Spokane Journal of Business

Making sure the 'golden years' don't lose financial luster

Preparing for retirement requires formulating realistic spending rate

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Workers approaching retirement age are in for an abrupt change. Never mind an end to deadlines, meetings, and late nights. After decades of steadily saving money for the golden years, retirees will be thrust into a new mode: spending.

When considering the ultimate sum of assets represented in 401(k) plans, Social Security, personal after-tax savings, home equity, and for the fortunate few, pension plans, retirees may be overwhelmed at the prospect of making those dollars last throughout retirement.

For some, 30 years or more in those golden years might not be unthinkable. Given constant fluctuation in the stock market combined with low interest rates and the potential of inflation, among other factors, how can retirees determine an annual withdrawal rate that won't drain accounts prematurely?

Planning for retirement typically starts with determining how much money will be needed to cover expenses. While some analysts believe that expenses in retirement will be 70 percent to 80 percent of those in the working years, others think the differences aren't so great, particularly if extensive travel, expensive hobbies, or major health issues are factors. Be realistic about how you plan to spend your retirement when estimating basic expenses as well as the extras.

Once you have a sense of how much you'll need on an annual basis, it's time to determine a comfortable rate at which to withdraw assets from your retirement accounts. Use your portfolio's asset allocation and historical market performance for guidance in estimating your portfolio's growth potential before and during retirement. Also, factor in any additional income expected, such as Social Security and pension benefits; if such income is significant enough, it may be possible to withdraw at a lower rate, preserving more assets for heirs or charitable beneficiaries.

The oft-cited 4 percent rate for withdrawal harkens to 1994 and research published by William Bengen in the Journal of Financial Planning. Bengen found a sensible drawdown approach that started at 4.15 percent in the first year on a balanced portfolio of large-cap stocks and intermediate bonds. In subsequent years, the withdrawal rate increases with the rate of inflation. At the same time, retirees reduce their exposure to market volatility by decreasing their allocation to stocks by 1 percent each year. This measured method should provide reasonable assurance that a portfolio would last 30 years or more.

Additional studies have pointed to withdrawal rates of 4 percent to 4.5 percent as ideal for preserving assets throughout retirement. Once investors try to withdraw more, they begin to increase their chances of running out of money. According to Bengen, at a withdrawal rate of 5 percent, investors have a 71 percent probability of having assets last 30 years, while a draw-down rate of 6 percent reduced the same probability to just 41 percent.

The 4 percent solution has become a relatively popular standard for its ease and simplicity. For instance, once you determine how much annual income you'll need from your retirement account, just multiply by 25 to see how big your portfolio needs to be at retirement. If you want to ensure $100,000 a year, you'll need to sock away $2.5 million before you start making withdrawals.

Though a popular rule of thumb, the 4 percent rule certainly isn't written in stone. A financial or trust professional advisor can help modify the rule—increasing or decreasing the rate—to account for an individual's particular asset allocation, tax rate, and time horizon. Reducing the required time horizon or the certainty level, for example, allows retirees to increase their withdrawal rates.

As many investors know, achieving the right portfolio balance of stocks and bonds can be tricky. Retirees can expose themselves to the risk of running out of money with either too much or too little exposure to stocks. The basic 4 percent rule is based on an initial portfolio with 50 percent to 75 percent allocated to large cap stocks and the balance invested in intermediate bonds. The portfolio then grows more conservative over time.

Today, a balanced portfolio might contain from 40 percent to 60 percent stocks, diversified among large cap, small cap, and foreign equities to spread the risk and enhance the return potential. While investors nearing retirement may be sensitive to the risk posed by a significant exposure to stocks, it has been found that dipping too far below a 50 percent stock allocation could deplete a portfolio too quickly. The lower return on bonds historically hasn't been enough to replenish funds and maintain a 4 percent withdrawal rate.

At the same time, taking on too much risk with a stock allocation of more than 75 percent also reduces safe draw-down rates. Given the historical volatility of equities, their over-representation in an account contributes greater uncertainty in terms of how quickly losses can be recouped.

Investors bracing for retirement in a bear market may be particularly sensitive to selecting a safe withdrawal rate, as the rate will increase in size relative to the diminished account. There is some good news for equity investors: While stocks can decline 25 percent in one year, they're capable of gaining it all back relatively quickly.

Nonetheless, as portfolios struggle in down markets, consider taking your withdrawal rate below 4 percent—or whatever your planned rate may be—to help preserve assets. Or, perhaps avoid adjusting for inflation. If your withdraw rate resulted in a distribution of $100,000 last year and inflation would nudge it up to $102,000 this year, consider keeping the distribution at $100,000 this year or even reducing it a bit, if you can manage with less. Even as markets and balances recover, maintain a conservative outlook as a defense against possible downturns.

  • J. Todd Edmonds

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  • Darcy MacLaren

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