How to Inflation-Adjust Your Retirement-Portfolio Withdrawals
Getting this calculation right can help ensure that you keep up with cost-of-living increases but don't outlive your savings.
It's challenging enough for today's retirees and pre-retirees who are being forced to fend for themselves without the benefit of pensions, in an ultralow interest-rate environment to boot.
To add insult to injury, the logistics of managing an in-retirement portfolio can be devilishly complicated, practically requiring retirees to be pocket-protector-wearing members of the math team. Retirees have to contend with the always-challenging issues of asset allocation and asset location, of course, as well as how to sequence their withdrawals from the various pots of money they've managed to accumulate in an effort to reduce the drag of taxes.
More fundamentally (and this is where the math really comes in), they need to determine whether they actually have enough to retire in the first place, as well as how much they can withdraw for living expenses per year without prematurely depleting their savings.
One widely accepted rule of thumb for calibrating in-retirement portfolio withdrawals is that spending 4% of your portfolio per year, then nudging up that amount each year to account for inflation, is a safe rate--that is, if you stick within those parameters, you'll have little risk of depleting your nest egg prematurely. The 4% rule is based on a landmark 1994 article by William Bengen in the Journal of Financial Planning; Bengen's analysis of historical investment performance assumed that 60% stock/40% bond investment portfolio should last at least 30 years, provided the retiree kept annual withdrawals within these parameters.
Where the Rubber Hits the Road
Assuming someone is using the 4% rule, calculating initial withdrawals is straightforward. If you've saved $800,000, the 4% rule means you can withdraw $32,000 in your first year of retirement. Whether you can live on $32,000 a year, in addition to any other money you expect from Social Security or a pension, is another matter, but the 4% rule provides a good, straightforward reality check.
Where some retirees get tripped up, however, is in the inflation-adjustment piece. If inflation runs at 3% in your first year of retirement and you're taking out 4% of your portfolio, does that mean you can withdraw 7%--or $56,000 from an $800,000 portfolio--in year two of retirement? Definitely not. In fact, you don't need to have your pocket protector on to realize that a retiree employing such an aggressive withdrawal rate would cycle through his or her money in far fewer than 30 years.
Instead, the 4% with inflation-adjustment rule assumes that you inflation-adjust the initial withdrawal amount. Assuming the retiree in my example experiences a 3% inflation rate in the first year of retirement, he or she would bump up that initial withdrawal amount of $32,000 by 3%, or $960, in the second year of retirement. If inflation increased by 3% again the next year, the third-year withdrawal amount would be $33,949. (That figure consists of the second-year withdrawal amount, $32,960, inflation-adjusted by another 3%, or $989.). You'd perform a similar calculation each year, making adjustments to the previous year's withdrawal amount based on the inflation rate.
Properly adjusting your withdrawal amounts to account for inflation isn't as simple as adding 3%-4%, but doing so helps ensure that you don't outlive your money. However, there are some important considerations to bear in mind when thinking about calibrating your own withdrawal rate. Those, in turn, might complicate your personal calculation somewhat.
For starters, the aforementioned dollars-and-cents examples don't factor in the potential role of taxes. If you're pulling money from a traditional 401(k) or IRA, or selling securities on which you'll owe income or capital-gains taxes, you need to factor in the tax hit when calibrating your withdrawal amount.
Moreover, although the Consumer Price Index is better than nothing when deciding how much to inflation-adjust your withdrawal amount, inflation will tend to ebb and flow with your own circumstances and spending habits. If you haven't seen a big increase in your own living costs even though the CPI has jumped up, you might want to inflation-adjust your withdrawal amount at a more modest level than CPI would suggest.
Last but not least, it's worth noting that the matter of so-called safe withdrawal rates is far from settled in the financial-planning community; even Bengen concedes that the rule might lead retirees to spend less than what's necessary. Others, such as financial expert Michael Kitces, have argued in favor of a flexible withdrawal rate that takes market valuations into account. Because this is such a crucial topic, I'll be exploring different aspects of the withdrawal rate question in upcoming articles on Morningstar.com.
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