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Retirement Income Planning: Why an Appropriate Withdrawal Rate Matters

Accumulating enough assets for retirement may be the top priority for investors. However, the amount that is withdrawn from a portfolio each year during retirement is what may ultimately determine how long retirement assets will last. That is why calculating the annual withdrawal rate from personal savings and investments is so critical for retirees and people about to retire. It's also a helpful exercise for younger investors who would like to gauge how much they will need to accumulate in order to provide adequate income during retirement.

Something to Consider. Several factors will influence your choice of an appropriate with­drawal rate. These include your age, health, the potential impact of inflation on your assets and cost of living, and the likely variability of your investment returns. If you plan to leave a legacy to your heirs, you should also factor this into your withdrawal rate decision.

Age and Health. Although you can't predict for certain how long you will live, you can make an estimate. However, basing your estimate on average life expectancy for your age and sex may be unwise, particularly if you are healthy. Be sure to take into account your risk of living longer than a life expectancy table would indicate. As a rule of thumb, plan on your retirement portfolio needing to generate income for 30 years.

Inflation. As you think about inflation, bear in mind that inflation affects the real return on your assets as well as the cost of goods and services. For long-term planning purposes, you might assume that consumer price inflation would continue at its historical average of 4% a year. But also keep in mind that year-to-year variations in inflation may also dramatically im­pact your plans. Should inflation flare up above the level you assumed after you retired, you would need to revisit your withdrawal rate along with the inflation-adjusted return potential of your investment portfolio.

Fluctuating Returns. When considering how much your investments may return over the course of your retirement, you might think you could base your assumptions on historical aver­ages, just as you may have done when project­ing your retirement savings goal. But once you start taking income from your portfolio, you no longer have the luxury of time to recover from possible market losses.

Just imagine how long it would take to restore the value of a portfolio if it suffered a large loss due to a market downturn. For example, if a portfolio worth $250,000 incurred succes­sive annual declines of 12% and 7% during years one and two respectively, its value would be reduced to $204,600. In order to restore its value to $250,000, it would require a gain of nearly 23% in year three. When a retiree's need for annual withdrawals is added to poor performance, the result can be a much earlier depletion of assets than would have occurred if portfolio returns had not declined.

Coming to a Decision. While it's possible your portfolio won't experience any losses, it's likely that you will at some point. For this reason, it may be safer to assume some setbacks will occur. Although past performance can never assure future results, market history may give some insight into setting an appropriate withdrawal rate. For example, an analysis by Standard & Poor's found that 5.5% was the maximum annual withdrawal rate that could be sustained from a balanced portfolio dur­ing all 30-year holding periods between 1926 and 2005. The portfolios, which were adjusted for actual consumer price inflation, were com­prised of 60% stocks represented by the S&P 500 and 40% long-term Treasury bonds. Dur­ing the period studied, sustainable withdrawal rates for the respective 30-year portfolios ranged from just over 3% to as high as 8%.

In view of the variability of investment returns and inflation, as well as the risk of living beyond your average life expectancy, you may want to err on the side of caution and choose a conservative annual withdrawal rate. The goal, after all, is to crack your nest egg in such a way that it will provide a reliable stream of income for as long as you live. That may mean taking out less in the early years of retirement in the hope of having sufficient income in your later years.

This article is not intended to provide specific investment or tax advice for any individual.

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