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Building and Managing a Retirement Portfolio-Part Two
One of the most important issues retirees face is deciding how much they can withdraw from their accounts without exhausting them.
Your decision involves a trade-off between spending too much and running out of money, and spending too little and reaching the end of retirement with a large portfolio that you’ll be unable to enjoy.
The amount of money you can reasonably drawdown from your portfolio depends upon several factors that differ for each person, including assumptions about investment returns, inflation rates, how long retirement will last, and the portfolio withdrawal strategy used. Although there are many “hybrid” approaches, there are two common withdrawal methods. Both have advantages and disadvantages. Let's take a look at them.
The Dollar Amount Plus Inflation Method involves withdrawing a pre-determined percentage of your portfolio for the first year only, and then increasing that dollar amount by the actual amount of inflation for each subsequent year. Simulations run by financial institutions, assuming historical investment returns and inflation rates, indicate a balanced portfolio of stocks and bonds has a good chance of lasting 30 years if you use an initial withdrawal rate of between 3% and 4%. Like most generalizations, each individual needs to adjust those percentages based upon their specific circumstances and assumptions.
Let’s look at a three-year example of the Dollar Amount Plus Inflation Method. A retiree with a $1,000,000 portfolio decides on a 3% initial withdrawal rate, experiences inflation of 4% ($1,200) in year one and 5% ($1,560) in year two:
First year: retiree withdraws $30,000 (3% of the initial portfolio balance)
Second year: retiree withdraws $31,200 ($30,000 increased by $1,200 of inflation)
Third year: retiree withdraws $32,760 ($31,200 increased by $1,560 of inflation)
This approach provides predictable, inflation-adjusted withdrawals, however, since the withdrawals are indifferent to the portfolio’s performance after the first year, a prolonged downturn could substantially deplete the assets. If you use this approach consider making “as needed” adjustments to your spending to avoid depleting the portfolio prematurely.
The Percent of Portfolio Method involves withdrawing a pre-determined percentage of your portfolio’s beginning balance each year. This method is highly responsive to the performance of your portfolio. Spending is automatically reduced when the markets have performed poorly, and automatically increased after your portfolio has performed well. This “built in” adjustment enables retirees to use a withdrawal rate a percentage or so higher than the Dollar Amount Plus Inflation Method.
Let’s look at a three-year example of the Percentage of Portfolio Method. A retiree with a $1,000,000 portfolio decides on a 4% initial withdrawal rate, experiences portfolio growth in year one and a portfolio decline in year two:
First year: retiree withdraws $40,000, which is 4% of the portfolio’s prior year’s ending balance
Second year: the portfolio has grown to $1,060,000 at the end of year one, so the retiree withdraws 4% or $42,400
Third-year: the portfolio has declined to $900,000 at the end of year two, so the retiree withdraws 4% or $36,000
Since poor investment returns are partially offset by a reduction in withdrawals, this strategy reduces the chance that the retiree will deplete the portfolio early. However, since the dollar amount of withdrawals fluctuates with the portfolio’s balance, many retirees may not be able to tolerate these spending adjustments.
Deciding how much to spend and how to spend from your savings may seem daunting, but it doesn’t need to be. By applying some of the above guidelines, being flexible, and making sensible adjustments to your spending when conditions dictate, you will significantly increase your chances of realizing a secure retirement.
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