you have savings in tax-deferred accounts, such
as an IRA or 401(k) plan, your withdrawals are subject to income
taxes. So you'll have to withdraw a larger amount to meet your expenses
after paying taxes than if you were withdrawing from taxable accounts.
Overall, your challenge is figuring out how to make your money last
without needlessly restricting your lifestyle.
Behind the numbers
Why do the academic studies limit your initial or fixed withdrawal
rate to only about 4% or 5%? Because a conservative withdrawal rate
is more likely to carry you through the inevitable market downturns
and any stretches of high inflation.
For example, as those who retired around the year 2000 know all
too well, your portfolio could experience significant market losses
early on in your retirement. When that happens, your losses, combined
with your withdrawals, could deplete your portfolio so much that
it may never recover enough to sustain a higher withdrawal rate,
even if the market picks up later.
Retirees who left the workforce at the end of 1972 faced a similar
situation when the S&P 500 Index of large-company stocks plunged
48% in the following years. Those retirees also faced the added
challenge of high inflation, which eroded the value of their savings
and also hit bond prices hard.
Improving the odds with a payout annuity
In addition to sticking with a modest withdrawal rate, the withdrawal
studies found that buying a payout annuity with some of your savings
increases the odds that your money will last.
With a lifetime payout annuity, you turn part of your savings into
a stream of income that's guaranteed to last for the rest of your
life, or for both your life and the life of your joint annuitant.
You can do this by annuitizing a deferred annuity you already own
or buying an immediate income annuity with part of your savings.
The bottom line
Most importantly, regardless of how much you withdraw, whether your
money actually lasts depends on your actual investment returns and
how much your expenses increase. If your investment returns are
worse than projected or your expenses increase faster than planned,
you could run out of money earlier than expected.
That's why it's up to you to reduce the amount you withdraw, if
necessary. Alternatively, if you're well into retirement and your
portfolio has done well you may want to consider modestly increasing
the amount you withdraw.
Retirement income calculators, available through financial advisors,
on the Internet, or in money management software packages, can help
you crunch the numbers.
Although the exact amount you can withdraw from your retirement
savings depends on many factors specific to your situation, recent
studies do offer some guidelines. Here's a summary of what these
studies from the Journal of Financial Planning* say.
Withdrawing a dollar amount that adjusts for inflation
One way to tap your savings for income is to set a percentage to
withdraw initially, and then annually increase that dollar amount
to keep pace with the general rate of inflation.
For instance, if you want to be fairly confident that your savings
will last for at least 30 years, through both good and bad economic
times, one study concludes that you should set the initial withdrawal
rate at about 4%.
For example, if you have $500,000 in retirement savings and you
set your initial withdrawal rate at 4%, you would take out $20,000
the first year.
Then the next year if inflation is running at 3%, you would withdraw
$20,600 (3% of $20,000 = $600).
A 4% initial withdrawal rate may seem like a limited amount. But
keep in mind, you have to start with a low rate so you can increase
your withdrawals each year for inflation. If you don't increase
your withdrawals for the general cost of living you may not be able
to cover your future expenses.
For example, let's say you start out withdrawing $20,000 a year.
Even with a modest 3% average annual inflation rate, that amount
will only have the purchasing power of $12,665 after 15 years.
Importantly, this 4% withdrawal rate assumes that your savings is
invested in a portfolio made up of 50% stock investments and 50%
bonds. It also assumes that you would dip into principal as necessary.
Obviously, including a large percentage of stock investments in
your portfolio subjects your savings to market dives like the one
from 2000 to 2002. But given the stock market's superior historical
returns over the long haul, investing in stocks also increases the
likelihood that your money will carry you through your retirement
years. That's assuming, however, that stocks continue to outperform
over the long run.
Withdrawing a dollar amount that adjusts for inflation - with limits
Another conservative way to spend money from your savings is to
set a percentage to withdraw initially, and then only annually increase
that amount under certain conditions. For instance, one study concludes
that you can set this initial amount to 5.8% and expect your savings
to last 40 years if you follow a set of strict rules.
These rules in general: You would maintain a diversified multi-asset
class portfolio that includes a 65% allocation to stock investments.
In addition, in years when your total investment return is negative
you would not increase your withdrawal amount. Likewise, you would
cap the amount you withdraw in years of high inflation.
Furthermore, you would have to follow specified rules for generating
your spending money, including selling the top performing investments
each year to rebalance your portfolio's target asset allocation
when necessary.
Withdrawing a fixed percentage
Another way to tap your savings for income is to select a reasonable
percentage rate and withdraw that same percentage each year, with
limits on the actual annual dollar amount you withdraw.
For instance, one study concludes that you can withdraw a fixed
5% each year and expect your savings to last 30 years if you set
limits on your withdrawal amount. Importantly, the study assumes
that you would maintain a portfolio made up of 63% large-company
stocks and 37% intermediate-term Treasury notes.
Specifically, in years when your investment returns are either exceptionally
good or extremely bad, you would cap the dollar amount you withdraw
by a designated ceiling or floor percentage. Therefore, when your
returns decrease, your withdrawals will decrease and you would have
to rein in your spending. Alternatively, when your returns increase,
your withdrawals will increase.
For example, if you have $500,000 in savings and you withdraw 5%
you can initially withdraw $25,000. If your portfolio falls to $400,000
you can only withdraw $20,000, but if it increases to $600,000,
you can withdraw $30,000 - assuming these amounts are within the
ceiling and floor limits you set.
By always withdrawing a fixed percentage from your remaining savings,
you're forced to adjust your spending along with your portfolio's
performance and you're less likely to run out of money. And by putting
a ceiling and floor on the amount you can withdraw you'll limit
the amount you have to cut back in down times.
* The Journal of Financial Planning: January 1994, December 1997,
April 2001, May 2001, December 2001, May 2003, October 2004
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