How Much Annual Income Can
Your Retirement Portfolio Provide?
By Greg Patterson
Your retirement lifestyle will depend not only on your assets
and investment choices, but also on how quickly you draw down
your retirement portfolio. The annual percentage that you take out
of your portfolio, whether from returns or the principal itself, is
known as your withdrawal rate. Figuring out an appropriate initial
withdrawal rate is a key issue in retirement planning and presents
many challenges.
, Why is your withdrawal rate important? Take out too much too soon, and
you might run out of money in your later years. Take out too little, and you might
not enjoy your retirement years as much as you could. Your withdrawal rate is
especially important in the early years of your retirement; how your portfolio is
structured then and how much you take out can have a significant impact on how
long your savings will last. Gains in life expectancy have been dramatic. According
to the National Center for Health Statistics, people today can expect to live more
than 30 years longer than they did a century ago. Individuals who reached age 65 in
1950 could anticipate living an average of 14 years more, to age 79; now a 65-year-
old might expect to live for roughly an additional 19 years. Assuming rising
inflation, your projected annual income in retirement will need to factor in those
cost-of-living increases. That means there needs to be careful thought and planning
around how to structure your portfolio to provide an appropriate withdrawal rate,
especially in the early years of retirement.
Conventional wisdom. So what withdrawal rate should you expect from your
retirement savings? The answer: it all depends. The seminal study on withdrawal rates
for tax-deferred retirement accounts (William P. Bengen, “Determining Withdrawal
Rates Using Historical Data,” Journal of Financial Planning, October 1994) looked at
the annual performance of hypothetical portfolios that are continually rebalanced
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to achieve a 50-50 mix of large-cap (S&P 500 Index) common stocks and
intermediate-term Treasury notes. The study took into account the potential impact
of major financial events such as the early Depression years, the stock decline of
1937-1941, and the 1973-1974 recession. It found that a withdrawal rate of slightly
more than 4% would have provided inflation-adjusted income for at least 30 years.
Other, later studies have shown that broader portfolio diversification,
rebalancing strategies, variable inflation rate assumptions, and being willing to
accept greater uncertainty about your annual income and how long your retirement
nest egg will be able to provide an income also can have a significant impact on
initial withdrawal rates. For example, if you’re unwilling to accept a 25% chance
that your chosen strategy will be successful, your sustainable initial withdrawal rate
may need to be lower than you’d prefer to increase your odds of getting the results
you desire.
Conversely, a higher withdrawal rate might mean greater uncertainty about
whether you risk running out of money. However, don’t forget that studies of
withdrawal rates are based on historical data about the performance of various
types of investments in the past. Given market performance in more recent years,
many experts are suggesting being more conservative in estimating future returns.
Inflation is a major consideration. To better understand why suggested initial
withdrawal rates aren’t higher, it is essential to think about how inflation can affect
your retirement income. Here’s a hypothetical illustration; to keep it simple, it does
not account for the impact of any taxes. If a $1 million portfolio is invested in an
account that yields 5%, it provides $50,000 of annual income. But if annual inflation
pushes prices up by 3%, more income ($51,500) would be needed next year to
preserve purchasing power. Since the account provides only $50,000 income, an
additional $1,500 must be withdrawn from the principal to meet expenses. That
principal reduction, in turn, reduces the portfolio’s ability to produce income the
following year. In a straight linear model, principal reductions accelerate, ultimately
resulting in a zero portfolio balance after 25 to 27 years, depending on the timing of
the withdrawals.
Volatility and portfolio longevity. When setting an initial withdrawal rate,
it is important to take a portfolio’s ups and downs into account—and the need
for a relatively predictable income stream in retirement isn’t the only reason.
According to several studies done in the late 1990s and updated in 2011 by Philip
L. Cooley, Carl M. Hubbard and Daniel T. Walz, the more dramatic a portfolio’s
fluctuations, the greater the odds that the portfolio might not last as long as needed.
If if becomes necessary during market downturns to sell some securities in order
to continue to meet a fixed withdrawal rate, selling at an inopportune time could
affect a portfolio’s ability to generate future income.
Making your portfolio either more aggressive or more conservative will affect its
lifespan. A more aggressive portfolio may produce higher returns but might also
be subject to a higher degree of loss. A more conservative portfolio might produce
steadier returns at a lower rate, but could lose purchasing power to inflation.
Calculating an appropriate withdrawal rate. Your withdrawal rate needs to
take into account many factors, including (but not limited to) your asset allocation,
projected inflation rate, expected rate of return, annual income targets, investment
horizon and comfort with uncertainty. The higher your withdrawal rate, the more
you’ll have to consider whether it is sustainable over the long term. Ultimately,
however, there is no standard rule of thumb; every individual has unique
retirement goals, means and circumstances that corne into play.
Copyright 2016 by Commonwealth Financial Network. This material has been provided for general
informational purposes only by Greg Patterson of Atlantic Wealth Management in Morehead City,
North Carolina, and does not constitute either tax or legal advice. You should consult a tax preparer,
professional-tax advisor or attorney before making investment decisions. Mr. Patterson can be reached at
515-7800 or greg@myatlanticwealth.com, and is a Registered Representative of Commonwealth Financial
Network, Member FINRA/SIPC.