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Dave Patterson and Erin Preston, a father-daughter team of Certified Financial Planner® licensees, provide thoughts and suggestions on a broad collection of personal finance topics.  Information provided in this BLOG is intended to be of a general nature and may not be appropriate for all situations.  Readers should consult with their own financial advisors before relying on any information contained herein.

Friday, October 9, 2009

Withdrawal Rates Can Be Critical to Successful Retirement

Last week we attended our annual Financial Planning Association (FPA) of Michigan fall symposium. One of the presentations focused on safe retirement withdrawal rates (i.e., the percent of your portfolio you can safely withdraw during each year of retirement). We’ve read many articles published in past issues of the Journal of Financial Planning so we thought our readers might be interested in how much they can safely spend once they retire.

It turns out that when you retire can have a huge impact on whether your money will last through retirement. If you’re lucky enough to retire at the beginning of a bull market your chance of having your money last is significantly greater than if you retire just before a market crash such as we have just recently experienced.

Traditional financial planning techniques utilized a set of assumptions about portfolio returns, inflation and tax rates along with income and expense data to project what would be left at the end life expectancy. Portfolio returns, tax rates and inflation were typically the same for each year. Yet we all know that tax rates, rates of return and inflation vary significantly from year to year. Therefore such a projection would likely differ significantly from actual results. Even by using very conservative assumptions, there was significant risk of running out of money before life expectancy if you happened to retire at an inopportune time.

A number of studies have been conducted to determine a “safe” withdrawal rate that would ensure your funds would last through retirement. A classic study by Bengen in 1994 suggested a safe withdrawal for a 30-year retirement of about 4.1% with adjustments for inflation. Note this 4.1% is based on the portfolio value on the first withdrawal year and is not recalculated every year – only the inflation adjustment is added to the previous year’s withdrawal amount. Bengen’s safe withdrawal rate assumed a portfolio mix of approximately 60% equities and 40% bonds. The withdrawal rate varied as the portfolio mix varied.

Thus, if you have a portfolio worth $1,000,000 at the beginning of retirement you could withdraw $41,000 the first year. Each year thereafter, your next year’s withdrawal would equal to the previous year’s amount adjusted by the previous year’s rate of inflation. In the example above, if inflation was 3% in the first retirement year, the second year’s withdrawal would be $41,000 x 1.03 = $42,230. Assuming 3% in year three: $43,497…and so on.

Obviously, how much you will need in retirement depends not only what you need to spend but also on other sources of income such as Social Security and any pensions you may have. Our next post will discuss some more recent research on withdrawal rates.


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