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What's in a Number? Choosing a Withdrawal Rate for Your Retirement Assets

 It's not just the amount of money you've saved that determines whether you'll have a comfortable retirement; it's also a matter of how quickly you spend it after you retire. The rate of annual withdrawals from personal savings and investments helps determine how long those assets will last and whether the assets may be able to generate a sustainable stream of income over the course of retirement. A number of factors will influence your choice of annual withdrawal rate. Following are a few key considerations.

Your Age and Health
As you think about what your withdrawal rate should be, begin by considering your age and health. Although you can't predict for certain how long you will live, you can make an estimate. However, it may not be wise to base your estimate on average life expectancy for your age and sex, particularly if you are healthy. Although average life expectancy has risen steadily in the United States, reaching 77.6 years for a child born in 2003, there is a 50% probability that a healthy 65-year-old man could live to age 85 and a woman in good health could live to age 88. Moreover, there's a 25% probability of the man living to age 92 and the woman to age 94. If they retired at age 65, they could be withdrawing from their assets for 30 or more years.1

Inflation is the tendency for prices to increase over time. Keep in mind that inflation not only raises the future cost of goods and services, but also affects the value of assets set aside to meet those costs. To account for the impact of inflation, include an annual percentage increase in your retirement income plan.

How much inflation should you plan for? Although the rate varies from year to year, U.S. consumer price inflation has averaged about 4% over the past 50 years.2 So, for long-term planning purposes, you might assume that inflation would average 4% a year. If, however, inflation flares up after you have retired, you may need to adjust your withdrawal rate to reflect the impact of higher inflation on both your expenses and investment returns. Also, once you retire you should assess your investment portfolio regularly to ensure that it continues to generate income that will at least keep pace with inflation.

Variability of Investment Returns
When considering how much your investments may earn over the course of your retirement, you might think you could base assumptions on historical stock market averages, as you may have done when projecting how many years you needed to reach 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%, its value would be reduced to $204,600, and it would require a gain of nearly 23% the next year to restore its value to $250,000.3 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 increased steadily.While it's possible that your portfolio will not experience any losses and will even grow to generate more income than you expected, it's safer to assume some setbacks will occur.
And the Number Is…
Although past performance cannot predict future results, fluctuations in the financial markets and inflation can be instructive when choosing an annual withdrawal rate. To provide an idea of how much might be withdrawn annually from a portfolio so that it would be likely to last 30 years or more, Standard & Poor's looked at the actual record for stocks, bonds and inflation and analyzed all possible 30-year holding periods since 1926. It determined that the average sustainable withdrawal rate for a portfolio composed of 60% U.S. stocks and 40% long-term Treasury bonds was about 5.8% per year when adjusted for inflation.4

In view of the variability of inflation and investment returns, as well as the risk of living beyond your average life expectancy, you may want to err on the side of caution and choose an annual withdrawal rate somewhat below 5.8%. 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 with the hope of having sufficient income for your later years.

1Source: Society of Actuaries 2000 Mortality Tables (most current data available).

2Source: Bureau of Labor Statistics, December 31, 2005.

3Example is hypothetical and for illustrative purposes only.

4This example is a compilation of each of all 30-year holding periods from 1926 to 2006. It assumes a portfolio comprised of 60% stocks represented by the S&P 500 and 40% bonds represented by U.S. Treasuries with average maturity of 10+ years, and annual withdrawals based on 5% of the first-year value and adjusted thereafter for inflation based on actual historical changes to the Consumer Price Index. Investors cannot invest directly in any index. This illustration does not take into account any transaction costs or taxes and is not representative of any particular investment or security. Past performance does not guarantee future results.

This article is not intended to provide specific investment or tax advice for any individual. Consult me, your financial advisor, or your tax advisor if you have any questions.


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