When to Reduce Your Investment Withdrawal Rate

The best way to safeguard your retirement is to be wise about your investment withdrawal rates. The good news is you don’t have to be an Einstein math genius in order to maximize withdrawal rates safely . I think you’ll see that it’s far easier to master this concept than you think.

Investment Withdrawal Rate Basics

First, I’m going to bend your mind a little by encouraging you to differentiate between investment returns and investment withdrawals. The return is what you earn on the money. The withdrawal is what you take out and spend.

These are two different animals completely. While one certainly has a huge impact on the other, they are not the same thing. When investors fail to recognize the distinction it can be very costly.

When Returns and Withdrawals Should Always Be Equal

When it comes to CDs and Bonds (fixed income) it makes sense to only withdraw what you earn. If you take any more out of the account than that you’ll deplete it .  Sooner or later you’ll end up working at Flippy Burger during retirement. Lousy plan friend.

When Returns and Withdrawals Should Never Be Equal

The withdrawal rate formula above doesn’t work when it comes to investments that also potentially grow like equity funds. Let me provide an example to illustrate what I mean. If a fund returned 7% on average over a period of 20 years, you can easily withdraw 4% each year and still grow your money by 3% annually. You can do this even if the fund in question pays no interest or dividends.

The trick of course is to earn that 7% or more on average over the 20-year period. It’s easy to do this with 20-20 hindsight but a bit more difficult when you’re in the middle of a gut-wrenching market decline. This is the reason why it’s absolutely critical to select investments that do give you some opportunity to grow your money but not expose you to a high probability of catastrophic losses. The bad news is that no matter what you do, if you invest in equities, you can never completely eliminate this risk. Sorry Charlie.

The Guarantees & the Risks

If you are looking for guarantees, I’ll give you one. Earn 1% on your CDs and withdraw 4% or 5% or more. My guarantee is that you will go broke real fast. I’m guessing that’s not the kind of guarantee you wanted. Let’s consider something more hopeful.

If we examine the past, we can see that investors who wanted long-term income have done really well with a balanced portfolio over the long-term. Here’s a graph that depicts what happens to a hypothetical investment of $500,000 from 1972 through 2011 given different levels of withdrawals. The portfolio is invested 50% in stocks, 40% in bonds and 10% short-term investments – a typical balanced approach.

Keep in mind that investors had a few big bumps in the road during that period. We had a big recession in 1972 and other significant market slumps in 1987, 2000 – 2002 and2008. And you can see that because the market did so poorly shortly after this hypothetical investor started making withdrawals, it really hurt the survivability of the account if the investor didn’t use a smart withdrawal approach for bear markets.

In fact, if an investor’s average annual withdrawal during this period was any greater than 4%, they ran out of money.

So, is 4% a safe withdrawal rate?

Possibly….but possibly not…..and I’ll tell you why. Remember with a 50-50 portfolio, a good portion of the return comes from bond interest. But interest rates are a lot lower now. And that means the overall return from a portfolio with a big slice of the pie in fixed income might be lower too.

Is there a solution?

Absolutely. You actually have 3 choices.

1. Reduce your withdrawal rate if you want to keep a high percentage of your money in fixed income. I don’t have any data to support how much to reduce the withdrawals by. But if it were me, I would start out with 3%. I get to this number because Investment News did a study and came up with 2.8% as a safe withdrawal rate for a portfolio made up of 40% stocks and 60% bonds. I estimate that a 50-50 split could support 3% but I am not certain.
2. Consider shorter duration bonds now and move them into higher paying bonds when rates rise.
3. Move a higher percentage of your portfolio into equity if you want to protect and grow your nest egg.

Each of these alternatives have pros and cons. There is no “one size fits all”. If you are unwilling to take on more short-term risk you’re safest choice is to reduce your withdrawal rates (and of course that means reducing your spending).

Looking for some help with your retirement planning?   Maybe I can help.   If you’d like to have a connect with me., let me know.

If you need more income and are unwilling to reduce spending, you’re going to have to take a bit more short-term risk with your portfolio. Either keep your bonds short-term and move into longer-term bonds when rates go up or move a larger percentage of your assets into equity growth.

Given today’s low interest rate environment, long-term investors have to adjust either their withdrawal rates or their portfolios. It’s one or the other.

Have you adjusted your withdrawal rates recently? How?

*Fidelity Investments

**Investment News