Setting a Reasonable Withdrawal Rate
A realistic approach to your initial retirement withdrawals may help prolong the life of your savings.
There are a host of methods retirees may adopt to manage income withdrawals from their investment portfolios. One of the most popular involves withdrawing a certain percentage from your nest egg in the first year of your retirement, then (using the first year's withdrawal as a base) increasing these amounts annually to account for inflation. So if you retire with investments of $500,000 and choose a withdrawal rate of 5%, you will take out $25,000 in the first year. If prices rise by 3%, your next year's withdrawals would increase to $25,750, and so on.
Such an approach may be very helpful in building budgetary discipline, since you must ensure that your annual expenses in retirement stay within the limits you establish. But studies suggest that the long-term success of this strategy — defined as preserving your portfolio's ability to generate income throughout your retirement — depends a great deal on the initial withdrawal rate you select.
Making Allowance for the Unknown: For a retirement portfolio to provide income over the long haul, ideally the initial withdrawal rate should not be much higher than the portfolio's long-term real annualized return. But at the start of your retirement, this figure is an unknown. Most studies that have examined the historical record (such as the landmark 1997 "Trinity Study"1 ) have concluded that an initial withdrawal rate in the immediate range of 4% greatly decreased the likelihood of portfolio exhaustion over longer retirements. Based on this information, how should you proceed? As with most things related to retirement investing, with caution. While some investors might find a 4% initial withdrawal rate uncomfortably low, it is important to weigh this against the very real possibility of outliving your nest egg.
1. "Retirement Savings: Choosing a Withdrawal Rate That Is Sustainable." AAII Journal, February 1998.