You need retirement income, but how much money should you take out each year? You want to make sure you don’t spend down your accounts too soon. The answer is determined by calculating a safe withdrawal rate.
A safe withdrawal rate is the estimated portion of money that you can withdraw from your investments each year while leaving enough principal so that the funds will last for your entire life—even if you retire during a time when the economy and/or the stock market is not doing well. For example, if you spend $4,000 for every $100,000 you have invested, you would have an initial withdrawal rate of 4%. Traditional calculations say this withdrawal rate is about right; you can spend about 4% of your investments each year and most likely never run out of money.
- Calculating a safe withdrawal rate will help you ensure that you don't spend down your retirement income too quickly.
- There are six withdrawal rate rules you can follow that will give you the greatest probability of increasing your retirement income.
- Remember that you'll have to be flexible, and you may have to make adjustments if things aren't going according to plan.
Following the Six Withdrawal Rate Rules
If you want to withdraw a little more money than in the example above, there are six rules you can follow that will give you the greatest probability of increasing your retirement income.
If you follow these rules, you may be able to have a withdrawal rate as high as 6% to 7% of your initial portfolio value, meaning that you could withdraw $6,000 to $7,000 per year for every $100,000 you have invested.
This is not a sure thing. If you are going to use these rules, you have to be flexible; if things don't go well, you may have to make some adjustments and take out less later.
1. Your portfolio will deliver a higher withdrawal rate when the market has a low-price-to earnings ratio.
A price-to-earnings ratio (P/E ratio) is a tool that can be used to estimate the future long-term returns (15-plus-year cycles) of the stock market. Consult the chart below for a visualization.
For a retiree, the market's P/E ratio can be used in determining the right starting withdrawal rate—an amount that can safely be withdrawn each year—with the ability for subsequent withdrawals to increase with inflation.
The important thing to remember is that if you retire when the stock market has a low P/E ratio, your portfolio will likely support more income over your lifetime than that of someone with the same amount who retires when the market has a high P/E ratio.
The P/E ratio is not very useful in predicting short-term stock market returns.
2. Keep the right proportion of equities to fixed income so your retirement income can keep pace with inflation.
Specifically, your portfolio should have a minimum equity exposure of 50% and a maximum equity exposure of 80%.
If you fall too far out of this range, you run the risk of running out of money. Too much investment in equities, and volatile markets may scare you away at the worst time. Too much investment in fixed income (e.g., bonds), and your retirement income will not keep pace with inflation.
3. Use a multi-asset class portfolio to maximize your withdrawal rate.
Think of building a multi-asset class portfolio like creating a well-balanced meal. Imagine, for example, sitting down to a sumptuous dinner of steak, shrimp, and baby back ribs. Although the meal has variety, it is not well balanced.
In the investment world, instead of food groups, you have asset classes. A well-balanced portfolio contains, at a minimum, an allocation toward each of the following asset classes: U.S. equities of both the large-cap and small-cap type (stocks or stock index funds); international equities; and fixed income (cash, certificates of deposits, and bonds). Each year, you would rebalance this portfolio back to a target mix.
If you use funds and/or financial advisors with higher expenses than index funds, then you may need to take a lower withdrawal rate to account for the higher fees you are paying.
4. Take retirement-income withdrawals in a particular, prescribed order.
When you take withdrawals, your retirement income should come from each category in a particular order. For the new investor, these rules can be complex. To simplify the idea, picture three buckets:
- Bucket number one is filled with cash, enough to cover one year’s worth of living expenses.
- Inside bucket number two, you stack your fixed-income investments (sometimes called a "bond ladder"). Each layer represents one year’s worth of living expenses. Every year, one year’s worth of spending money “matures” and moves from the “fixed income” basket to the “cash” basket. That ensures that you will always have enough cash on hand to cover your upcoming expenses.
- The third bucket is filled to the rim with equities. You would only take money from the equity bucket when it overflows. An overflow year is any year when equities have above-average returns, excess of 12% to 15%, perhaps. At the end of an overflow year, you sell excess equities and use the proceeds to refill the fixed income and cash buckets.
There will be many years when the equity bucket does not overflow. It will take discipline to realize that it is okay to let the fixed income and cash buckets get to low levels during those years. Eventually, an overflow year will come along, and all buckets will be refilled. Following this rule will prevent you from becoming a victim of your own emotions and selling investments at unfavorable times.
5. Take retirement-income pay cuts during bear markets.
This rule functions as a safety net to protect your future retirement income from erosion during bear markets. It is triggered when your current withdrawal rate is 20% greater than your initial withdrawal rate. The best way to explain this rule is to use an example:
Suppose you have $100,000, and you start withdrawing 7%, or $7,000, each year. The market goes down for several years, and your portfolio value is now at $82,000. The same $7,000 withdrawal is now 8.5% of your current portfolio value. Since your withdrawals now represent a bigger piece of your portfolio, this "pay cut" rule kicks in and says that you must reduce your current year’s withdrawal by 10%. In this example, your withdrawal would go from $7,000 to $6,300 for the year.
Much like real life, where some years you receive a bonus, and other years a pay cut may happen, this rule adds the flexibility you need to endure changing economic conditions.
6. When times are good, you’re eligible for a raise.
This final rule is most people’s favorite. The opposite of the pay-cut rule, this one is called the "prosperity rule." It says that as long as the portfolio had a positive return in the prior year, you may give yourself a raise.
Your raise is calculated by increasing your monthly withdrawal in proportion to the increase in the consumer price index (CPI). If you were withdrawing $7,000 per year, the market had a positive return, and the CPI went up by 3%, then the following year you would withdraw $7,210.
Following these rules takes discipline. The rewards are a higher level of retirement income and an increased ability to maintain purchasing power.
If this subject confuses you, then take a step back and think of it as a new career. It takes time to learn new skills. Remember, the right decisions will help you generate retirement income that will last.
Prior to implementing a retirement income plan of your own, take the time to learn as much as you can. Try one of these online investment classes to learn more. If you seek professional advice from a qualified fee-only financial advisor, make sure you find someone who is familiar with the latest research in this area.