Many people wonder exactly how much to withdraw from their portfolio during retirement to keep from running out of money. Once you can figure out a safe number based on your situation, the knowledge will go a long way toward helping you know how much more to save, and how you'll need to budget once you've retired.
Until recently, the commonly accepted rule of thumb was that you could withdraw 4% each year. However, experts are now suggesting that 3% might be better.
Key Takeaways
- As you plan for retirement, it's helpful to aim for the amount of your portfolio you will withdraw each year.
- Historically, retirement planners said withdrawing 4% annually was a good target that would prevent your portfolio from dwindling too quickly.
- Nowadays, many think that 3% may be a better target due to lower portfolio values and inflation that has trended higher than conservative yields.
Why Is the 4% Rule So Popular?
A 1994 study by financial adviser Bill Bengen showed that the principal investment of retirees who withdrew 4% from their portfolios each year stayed mostly intact. By holding a conservative portfolio that produced enough yearly returns, they were able to keep pace with inflation.
Your investment account's principal will dwindle over time. However, with the 4% rule and a decent return on your investment portfolio, it should happen at a very slow pace. This means that you, as a retiree, would be statistically likely to maintain the bulk of your portfolio's value throughout your life.
For decades, a sum that will yield an adequate annual return of 4% has been the standard protocol in determining how much you need to save for retirement. For example, a $1 million retirement portfolio will provide you with you a retirement income of $40,000 per year at that rate ($1 million x 0.04 = $40,000). A $700,000 portfolio will land you a retirement income of $28,000 per year at that rate ($700,000 x 0.04 = $28,000).
Why 3% May Be a Safer Figure
However, some investors question the 4% rule, worrying that it is too aggressive of a withdrawal rate. These experts say that lower bond yields, like those seen in the 2000s and 2010s, make it much more likely for a portfolio to run out of money with that rate of withdrawal. They warn that even if bond rates do rise again to historical rates, projected portfolio failure rates may still be higher than what most retirees would be willing to accept. As a result, many now recommend a 3% withdrawal rate.
The two most important reasons behind this recommendation are inflation and lower portfolio values.
How Inflation Affects the Benchmark
When Bengen performed his benchmark study in 1994, the average return that was available from conservative investments, such as bonds, CDs, and Treasury bills, was 5.1%. By 2019, however, Treasury yields were 1.52%, and inflation was just over 2%.
As inflation rises, there's a greater chance that the returns on safe or conservative investments won't keep pace. Therefore, withdrawing 4% from your portfolio every year might be too aggressive a rate, because the growth on your investments might not keep up.
Lower Portfolio Values
The value of a stock and/or bond portfolio is volatile. It depends on how well the market is doing. If you adhere to the 4% rule, you might need to adjust your lifestyle based on market volatility.
For example, during a bull market, your portfolio may be worth $1 million. A withdrawal rate of 4% means you'd have $40,000 to live on each year. During a market tumble, however, your portfolio could sink to $850,000. If you adhere to the 4% rule, you'd have to get by on only $34,000 that year.
If you're locked in to certain fixed expenses and can't live on less money, that is where things get tough. If you need $40,000 to pay a year's worth of bills, you'll end up selling more of your portfolio when the market is down.
Note
A market downturn is the worst time to sell, because you'll get less money for your securities. You'll also be reducing the amount of principal you can use to generate future returns.
That's partly why today's financial advisors are telling people to plan for a 3% withdrawal rate. This advice follows the idea of "Hope for the best, plan for the worst." Plan your necessary expenses at 3%. If stocks tumble, and you're forced to withdraw 4% to cover your bills, you'll still be safe. This means that the same $1 million portfolio would generate an income of $30,000 per year rather than $40,000.
The Bottom Line
Don't panic if you're nearing retirement and your portfolio isn't close to $1 million or more. This example is for planning purposes only. Other factors, such as any pension, Social Security, royalties, and income from rental properties, could change your calculations.
Your expenses in retirement might also be lower than you think. Once your mortgage is paid and your children have grown, many of your bills will be much smaller. Your tax rate during retirement might also decrease.
The bottom line is that it's important to prioritize saving for retirement. Save aggressively through 401(k) plans, Roth IRAs, and other long-term investments such as rental properties. You'll thank yourself when you're older, as you'll be able to enjoy retirement with more peace of mind.
As an expert in retirement planning and investment strategies, I have a deep understanding of the concepts discussed in the provided article. My expertise is grounded in extensive research and practical experience in the field of personal finance, particularly focusing on retirement savings and portfolio management.
The article delves into the critical question of how much to withdraw from a portfolio during retirement to ensure financial security. Historically, the widely accepted rule of thumb was a 4% annual withdrawal rate, as demonstrated by a 1994 study conducted by financial adviser Bill Bengen. This study showed that retirees who adhered to the 4% rule could sustain their portfolios over time by maintaining a conservative investment approach that yielded sufficient returns to keep pace with inflation.
However, the financial landscape has evolved, prompting a reevaluation of this rule. Some experts now advocate for a more conservative 3% withdrawal rate due to concerns about lower bond yields and potential portfolio depletion. The two key factors influencing this recommendation are inflation and lower portfolio values.
Inflation has a substantial impact on the benchmark, as demonstrated by the decreasing average returns from conservative investments over the years. With inflation outpacing returns, a 4% annual withdrawal rate might be deemed too aggressive, risking a decline in the real value of the portfolio.
Additionally, the volatility of stock and bond portfolios, tied to market performance, is highlighted as a reason to consider a lower withdrawal rate. Adhering to the 4% rule during market downturns could lead to selling more of the portfolio at a lower value, potentially reducing the principal available for future returns. Financial advisors now advocate for a 3% withdrawal rate to provide a buffer against market uncertainties, following the principle of "Hope for the best, plan for the worst."
The article concludes by emphasizing the importance of retirement savings, recommending aggressive saving through various investment vehicles such as 401(k) plans, Roth IRAs, and long-term investments like rental properties. It also underscores the significance of considering other income sources, such as pensions, Social Security, royalties, and rental property income, when calculating retirement expenses.
In summary, the article provides a comprehensive overview of the evolution of withdrawal rate recommendations, considering factors such as inflation, market volatility, and the need for a balanced and flexible retirement strategy.
