Find a Safe Withdrawal Rate
How much can you withdraw annually from your investment portfolio to be sure you don't outlive your money? Here are three tips to get you through retirement financially.
Don’t get bogged down worrying about exogenous issues like inflation rates, historical investment rates of return and life expectancy projections. Instead, focus more on the things that you can control like living within your means, how much you pay in taxes and taking appropriate risk for your situation.
Live within your means to beat inflation. The cost of living rises over the years, and the compounded effect of inflation over time is startling. For real people, however, it is more complex than just measuring the price level across the whole economy. Younger and middle-aged Americans see prices rise substantially over their lifetimes. But while working, their wages also increase generally faster than inflation, though not always. And if you consistently save 10% of your earnings, the amount you put away increases each year and easily beats the inflation rate.
For older retired people, it might seem that inflation is disastrous. Certainly, it is a continual struggle for those living at a subsistence level. For the more affluent, expenses tend to start dropping when they are in their 70s, and continue dropping more rapidly as they age, despite increases in inflation. Older people are less mobile, travel less and are less fashion conscious.
So while the rate of inflation is a big concern for money managers who run gigantic pension plans, in reality it has little impact on personal financial planning.
Don’t plan on dying broke: Folks sometimes say they want to withdraw their retirement portfolio money and spend it all on themselves during their lifetimes. That’s no problem, provided that you somehow know your date of death.
The simplest and most effective strategy to make sure you never run out of money is to continually save 10% of your total income. While working, most people do this by contributing to a 401(k). Even in retirement, continue to live at 90% of your pension income, Social Security and estimated long-term investment returns. In effect, you save 10% per year. Then you don't have to worry about your life expectancy. If you always save 10% of your income, you never run out of money.
True, you could end up spending all of your savings on catastrophic medical expenses. But in that unlikely event, you are much better off having saved 10% of your income after retirement than you are spending down to your life expectancy.
Of course, there is a selection bias in determining which people hire financial advisors, which is where our experience largely comes from. These people generally live within their means and save the surplus their whole lives. For them, the prospect of saving 10% is more comforting than challenging.
Focus on your taxes. Generally, the so-called safe withdrawal rate expert financial analysts cite ranges from 3.5% to 4.5% of your investment portfolio annually (depending on inflation and longevity assumptions). For real people, though, the source of the funds is much more critical as this determines how much you pay in taxes.
After-tax cash savings are obviously preferable to withdrawals from a qualified retirement account. This affects your withdrawal rate significantly. People in their early 60s have to withdraw $15,000 from an individual retirement account to end up with $10,000 in after-tax dollars to spend, assuming that IRA withdrawals are subject to 28% federal and 5% state taxes.
Withdrawals from a Roth IRA aren't taxable, so it makes more sense to first take money out of taxable accounts. This allows more time for the savings inside a Roth to compound tax-free.
Taking capital gains results in 50% less tax than a stream of income from an ordinary annuity with the same basis (the amount you paid for the investment initially – all growth above that is taxed). Selling high-risk assets with uncertain marketability in an over-leveraged portfolio is better than blindly taking a 4% withdrawal from ready cash.
These issues are dependent on asset location, which determines how investments are structured to be tax efficient. Clearly this is a something you should look at when determining withdrawal rates. The composition of assets is different for everyone.
Take the appropriate amount of risk. A great money manager can develop charts, graphs and long lists of numbers to demonstrate his investment prowess but might not recognize the really significant issues you face.
If you were taking a flight, do you get in a fighter jet that can break the sound barrier or a go with an airline pilot who avoids bad weather systems, knows how to handle the jet streams and is concerned about the comfort and safety of your flight?
By the same token, a safe withdrawal rate depends in part on having a safe level of risk in your portfolio that is appropriate for you and you alone.
Evaluate the factors that you can control when determining the optimal safe withdrawal rate for you. Forget the academic studies and historical reconstructions and pay attention to the factors that really affect your future by living within your means, staying attuned to taxes and investing with appropriate risk.
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Bert Whitehead, MBA, JD, is a fee-only financial planner in Franklin, Mich. He regularly blogs at www.bertwhitehead.com and on FiGuide. Bert is a founding member of the National Association of Financial Planners (NAPFA) and the Alliance of Cambridge Advisors (ACA).
Charles Simon, CFP, is a financial planner at Taconic Advisors in Poughkeepsie, N.Y.
This article also appeared on FiGuide at http://www.figuide.com/our-new-investment-reality.html
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