31 January 2008
In the five years leading up to retirement, what I noted in January’s newsletter as the red zone, most people start thinking about where they might get their retirement income. Whether from a pension, social security, 401(k) or the sale of a business, many start gearing up for the question of where with little thought towards how much. I think it is more important to establish guidelines towards how much can be withdrawn from your overall portfolio.
There have been a lot of studies in our profession regarding the sustainability of the portfolio using certain withdrawal rates. I will not bore you with the details, but if you do not want to spend down principal, most financial planners agree that a 4% withdrawal rate, indexed for inflation, allows for a steady income that can last for 30 years of retirement.
To calculate this at retirement, take your portfolio balance (add up all accounts) on December 31, 2007 and multiply by .04. For example, if you have $1,000,000 your allowable income would be $40,000 ($1,000,000 x .04 = $40,000).&nübsp; If you want to back into the portfolio number since you are still working, or even in the red zone and can still save money, take your current income (or expenses if that is a more appropriate number to relate to what you will need in retirement) and divide by .04. This will give you the size of portfolio you will need to sustain your lifestyle. For example, if you will need $125,000 per year in retirement – net of tax – then your portfolio at retirement should be $3,125,000 ($125,000/.04 = $3,125,000).
And now two caveats: First, the numbers are the numbers and life does not always work out that way. We work witüh people who withdraw 2% of their portfolio and probably will never run out of money, and we work with clients who withdraw 6% and might face a challenge maintaining a portfolio down the road. Unexpected surprises come up – like helping children – so note that the goal of 4% is ideal, but not always attainable every single year.
A second caveat: In reviewing the previous paragraph, try to stay disciplined. Often people will say they understand our point in this and agree to a spending policy, and then call in a week with some large expense that totally ignores what we are trying to accomplish – not outspending your longevity. In a world where impulse dictates our wants, we need discipline to kick in. But even if you just do one thing, try not to spend more in years where the portfolio has a negative return and you will have helped yourself out more than you can understand 20 or 30 years from now.
Finally, this needs to be reviewed year-in and year-out to make sure you stay on track. Once comfortable with how this works, you can actually feel empowered to make spending decisions that allow for a retirement full of a kaleidoscope of color. You can finally enjoy the rewards of all those years of work!