Outside the Box: How much should you take out of your portfolio when you retire?

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Here’s a question: In these times of stock-market shock — when the market can be up or down in one day as much as it might be up or down in a year — who has the patience to think rationally about long-term retirement planning?

Here’s the answer: If you haven’t retired yet, you should find a way to do exactly that sort of thinking. Perhaps more than ever, this is a good time to get the help of a good financial adviser for this task.

While we hold our breath for the latest good or (more likely) not-so-good news, let’s wade into this topic a bit.

Most people look forward eagerly to retirement, but it’s a change that requires many important choices, some of which can have pretty big consequences.

Today I want to focus on one of those forks in the road: How much money you expect your life savings to provide every year for your living expenses.

The big trade-off:

On the one hand, if you take out more money, you run a greater risk of running out of money. On the other hand, if you take out less money, you forego the retirement lifestyle you have looked forward to.

How you navigate this puzzling landscape is a bit of a challenge. But I’ll give you a “map” to make it easier.

Let’s start with a set of numbers I have developed over the years to show what would have happened to somebody who retired at the start of 1970.

There’s nothing magic about that year except that we have reliable data for the subsequent years, a period that included lots of favorable and unfavorable economic trends, world crises, some years of substantial inflation, and serious unexpected ups and downs in the stock market.

The years since 1970 give us a window into the wide range of market returns that might happen in the future. To follow the numbers, imagine (even though you’re probably much too young) that you retired in 1970 with a portfolio worth $1 million.

I’ll assume you chose a first-year withdrawal of $30,000 or $40,000 or $50,000 or $60,000, and that you wanted subsequent annual withdrawals to go up reflecting actual inflation.

To limit the variables, I’ll further assume that your $1 million was invested equally (50/50, in other words) in the S&P 500 Index SPX, -0.16% and a combination of short-term and intermediate-term U.S. government bonds.

That’s a pretty reasonable stock/bond allocation for retirees, and it reflects the overall risk level of my own investments.

So your choice in this exercise is whether you start by taking out $30,000, $40,000, $50,000, or $60,000.

Here’s where that fundamental trade-off translates into numbers: If you chose $30,000, you would have a lot less to spend but also much less risk of running out of money. If you chose $60,000, you would have much more to spend, but a considerably higher risk of running out of money.

Here’s a table to give you a snapshot of how you would have fared in the first 10 years of your retirement, depending on your rate of withdrawal.

Table 1: The first 10 years

Withdrawal rate 3% 4% 5% 6%
Withdrawal 1970 $30,000 $40,000 $50,000 $60,000
First 5 years withdrawals $164,961 $219,947 $274,933 $329,920
Balance 12/31/1974 $945,630 $940,276 $887,734 $834,192
Withdrawal 1975 $41,300 $55,066 $68,833 $82,599
First 10 years withdrawals $400,027 $533,369 $666,710 $800,052
Balance 12/31/1979 $1.33 million $1.15 million $959,623 $771,937
Withdrawal 1980 $61,034 $81,379 $101,724 $122,069

If your retirement lasted only 10 years, you of course would be fine taking out the 6%. But after that, you’d be in trouble.

At the start of 1980, according to this plan, you would take out $122,069 from a portfolio worth $771,937. That is a withdrawal rate of nearly 16%, obviously too much to last much longer.

If on the other hand you were following the 3% route, in 1980 your portfolio would be worth more than it started with, but you’d be taking out much, much less for living it up in retirement.

Most people expect their retirement to last more than 10 years. So let’s look at the second 10 years of these four scenarios.

Table 2: The second 10 years

Withdrawal rate 3% 4% 5% 6%
Withdrawal 1980 $61,034 $81,379 $101,724 $122,069
First 15 years withdrawals $762,812 $1.02 million $1.27 million $1.53 million
Balance 12/31/1984 $2.0 million $1.5 million $951,709 $414,886
Withdrawal 1985 $83,792 $111,724 $139,655 $167,800
First 20 years withdrawals $1.21 million $1.61 million $2.02 million $2.03 million
Balance 12/31/1989 $3.57 million $2.2 million $849,493 No $$ left
Withdrawal 1990 $100,345 $133,793 $167,241 No $$ left

As table 2 shows, the 6% withdrawal rate meant this portfolio could not keep up with inflation for 20 years. As soon as you took money out at the start of 1987 (and you could not take out the full amount), that portfolio was flat broke.

Note also that the 5% withdrawal plan was in obvious trouble by the end of 20 years. The 1990 withdrawal of $167,241 amounted to 20% of the portfolio value; in fact, that portfolio ran out of money in 1994 — less than 25 years after you retired.

The table does not show this, but by the end of 1999, representing a full 30 years of retirement, the 4% portfolio was holding up just fine, worth $4 million. The 3% portfolio was worth a whopping $9.3 million.

If you started out withdrawing 3%, at some point in the 1980s you could easily afford to take out more money every year.

But there’s a trade-off in that choice, too. In your early years of retirement, when you were presumably more healthy and able to travel and otherwise be active, the 3% withdrawal rate left you with less money. By the time you loosened the purse strings, so to speak, you had more money but perhaps less ability to take full advantage of it.

If you’re interested in how all this played out year-by-year for these four withdrawal rates, check out these four tables of returns. (If you scroll down farther on that page, you’ll find similar tables showing inflation-adjusted distributions for portfolios based on my recommendations for Worldwide and All-Value equity combinations.)

The bad news is that there’s no way to avoid the trade-off between spending now or spending later. And in most cases, you cannot know in advance how long you will live.

Fortunately, there are very worthwhile options for dealing with this trade-off.

The best option, assuming you have saved enough money, is to abandon the idea that your withdrawals have to go up with inflation regardless of how well or how poorly your investments are doing.

The financial world is unpredictable, at least in the short term, as we’ve seen very dramatically this year.

If you can maintain some flexibility in your spending needs, and if you have an adequate emergency fund, you can consider calculating your annual withdrawals as a constant percentage of what your portfolio is worth.

That way, when things are going well, you take out more money. When things are going not so well, you tighten your belt.

This is called a variable distribution plan, and it can give you the option to safely bump up your allocation to stocks.

A portfolio with a 60/40 percentage mix of stocks and bonds and a 6% variable distribution plan required some serious belt-tightening in the early years. But it held up nicely for 50 years…well beyond the typical span of anybody’s retirement.

I’ll dig into variable distributions in an upcoming article.

To be sure, retirement can be tricky. But if you start with ample savings and make sound distribution choices, you can live it up without outliving your money.

For more, check out my recent podcast: “All About Fixed Distributions.”

Richard Buck contributed to this article.