How Much Can You Withdraw From Your Retirement Portfolio?

The Case for a 3 Percent Retirement Portfolio Withdrawal

A senior woman in wheelchair sitting at the table at home, taking painkillers and talking to her husband.
••• Halfpoint Images / Getty Images

Many people wonder exactly how much money they can safely withdraw from their retirement portfolio without cutting into their principal. Once you can figure out this number based on your own situation, the knowledge will go a long way toward helping you know how much more to save, and how you need to budget once you're in retirement.

Until recently, the commonly accepted rule of thumb said to withdraw 4% each year. However, now experts are stating that 3% might be better.

Why Is the 4 Percent Rule so Popular?

A 1994 study by financial adviser Bill Bengen showed that the principal investment of retirees who withdrew 4% from their portfolios each year stayed mostly intact. By keeping a conservative portfolio that produced enough yearly returns, they were able to keep pace with inflation.

Your investment account's principal will dwindle over time. However, with the 4 Percent Rule and a decent return on your investment portfolio, it happens at a very slow pace. This means that you, as a retiree, are statistically likely to maintain the bulk of your portfolio's value throughout your life.

For decades, 4% has been the standard protocol in determining how much you need to save for retirement. For example, a $1 million retirement portfolio will provide you with you a retirement income of $40,000 per year ($1,000,000 times 0.04 equals $40,000). A $700,000 portfolio will land you a retirement income of $28,000 per year ($700,000 times 0.04 equals $28,000).

However, the market returns of the past are making investors question the 4 Percent Rule. Some financial advisors worry that 4% is too aggressive of a withdrawal rate. As a result, many now recommend a 3% withdrawal rate.

The two important reasons behind this recommendation are inflation and lower portfolio values.

How Inflation Affects the Benchmark

When Bengen performed the benchmark 4% study in 1994, the return you could get from conservative investments like bonds, CDs, and Treasury bills was decent. However, in April 2012, the return on these conservative investments was next to nothing.

At the same time, inflation was also next to nothing. It's appropriate that "safe returns" are aligned with inflation. In other words, returns relative to inflation are similar, even though the raw numbers have changed.

What happened to investment returns in 2012 wasn't normal, although recent years have continued with this trend. However, interest rates can't stay this low forever. There's a chance that inflation could rise within the next few years as a result of such low interest rates.

If that happens, there's also a chance the returns on safe or conservative investments won't keep pace with inflation. In this case, 4% might be too aggressive of a withdrawal rate.

Lower Portfolio Values

The value of your portfolio is volatile. It depends on how well the market is doing. If you adhere to the 4 Percent Rule, you'll need to adjust your lifestyle based on market volatility.

For example, during a bull market, your portfolio may stand at $1 million. That means you'll have $40,000 to live on each year. During a market tumble, however, your portfolio may sink to $850,000. If you adhere to the 4 Percent Rule, you'll have to get by on only $34,000 that year.

If you're locked into certain fixed expenses and can't live on less money, this is where things get tough. If you need $40,000 to pay your bills, you'll end up selling more of your portfolio when the market is down. That's the worst time to sell because you'll get less money for your securities. In addition, you'll also be reducing the amount of principal you can use to generate future interest income.

That's partly why today's financial advisors are telling people to plan for a 3% withdrawal rate. This advice follows the idea of "hope for the best, plan for the worst." Plan your necessary expenses at 3%. If stocks tumble and you're forced to withdraw 4% to cover your bills, you'll still be safe. This means that the same $1 million portfolio will generate you an income of $30,000 per year rather than $40,000.

The Bottom Line

Don't panic if you're nearing retirement and your portfolio isn't close to $1 million or more. This is for planning purposes only. Other factors like your pension, Social Security, royalties, and income from rental properties will change your calculations.

Your expenses in retirement might also be lower than you think. Once your mortgage is paid and your children are earning money, your bills will be much smaller. Your tax rate during retirement might also decrease.

The bottom line is that it's important to prioritize saving for retirement. Save aggressively through 401(k) plans, Roth IRAs, and other long-term investments such as rental properties. You'll thank yourself when you're older, as you'll be able to enjoy retirement with more peace of mind.