When you have retired, your goal is to expire before your bank account does. The easiest way, of course, is to take up juggling hatchets.
A more moderate solution, however, is to try and figure out how much you can withdraw each year—a tricky calculation at best, since you know neither what you'll earn in any given year, nor what the rate of inflation will be, nor how long you'll live.
Financial planners have long recommended that your initial withdrawal be 4% of your savings, which you then adjust each year for inflation. Recently, however, others have suggested that 3% is a more reasonable alternative, given that savings rates are virtually zero.
But don't get out the hatchets yet. Being too conservative in your assumptions will rob you of retirement joy. You can probably take out more than 4% a year and be reasonably assured of not running out of money.
Most people figure that you can just take your earnings any given year, and live off those. For example, suppose you have $250,000 in retirement savings.
If you have a bond or other income investment that throws off 5% income a year, you could take 5%—$12,500 a year—without fears of running out of money or dipping into your principal, for that matter.
There are two problems with that. The first is that in these days of low interest rates, a 5% return is edging into high-yield category, which means high risk. The average exchange traded junk-bond fund in Morningstar's database has a current yield of 5.38%. If you crave safety, a one-year Treasury bill yields just 0.1%, or $21 a year. You'd be able to afford a peeled lima bean every other Friday.
The second is inflation. Even modest inflation will erode your buying power over time. Suppose you withdraw $500 every month from your retirement kitty. After 10 years of 3% inflation, $500 will have the purchasing power of $380.
Several academic studies have shown that if you start with a 4% initial withdrawal and adjust it each year for inflation, you have a good chance of never running out of money. The rule of thumb assumes a relatively conservative portfolio, typically 50% or 60% stocks, with the balance in cash or bonds.
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Given a $250,000 retirement portfolio, your withdrawal in the first year would be $10,000, or a monthly income of $833 a month. The next year, you'd boost your withdrawal by the rate of inflation, and so on.
Had you followed this plan in 1960 using a balanced fund, which is typically a mix of 60% stocks and 40% bonds, you would not have run out of money until 2002, 41 years later. And this in a period that featured soaring inflation, several wretched bear markets, and disco.