What’s your biggest fear as a retiree? Outliving your money.
The securities industry is great at fearmongering. It wants you to believe you need it to avoid this fate. The harsh reality is that using brokers and advisers who tell you they can “beat the markets” makes running out of money a self-fulfilling prophecy.
Unfortunately, determining how much money you can withdraw from savings is not easy with all the misinformation that exists.
Here’s one example. Remember when Peter Lynch, the former manager of the Fidelity Magellan Fund, was regarded as nothing short of an investment deity? Lynch believed that retirees could safely withdraw slightly less than the historical returns of their portfolios.
Using this formula, a retiree with an asset allocation of 60 percent stocks and 40 percent bonds might conclude that a withdrawal of 7 or even 8 percent annually is prudent. It isn’t.
One study showed that, depending on the market environment, this rate of withdrawal could reduce a nest egg to zero in thirteen years!
When determining how much you can withdraw from your portfolio, the most critical factor is its annual performance, especially in the first few years of retirement. If the stock market collapses in the early years of retirement, your nest egg can be decimated by withdrawals that might otherwise seem reasonable. If the market flourishes in the early years, your retirement account could withstand higher levels of withdrawals and still flourish.
If you’re worried about running out of money, here are some guidelines to follow that will keep your retirement account intact and help make your money outlive you regardless of market conditions:
- The 2-to-4-percent rule. William Bernstein, the author of The Four Pillars of Investing, summarized it best when he said, “Two percent is bullet-proof, 3 percent is probably safe, 4 percent is pushing it and, at 5 percent, you’re eating Alpo in your old age.” If you can make it by limiting your withdrawals to 2-4 percent a year, you will be fine. If not, there are ways to extract more from your retirement nest egg without jeopardizing it.
- The 4-percent-plus rule. This option works only if 50 to 75 percent of your portfolio is invested in stocks. Don’t withdraw more than 4.15 percent during the first year of retirement. For subsequent years, take the amount of the previous year’s withdrawal and increase it by the inflation rate. For example, if you withdrew $41,500 in the previous year and the inflation rate was 3 percent, you could bump up the withdrawal for the current year by $1,245. This is an option for squeezing more from your retirement nest egg, but if you are more conservatively invested, stick with the 2-to-4-percent rule.
- The “floor-to-ceiling” rule. William Bengen—an icon of withdrawal research-created a different approach to calculating safe withdrawal rates. He calls it a “floor-to-ceiling” strategy. In this approach, a retiree starts out with a withdrawal of 5 percent and agrees to follow a couple of rules. In a bull market, the retiree could take up to 25 percent more than the initial year’s withdrawal. But in a bear market, the retiree would cut back and limit withdrawals to 10 percent less than the initial withdrawal. Withdrawals would be taken at the beginning of the year. Bengen concluded that retirees who followed this approach had a 91percent chance of their portfolios lasting for thirty years.
Given current market conditions, all of these approaches present meaningful challenges to those planning for retirement and those who have already retired. At the end of the day, bigger is better when it comes to retirement nest eggs.
Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read and The Smartest 401(k) Book You’ll Ever Read. His latest book is The Smartest Retirement Book You’ll Ever Read.