When planning for retirement, it’s not just about how much you money you save up. One of the most important variables to consider is what’s called the safe retirement withdrawal rate – how much money you’ll withdraw each year to live off of. To take too much may drain your nest egg and leave you with nothing. To take too little may curb your lifestyle more than you’re use to.
For years, financial advisers have long proclaimed a safe withdrawal rate of 4 percent from your retirement accounts as the rule of thumb. That means you would have a relatively high chance of success if you start off by taking out only 4 percent and then adjust each year with the rate of inflation. But lately not everyone agrees, and the spread is more surprising than you think.
A New Spin on the Retirement Safe Withdrawal Rate:
Smart Money magazine recently ran a great article in their February 2012 “New Retirement” section by Glenn Ruffenach that investigated the viability of the 4 percent rule. In the article, he cited:
• The Journal of Financial Planning predicted that a retirement safe withdrawal rate from nest egg is 1.8 percent.
• The Retirement Management Journal said some individuals may be able safe withdrawing as much as 7 percent during retirement.
So if the experts can’t agree, what are you supposed to believe?
Where Did the 4 Percent Rule Come From?
The 4 percent rule as a retirement safe withdrawal rate was developed in the 1990’s by a certified financial planner from California named William Bengen. It was meant to establish a high probability that your money would last for the next 30 years. Bengen’s findings became a popular rule of thumb for planners and analysts everywhere to use in helping their clients with retirement planning.
So what do you believe will make a safe withdrawal rate?
For me, 7% sounds pretty wild! I don’t think I’d chance my life savings with a withdrawal rate that high. Yet, 2% sounds a little too conservative.
When I work on my own money design, I prefer to keep things easy. Here is the formula I use for planning my retirement:
• My balance with grow by an average of 6% annually.
• Inflation will decrease my portfolio by an average of 3% annually.
• Therefore, I should be able to safely withdraw an average of 3% annually from my retirement balance.
Sounds simple, right? If your money grows by 6% but decreases by 3% for withdrawals and another 3% for inflation, then your money should (in theory) last for virtually the rest of your life. I purposely use 6% instead of 8% for predicting future returns as a safety buffer against the unforeseen. In addition, these figures will also help foster a consistent withdrawal rate. In other words, you shouldn’t start off taking out a large sum of money only to be left taking out lesser amounts of money in the years to come as your nest egg disappears.
The following graph is an illustration of what a portfolio of $1 million dollars would look like for the next 50 years depending on which number believe is a safe retirement withdrawal rate. You can download my Excel worksheet and try your own figures yourself.
Download My File: MyMoneyDesign_Retirement_Withdrawal_Example.xls
As you can see, the higher the safe withdrawal rate you pick, the more likely you are to run out of money. My preference for the 3% figure puts me as close as possible to nearly “breaking even” each year.
Testing Your Retirement Safe Withdrawal Rate:
I will admit there is a problem with my model as well as all “rule of thumb” calculations:
• Portfolios don’t necessarily grow by a certain percentage every year. In fact, some years they decrease.
Failure to consider this truth is why sometimes our models do not turn out the way we think they will. To really “test” our safe retirement withdrawal rate, we’ll need to create a simulation of the next 30 to 50 years. You can try this out for yourself in my next post: A Better Way to See If You’ll Run Out of Money During Retirement.
Photo Credit: Microsoft Clip Art