Three factors that determine the best way to withdraw funds during retirement.
We are often asked by clients nearing or in retirement “How much money can I spend in retirement?” This is another way of asking what is a sustainable withdrawal rate? Or, what amount can you withdraw from your investments and ensure you will not run out of money during your lifetime? There is no simple answer that applies in all cases, but there are rules of thumb we use to make generalizations.
This week, we’d like to share with you these rules to plan by.
Three Factors That Determine Optimal Withdrawal Rates
When evaluating how much you can pull from your retirement savings, your answer will likely depend on 3 primary factors:
1. What is your retirement planning horizon? While some individuals would like to plan to spend their last dollar on their last day, reality is not this simple. You will need to ensure that the assets will outlast your life span to ensure your needs are met. General planning guidelines call for a planning horizon of 30 years, but this can vary depending on various factors including retirement age and family history of longevity.
2. What is your portfolio mix of stocks, bonds, alternative investments? The investments you own will impact how much your assets grow over time. You need to ensure your investments are aggressive enough to grow at a rate that outpaces your withdrawals (if you wish to maintain your principal balance) but not too aggressive such that your balance could be depleted by the combination of market fluctuations and withdrawals. The chart below shows portfolio at various mixes of stocks and bonds. You can see that by being less risky, you could actually be putting your portfolio at more risk of running out of money over time.
3. What is the probability of success you are comfortable with? Based on a tool called Monte Carlo, you can project out scenarios to evaluate the likelihood your funds will last. If you have a 50% chance of success, you also have a 50% chance of running out of funds. Alternatively, if you have a 90% chance of success, you are likely to have sufficient funds to meet your withdrawal needs. Generally, you want to see a success rate of over 80% to be considered acceptable.
For illustrative purposes, let’s consider the following chart which shows how long a hypothetical $1,000,000 initial balance lasts at a 4%, 5%, and 6% withdrawal rate. The 4% rate—a general rule of thumb introduced in 1994, which adjusts the initial withdrawal amount for inflation over time to preserve purchasing power—maintains assets through the 30 year timeframe. To the contrary, both a 5% and 6% initial withdrawal rate proves not as successful (you run out of money in approximately 21 years at 6% and 26 years at 5%) and may put retirement spending at risk. At the very least, the probability of having sufficient funds through your entire lifespan falls to a very low percentage.
Best Case Retirement Scenario: Eat The Fruit, Not The Tree
If at all possible, we recommend that you plan to spend the “fruits” of the retirement “tree” and not chop off the “branches”. In other words, attempt to live off of the growth each year and not eat into the principal balance. Planning with this approach allows your assets to not only provide income during your lifetime but also to allow for your heirs (or a charity) to receive the remainder.
Given the inputs discussed above, it should be obvious this is a challenging question without an easy answer. We are happy to discuss your situation with you in greater detail to help evaluate whether your current or planned withdrawal rate is sustainable over the long-term. Don’t hesitate to reach out to us if we can be of assistance.
Chart Disclosure: These charts are based on 50th percentile which means that 50% of the time you’ll have better outcomes. Based on the high percentage of outcomes that tend to be clustered near the median, this may be considered the most likely potential outcome. The charts are for illustrative purposes only and must not be used, or relied upon, to make investment decisions. Portfolios are described using equity/bond denotation (e.g. a 40/60 portfolio is 40% equities and 60% bonds). Hypothetical portfolios are composed of US Large Cap for equity, US Aggregate Bonds and US Cash for cash, with compound returns projected to be 6.25%, 3.00% and 2.00%, respectively. J.P. Morgan’s model is based on J.P. Morgan Asset Management’s (JPMAM) proprietary Long-Term Capital Markets Assumptions (10–15 years). The resulting projections include only the benchmark return associated with the portfolio and does not include alpha from the underlying product strategies within each asset class. The yearly withdrawal amount is set as a fixed percentage of the initial amount of $1,000,000 and is then inflation adjusted over the period (2.25%). Allocations, assumptions and expected returns are not meant to represent JPMAM performance. Given the complex risk/reward tradeoffs involved, we advise clients to rely on judgment as well as quantitative optimization approaches in setting strategic allocations. References to future returns for either asset allocation strategies or asset classes are not promises or even estimates of actual returns a client portfolio may achieve.
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