At some point (if you haven’t already reached it) you’re going to want to tap into your nest egg. Of course the big question is what are safe withdrawal rates? In other words, how much money can you take out of your portfolio without depleting it too quickly?
The conventional wisdom is that you can withdraw 4% from a diversified portfolio, give yourself a bump every year to offset inflation and not worry about running out of money. The good news is there have been some important studies that indicate you can increase that payout to 5.5% if you are willing to implement one safeguard. The bad news is, no matter what you do, there are two possible events that could derail even a 4% withdrawal rate. We’ll get to that in a bit.
How do you increase your withdrawal rates by 20%?
According to Investment News Magazine, you can increase your withdrawal rate from 4% to 5.5% if you are willing to take a haircut when things get rough. In other words, your bear market withdrawal strategy helps your income remain higher during better markets.
Specifically, the magazine cites a study done by Mr. Jonathan Guyton. He found that you can withdraw 5.5% from a diversified portfolio and not significantly increase your risk of running out of money over the long haul. But you must make a shift, according to Mr. Guyton, if the market tanks. This is triggered by watching your percentage withdrawal rate. If it increases by 20% that means your portfolio has declined in value. If that happens, you have to cut your withdrawal rate by 10%. Let’s go through an example.
Let’s say you start with a portfolio of $100,000 and withdraw $5500 in year one. In year two, the portfolio grows to $110,000 (after withdrawals) and your 5.5% withdrawal comes to $6050. But then calamity hits. The market tanks and your account value drops to $85,000. Now your withdrawal is way too high. You can see that if you continue taking that $6050 while the account value is only $85,000, your withdrawal rate is actually 7.12%.
That is an increase of more than 29% (7.12%-5.5%=1.62% increase. 1.62%/5.5% = 29% increase). So according to the new rules, you must drop your withdrawal by 10%.
The upside to this strategy is that you take out more income for more years. But the downside is there will be years when you’re income check will take a pretty serious haircut. If you are not willing to reduce your withdrawals in such circumstances, you better stick to the 4% withdrawal rate.
The Good News
According to Mr. Guyton’s 2006 study, an investor with 35% fixed-income and 65% equity had a 99% success rate of not running out of money as tested over the last 40 years. Better still; the 10% withdrawal rate reduction was only put in place between 2 and 3 times over that period. That means an investor using this withdraw rate method would have very stable income over most of the period. Nicey nice.
At the beginning of this post I mentioned that there are two events that could derail this plan. What are they? First, if the market were to experience a catastrophic event with huge declines, your portfolio may not be able to survive unless you make very deep cuts in your income. Second, if the market suffers such declines and you stay out of the market as a result, your portfolio won’t be able to recover.
A potential severe stock market decline is a real possibility if you are a long-term investor. In order to make sure such shocks don’t destroy your retirement income dreams, I suggest that you consider using an investment strategy that seeks to minimize the chances of this from happening to you. Specifically, I suggest that you refrain from relying on “buy and hold” and investigate market timing strategies.
This won’t guarantee that you can insulate yourself from steep market declines but at least such an approach does provide tools that can help.
Are you willing to make bigger adjustments to your withdrawal rate in exchange for more retirement income now?