Finding the Right Withdrawal Rate

"Can we afford to retire?"

That was a common question, and its one that a subscriber posed to me in a request for a portfolio makeover in mid-2009.

A former community college administrator, this 59-year-old reader had already retired, but her husband, 58, was still working in a position in state government. His commute took roughly three hours a day, cutting into this couple's leisure time and prompting them to consider whether full-time retirement was a possibility for both of them.

They had diligently saved and lived frugally; they also would be able to draw on pensions in retirement. That helps explain why they were able to consider retiring at a much younger age than most of us can contemplate. However, their retirement portfolio had taken a big hit during the bear market, and this couple had also invested in two real estate properties in 2006, near the peak of the bubble. They had hoped to use one of the properties as a vacation home and sell the other to help fund retirement, but the tanking markets for property had called that plan into question.

Determining the feasibility of an early retirement for this couple depended on a combination of factors, some of them knowable, some of them not. In the (at least somewhat) knowable column was how much they intended to spend in retirement as well as the income they could expect from sources other than their investment and real estate portfolios--in this couple's case, both Social Security and their pensions. In the unknowable category were two biggies: what kind of investment return they could expect as well as how long they would each live. They also had to evaluate some factors that were specific to their situation, such as whether (and when) they wanted to sell their investment properties and whether they wanted to leave a legacy for their loved ones.

In the end, they determined that they could retire sooner rather than later, in part because their two pensions fulfilled more than half of their income needs. When they began taking Social Security payments, they would be even closer to meeting their income needs without having to aggressively draw on their investment portfolio. And if this couple wanted to further ensure that their assets would last throughout their retirement years, one or both of them could consider working part-time (closer to home, of course); they could then delay the receipt of Social Security benefits until they're in their mid-60s rather than taking them as soon as they're eligible.

As this couple's story illustrates, determining when you can retire and how much you can safely withdraw from your investments when you do is a complicated exercise. And unfortunately, the numbers won't always tell you what you want to hear. However, the advantage of checking up on when and how you might be able to retire is that it can help you determine whether changes are in order while there's still time to make them. You can work longer, save more, or spend less; you can also recalibrate your planned spending during retirement or make changes to your investments in an effort to optimize your returns.

To determine how much you can spend during retirement, you'll need:

• Most recent investment statements with current account balances
• Morningstar's Instant X-Ray tool
• Retirement Income Worksheet

Start the Clock

Step 1
Start by finding your portfolio's current asset allocation--how your investment assets are apportioned among stocks, bonds, and cash.

If you don't know yours, Morningstar's Instant X-Ray tool can help you determine it. Enter each of your holdings into the tool and then click Show Instant X-Ray. (If your current asset allocation is different from what you expect it to be when you're close to retirement, adjust accordingly.)

On the Retirement Income Worksheet, circle the portfolio mix that most closely matches your own.

Step 2
Next to the pie chart that matches your asset allocation, circle the number of years that you expect to be retired. Go to the Social Security website for a table to help to determine your life expectancy. If you're married, use the female partner's life expectancy because it's longer. If you and/or your spouse are in good health, add a few years or more.

Step 3
How much certainty do you need in your life? Are you a "live for today" sort of person, willing to spend now even if it could result in a shortfall in your income later in life? Or are you someone who would rather spend less during retirement if it means a greater degree of certainty that your money won't run out?

The answer to this question will determine the percentage that you mark in the Certainty of Income column. If you'd like a high degree of certainty that your money will last throughout your retirement years, circle 85% or 95%. If you're willing to tolerate the possibility of a shortfall in exchange for more spending power early in your retirement years, circle 50%.

 

Step 4
To help determine your optimal portfolio withdrawal rate given the specifics you've just outlined, find the point where Asset Mix, Certainty of Income, and Years Expected in Retirement intersect. For example, someone with a Moderate Aggressive portfolio seeking an 85% degree of income certainty who expects to be retired 30 years would target a 4.8% withdrawal rate. That's the percentage of your portfolio that you can withdraw per year without a significant risk of running out.

Note that these withdrawal rates assume that your withdrawals will step up annually to keep pace with inflation. They also assume that you'll completely deplete your assets during retirement. Thus, if you're hoping to leave assets to your heirs, you'll need to shrink your withdrawal rate, switch to a more aggressive asset allocation, save more, or plan to retire later.

Step 5
To help determine whether that amount is enough to cover your spending needs in retirement, look at the second page of the worksheet. Start by totaling up your investment assets, including taxable accounts as well as any company retirement plan assets.

Step 6
Next, multiply that amount by the percentage withdrawal amount that you came up with in Step 4. That's the actual amount that you can withdraw from your portfolio during the first year of retirement. (Divide by 12 to arrive at a monthly withdrawal amount.)

If you're retiring and won't have income from other sources--for example, if you don't have a pension and aren't yet eligible for Social Security--decide whether that income--plus an annual inflation adjustment--is enough to sustain you during your retirement years.

If you're expecting retirement income from other sources during retirement, move on to Step 7.

Step 7
After you've figured out how much help you'll get from your portfolio during retirement, take stock of other expected sources of income during retirement--excluding any withdrawals or income from your investment portfolio. Include income from part-time work, pensions, and any annuity income you're expecting. Also estimate your Social Security benefits using one of these calculators.

Step 8
Add together the amounts that you arrived at in Steps 6 and 7. That's the amount of income that you can expect during your first year of retirement.

Step 9
Finally, adjust your income for taxes. The quick and dirty way to do this is to multiply the income amount by your tax rate. In reality, however, your tax burden may be higher or lower.

Next Steps

• Will your expected income cover your spending needs during retirement? If not, spend some time tinkering with the variables. For example, switching to a more aggressive asset-allocation mix could improve your portfolio's return potential (but it could also increase its risk level). And if you're willing to work longer, you could reduce the number of years that you'll spend in retirement (and, in turn, the need for income from your investment portfolio).
• This worksheet provides you with a quick and dirty idea of what your target withdrawal rate in retirement might be. But the questions of how much you'll need to retire--and how much you'll be able to withdraw from your investments when you do--are crucial ones, so it's helpful to seek a variety of opinions.  Morningstar's Asset Allocator tool can help you determine whether your current portfolio--both in terms of its size and asset mix--is sufficient relative to your income needs. T. Rowe Price's free Retirement Income Calculator and Fidelity's Retirement Income Planner can provide yet another read on whether your current investments are enough to provide you with the income you seek. (These two tools factor in tax rates and other factors, giving their output a higher degree of precision than the worksheet.)
• Although we've discussed a fixed withdrawal rate (with an inflation adjustment) in this exercise, you of course will be able to withdraw more or less as circumstances dictate. In fact, a 2008 study from T. Rowe Price showed that the best strategy for retirees who encountered a bear market early on in retirement was to reduce their withdrawal rates. Doing so would help them avoid turning paper portfolio losses into real ones by having to sell out of their long-term investments at an inopportune time.

Excerpted with permission of the publisher John Wiley & Sons, Inc. from 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances. Copyright (c) MMX by Morningstar Inc.

 

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