Considering the recent market volatility, those approaching or who are in retirement may be concerned that they’ll be withdrawing money from a portfolio that has experienced flat to negative returns. What can one do to make sure the amount withdrawn today won’t jeopardize one’s future financial independence?
“Withdrawing 4 percent has long been touted as the safe amount that can be pulled from a portfolio in the first year of retirement, increasing by inflation each year, with a less than 10 percent probability that one will run out of money,” says Daniel L. Due, CFP, Senior Wealth Manager at Budros, Ruhlin and Roe, Inc.
He cautions, however, that starting with a rule of thumb is helpful, but shouldn’t be followed blindly.
Smart Business spoke with Due about ways to safely manage retirement spending.
What is the 4 percent safe withdrawal rate based on?
The original study looked at historical data over a 30-year period and determined that, even in the worst scenario, 4 percent could be withdrawn from a portfolio and the individual would not run out of money. Under this rule, there is a high probability that a retiree will have a portfolio worth more than his or her starting principal at the end of a 30-year time horizon.
There are no set savings or income amounts, which makes the 4 percent rule applicable to most retirees. One caveat is that the investor’s savings are in a portfolio with at least 50 to 60 percent in U.S. stocks and the rest in U.S. long-term bonds.
The sequence of returns and inflation rate matter. The correlation between the first year return and the safe withdrawal rate is very low, so one must look at returns over a longer time period. One must also consider inflation rates over those time horizons and focus on real rates of return.
How does one determine how much can be safely pulled out of one’s portfolio?
Diversification is an important consideration. The original study was based on an asset allocation of approximately 60 percent in U.S. large-cap stocks and 40 percent in U.S. long-term bonds, rebalanced annually. Subsequent studies have shown that additional allocations into other asset classes such as U.S. small-cap stocks, as well as stocks and bonds of non-U.S. companies, provides greater diversification and can result in increased withdrawals. Other sources of income, such as a pension or Social Security that kick in at a later time, must also be taken into consideration.
Receiving an inheritance at some point is something else to consider, but carefully assign the probability of receiving one and be conservative in regards to the amount so that too much weight isn’t placed on that one assumption.
Don’t forget to take taxes into consideration when determining how much you’ll need from your portfolio. For example, once someone begins pulling from assets like an IRA, 401(k) or 403(b), these withdrawals are taxed as ordinary income and the tax should be budgeted for.
How can one be assured that their retirement nest egg will last?
First of all, avoid some of the mistakes that many retirees make that can lead to having less money than they hoped. Top among them is not paying attention to what you are spending. Take the time to outline a budget of annual expenses and don’t forget to account for one-time expenses such as bigger vacations and home maintenance/remodeling projects. Those who have a better handle on what they spend find it easier to make adjustments and decrease withdrawals in a down market.
Stick to an asset allocation strategy, rebalance at least quarterly and don’t increase your spending just because the market experiences a banner year. Establish a cash reserve strategy by setting aside the cash you’ll need to withdraw from your portfolio over the next 18 to 24 months. That will provide peace of mind that the funds are there to weather any storm and reduce the need to sell in a down market, thus locking in short-term losses.
If an investor was disciplined and made good decisions during his or her working years to generate a portfolio that’s sufficient for retirement, prudent decisions will continue to be made that avoid trouble.
Insights Wealth Management is brought to you by Budros, Ruhlin & Roe, Inc.
