How much can I live on this year?
Continuing with the third installment of the “How to Manage Your Retirement” series we consider the amount of money you can take out each year. This key step helps guard against overspending and increases the longevity of your assets. Click here for Part I and here for Part II in the series.
PLAN YOUR ASSET WITHDRAWALS
To prevent exhausting your savings it is important to calculate your monthly/annual withdrawal amount. There are two generally recommended withdrawal methods both requiring you to sell a portion of assets to produce retirement income. Your assets include the interest, dividends, and capital gains you’ve reinvested, along with your principal.
It may make sense to sell assets once or twice a year and place the funds in a money market account that has check writing privileges. For convenience, you could also deposit ongoing income payments, such as Social Security and pension, in this account.
Choosing Your Withdrawal Method
There are two basic methods for turning your assets into income, and each has advantages and disadvantages. As you consider the two methods, keep in mind that the income produced by Method 1 isn’t tied to market conditions and the annual income produced will be predictable. However, the income produced by Method 2 is directly tied to the performance of financial markets every year and will fluctuate.
Method 1: Dollar-Adjusted Withdrawals
Using this method, you withdraw 3% to 4% of your portfolio the first year. Each subsequent year the dollar amount of your withdrawal increases by the previous year’s inflation rate. The initial withdrawal will be based on what you’ll need in order to cover the differences between your income and expenses.
With this method, withdrawals are relatively predictable and generally keep pace with inflation. However, if the market should undergo a prolonged downturn during the first few years of retirement, your assets could be substantially depleted. That’s because as your portfolio value shrinks, you’ll be spending a larger percentage of your portfolio than you had originally intended. In this situation, it may be wise to recalculate your withdrawals so that you do not continue to overspend.
Here’s a three-year example of the dollar-adjusted method for a retiree, Sarah, who has a $500,000 portfolio and decides on a 3% withdrawal rate:
•First year. Sarah withdraws $15,000: 3% of the portfolio balance.
•Second year. Sarah withdraws $15,600: the previous year’s amount ($15,000) increased by an amount to take into account a 4% inflation rate ($600).
•Third year. Sarah withdraws $16,380: the prior year’s inflation-adjusted withdrawal ($15,600) bumped up by a 5% inflation rate ($780).
Method 2: Percentage Withdrawals
Using this method, you withdraw the same percentage annually from your portfolio.
Annual withdrawals aren’t increased for inflation; instead, this method counts on long-term portfolio growth to take care of adjusting for inflation. Recent studies and analysis indicates that an annual withdrawal rate between 4% and 5% is reasonable. The recommended percentage will be based on the amount you’ll need to cover the difference between your income and expenses.
Here’s how a retiree, Liberty, would use the percentage-withdrawal method over a three-year period. Liberty starts out with a $500,000 portfolio and chooses a 5% annual withdrawal rate:
•First year. Liberty withdraws $25,000: 5% of her portfolio balance.
•Second year. The portfolio has grown to $530,000: Liberty withdraws $26,500 (5%).
•Third year. The portfolio has declined to $450,000: Liberty withdraws $22,500 (5% but 15% less than in the second year).
Liberty has to discipline herself to spend less during periods when her portfolio balance drops. For example, if after the third year shown in the example, the portfolio declines again, say by 10%, her income would drop to $19,238—about 23% lower than the first year’s withdrawal.
Method 2 is easier to use and can mean your assets will last longer. But your income stream will fluctuate—significantly at times. This means during periods when your income drops you’ll have to discipline yourself to spend less. On the other hand, during years when the market is performing well, you’ll have the enviable task of deciding whether to withdraw the amount that exceeds your spending needs or leave it in the portfolio to potentially grow for future needs.
