When you take a fixed amount from your investments or savings at fixed intervals you are taking a systematic withdrawal. So in other words, if you withdraw $500 from your account every month, that’s a systematic withdrawal. “Simplisimo”!
Why Are Systematic Withdrawals Your Secret Weapon For Enhanced Retirement Income?
Systematic withdrawals could be the key to a better retirement because they open up a world of possibilities. When most people invest to create income, they usually restrict their search to those investments that pay interest or dividends like bonds, preferred stocks and annuities. That’s because they want steady income and they don’t want to invade their principal. It’s understandable.
But sadly, few think about growth or balanced equity funds. That’s because the returns associated with equities are unpredictable and most growth funds don’t pay out high dividends. They often make the error of confusing investment earnings and withdrawal rates. But you can use systematic withdrawals to tap into your equity funds and possibly create more monthly income than bonds or annuities do over time.
And this actually makes sense if you think about it. If you are investing for income, the chances are high that you want that income to last for a long period of time. What are some of the best long-term investments? In my experience, there is probably no better long-term investment than equity if you examine the facts.
How Does It Work?
When you take a systematic withdrawal from your equity funds, you take a percentage of the account each year and divide it up by 12. Then at the end of the year, you recalculate your withdrawal rate based on the existing balance using that same percentage. Planners usually suggest you use 4% as a withdrawal rate and we’ll use it for example but keep in mind there are ways to increase that rate.
Let’s say you have $150,000 in an investment account and decide to take a 4% withdrawal from the account evenly throughout the year. Since 4% of $150,000 is $6,000, you will take $500 year month.
Assume at the end of the first year, your account balance is $160,000 after your $6,000 withdrawal. At that point, you calculate your new monthly withdrawal based on the balance of $160,000. It works out to be $6400 a year or $533 a month which is a nice little bump and it helps to battle inflation. That’s your new systematic withdrawal.
The Problems
This approach is great as long as your funds go up in value. But what happens if they drop? In that case, your income will diminish. And if your funds drop significantly – like they did in 2008 for example – your income will plummet. You might be able to reduce the likelihood of that happening by using balanced rather than pure growth funds but you can never completely eliminate this risk when you invest in the market.
Look at the chart below:
The middle two columns show what would happen to your account if you invested $100,000 in the S&P 500 back in 2003 and withdrew 4% of the balance each year. (This is hypothetical only. It’s impossible to directly invest in the S&P 500.)
Look at that red line. When 2008 came around your account got slammed. It dropped from $138k to about $80k. Wow. That hurts. And as a result, your annual income dropped from $5552 to $3220. But because you enjoyed several good years before and after the market debacle, your income got back above $4000 a year within 3 years.
But if you were unfortunate enough to start your investing and systematic withdrawals in 2008, it took at least 5 years just to get back to even. And it could be worse. There is no guarantee that future markets will behave in a similar fashion. And if you withdraw more than 4% and/or you start off during one of these terrible years, you could end up broke.
Bottom Line
Despite the risks and dangers, I suggest you consider using equity to create income and tap into those accounts with systematic withdrawals. It’s true that if you start off during a particularly horrific market, you will get roughed up. But the medicine (staying away from equities to create retirement income) is usually worse than the disease (bear markets).
Let’s wrap this up by examining some data. According to Seeking Alpha, here are the stats for bull and bear markets:
You can see that the bear markets do happen (you knew that already) but historically, the market has paid investors handsomely for the inconvenience. For me, that is the point. When investors want income, they want it for the long-term. And if you investing for the long-term, why not tap into the power of equities using a systematic withdrawal?
Does this approach make sense to you? Why or why not?
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