How much can you withdraw annually from your investment portfolio to be sure you don't outlive your money? If you regularly read investment articles, you know that this issue is often debated. Scenarios are analyzed, and various inflation rates, historical investment rates of return, and life expectancy projections are compared.
While these are key and critical exogenous issues if you are managing billions of dollars in pension investments, if you are a real person it is the endogenous factors that are important when you decide how much money to take from your retirement portfolio. Endogenous factors include living within your means, how much you pay in taxes, and taking appropriate risk for your situation.
Inflation: The Bogey Man.There is no question that the cost of living has risen over the years, and the compounded effect of inflation over time is startling. For real people, however, it is more complex than just measuring the price level across the whole economy. Younger and middle-aged Americans will likely see prices rise substantially over their lifetimes, but while working their wages can also increase, and generally faster than the rate of inflation. And if you consistently save 10% of your earnings, the amount you save increases each year and easily outpaces the inflation rate.
For older retired people, especially those on a 'fixed income,' you would think that inflation would be disastrous. Certainly inflation is a continual struggle for those living at a subsistence level. For the more affluent, however, expenses tend to start dropping when they are in their 70's, and continue dropping more rapidly as they age despite increases in inflation. Older people are less mobile, have 'been there, done that, and have the T-Shirt.' They travel less, are generally less active, and less fashion conscious.
So while the rate of inflation is a big concern for money managers who run gigantic pension plans, in reality it has virtually no impact on personal financial planning.
‘I just want to 'Die Broke!'New clients sometimes say they want to withdraw their retirement portfolio money and spend it all on themselves during their lifetimes. No problem, I say: just let me know your date of death!
The simplest and most effective strategy to make sure you never run out of money is to continually save 10% of your total income. While working, most people do this by contributing to their 401Ks. Even in retirement it is prudent to continue to save 10% of your total income (that is, to live at 90% of your means) which includes pension income, social security, and estimated long-term investment returns. Then you don't have to worry about your life expectancy: if you always save 10% of your income you are by definition always living within your means and you will never run out of money.
True, you could end up spending all of your savings for a catastrophic medical expenses. But in that unlikely event, you will be much better off having saved 10% of your income after retirement than you would be trying to spend down to your life expectancy as a primary investment guide.
Of course there is a selection bias in determining which people hire financial advisors. These people generally have been living within their means and saving the surplus their whole lives. For them, the prospect of saving 10% is more comforting than challenging.
If you are going to worry about returns, make it your tax return!Generally the 'safe withdraw rate' calculated by expert financial analysts today ranges from 3.5% to 4.5% of your investment portfolio annually (depending on inflation and longevity assumptions). For real people, however, the source of the funds is much more critical as this determines how much you will pay in taxes.
After-tax cash savings are obviously preferable to withdrawals from a qualified retirement account and impacts your withdrawal rate significantly. Individuals in their early 60's would likely* have to withdraw $15,000 from an IRA to end up with $10,000 in after-tax dollars to spend. Withdrawals from a Roth IRA aren't taxable, but are generally less advantageous than using after-tax savings because investments inside a Roth compound tax free. Taking capital gains results in 50% less tax than a stream of income from an ordinary annuity with the same basis. Selling high-risk assets with uncertain marketability in an over-leveraged portfolio may be more advisable than blindly taking a 4% withdrawal from ready cash.
These issues are dependent on 'asset location,' which determines how investments are structured to be tax efficient. Clearly this is an endogenous consideration when determining withdrawal rates. The composition of assets is different for everyone.
“Are you leavin’ on a jet plane…?”Finally, hiring a great money manager who develops charts, graphs, and long lists of numbers to demonstrate their investment prowess doesn't recognize the really significant issues you face.
Look at the risk in your portfolio this way. If you are flying from New York to Los Angeles, you could hire a fighter pilot who can demonstrate how fast the jet flies, how quickly he or she can maneuver, their skills are in steeply ascending and descending, and that their record flight is 4.25 hours. However, you also have the option to travel with a trained airline pilot who avoids bad weather systems, knows how to handle the jet streams, and is more concerned about the comfort and safety of your flight. Be aware that the airline pilot will estimate your time of arrival as 5.15 hours, but pads the schedule because the trip usually only takes 4.45 hours. If you can “fly comfortably” by withdrawing dollars from a lower risk portfolio during retirement, doesn’t it make sense to do? Doesn’t a safe withdrawal rate depend in part on having a safe level of risk in your portfolio that is appropriate for you and you alone?
Real people need to evaluate the factors that they can control when considering the optimal safe withdrawal rate. Forget the academic studies and historical reconstructions and pay attention to the factors that really affect your future by living within your means, staying attuned to taxes, and investing with appropriate risk.
*Assumes IRA withdrawals are subject to 28% federal plus 5% state taxes.
Special thanks to those who collaborated on this post: Chip Simon, an ACA colleague from Poughkeepsie, N.Y., and Shari Cohen who was the copy editor.