Determining portfolio withdrawal rate is a key retirement decision

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During your working years, you probably set aside money for retirement in an IRA, 401(k), and other workplace savings plans, as well as in taxable accounts.

Your challenge during retirement is to convert those savings into an ongoing income stream that will be adequate for your needs throughout your retirement years.

Your retirement lifestyle will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. The annual percentage that you take out of your portfolio, whether from returns or the principal itself, is known as your withdrawal rate. Figuring out an appropriate initial withdrawal rate is a key issue in retirement planning – and presents many challenges.

If you take out too much too soon, you might run out of money in your later years. Take out too little, and you might not enjoy your retirement years as much as you could.

Your withdrawal rate is especially important in the early years of your retirement, as it will have a lasting impact on how long your savings last.

So, what should your withdrawal rate be? One widely used standard states that your portfolio should last for your lifetime if you initially withdraw 4 percent of your balance (based on an asset mix of 50 percent stocks and 50 percent intermediate-term Treasury notes), and then continue drawing the same dollar amount each year, adjusted for inflation. However, this rule of thumb has been under increasing scrutiny.

Some experts contend that a higher withdrawal rate – closer to 5 percent – may be possible in the early, active retirement years if later withdrawals grow more slowly than inflation. Others contend that portfolios can last longer by adding asset classes and freezing the withdrawal amount during years of poor performance. By doing so, they argue, “safe” initial withdrawal rates above 5 percent might be possible. Still other experts suggest that our current environment of lower government bond yields may warrant a lower withdrawal rate, around 3 percent.

Don’t forget that these hypotheses are based on historical data about various types of investments, and past results don’t guarantee future performance.

The rate of inflation is an important factor and should figure into your decision. An initial withdrawal rate of, say, 4 percent may seem relatively low, particularly if you have a large portfolio. However, if your initial withdrawal rate is too high, it can increase the chance that your portfolio will be exhausted too quickly, because you’ll need to withdraw a greater amount of money each year just to keep up with inflation and preserve the same purchasing power over time.

In addition, inflation may have a greater impact on retirees than the overall population. That’s because costs for some services, such as health care and food, have risen more dramatically than the Consumer Price Index (the basic inflation measure) for several years. As these costs may represent a disproportionate share of retirees’ budgets, they may experience higher inflation costs than younger people, and therefore might need to keep initial withdrawal rates relatively modest.

The bottom line is that there is no rule of thumb. Every individual has unique retirement goals and means, and your withdrawal rate needs to be tailored to your particular circumstances. But be sure to keep in mind that the higher your withdrawal rate, the more you’ll have to consider whether it is sustainable over the long term.

For additional views and insights into setting a withdrawal rate, see:

              • “Determining Withdrawal Rates Using Historical Data,” William P. Bengen, Journal of Financial Planning, October 1994.

              •            “Decision Rules and Portfolio Management for Retirees: Is the ‘Safe’ Initial Withdrawal Rate Too Safe?” Jonathan Guyton, Journal of Financial Planning, October 2004.

              •            “Low Bond Yields and Safe Portfolio Withdrawal Rates,” Blanchett, Finke, and Pfau, Journal of Wealth Management, Fall 2013.

BARBARA KENERSON is first vice president/Investments at Janney Montgomery Scott LLC and can be reached at BarbaraKenerson.com.