The ultimate retirement withdrawal strategy

Reprinted courtesy of marketwatch.com.

To read the original article click here

What’s the greatest financial luxury that a retiree can have? All the money in the world? No. More money than Bill Gates? Not that either. In my view, the answer is much more attainable: Having more than enough money to meet your needs.

I know that sounds really simple, and in one sense it is. But let me tell you how it plays out. My columnlast week outlined several scenarios for determining how much money to withdraw from your portfolio when you’re retired. They were all based on the premise that you need all you can get without taking the risk of running out of money.

But if you have saved more than you need (or to put it another way, if you can live below your means), you should be able to tolerate a stream of cash flow that goes up and down with the waning and waxing of your investments. I call this a “flexible” withdrawal plan.

Let me show you why I think this is a luxury. A flexible distribution is one that varies from year to year, based not on inflation but according to the value of your portfolio. It automatically does something that most smart retirees would naturally want to do if they could. That is to take out more money after good years and scale back when their investments are struggling.

When your investments are doing well, this is a wonderful plan. But in bad times, it can be tough.

A historical table of numbers gives you an example of what would have happened to somebody who retired in 1970 with a $1 million portfolio. The table is based on the assumption that 5% of the portfolio was withdrawn at the start of every year, based on the prior year-end value.

Several allocations are shown, all the way from 40% stocks and 60% bonds up to 100% global stocks, and with the Standard & Poor’s 500 IndexSPX -0.24%  included for comparison. The returns that were used to generate this table are from the big table referred to in my column, “Fine-tuning retirement portfolio allocations”.

You will see that, after 43 years, none of these portfolios was anywhere near the danger zone of running out of money as 2012 came to a close.

But our imaginary investor paid a price for this. If you follow the distribution column for the 60% equity portfolio, you’ll see that the newly minted retiree had to get by with sharply fluctuating income for a few years. The low point, 1975, provided only $43,461 that year, a significant drop from the initial $50,000. If you really needed $50,000 to cover your cost of living, this had to hurt.

We can see now that everything worked out well after 1975. But at the time, our hypothetical retiree had no way to know that.

Would any intelligent retiree knowingly embark on a withdrawal plan like this?

Yes, I think this plan could make great sense to a retiree who had over-saved. Imagine that you had $1.5 million in your portfolio and your needs didn’t exceed $50,000. You could then multiply each of the withdrawals by 1.5. In 1970 you would take out $75,000 instead of $50,000. What a nice kickoff!

At the low point, you would have $65,191 instead of only $43,461. Assuming you kept your cost of living under control, that would be well above your basic needs.

After that, your withdrawals would have risen handsomely: $114,792 in 1980; $169,042 in 1985; and $315,780 in 1990.

And it gets even better than that for the retiree who has saved more than enough, because I think this person could afford to take out 6% instead of 5%. On my website is another table that shows the results of this.

In the column showing the same 60% equity allocation, the 1975 low distribution was $49,466, just barely below this retiree’s assumed cost of living of $50,000.

But a retiree who started with $1.5 million and took out 6%, the low point was $74,199, well above the $50,000 basic needs even after adjusting for inflation.

And the next dozen years were even kinder: $123,918 in 1980; $173,077 in 1985; and $306,655 in 1990.

If you’re paying strict attention, you might have noticed that the 1990 figure of $306,655 (for a 6% withdrawal rate) is actually smaller than the figure for the 5% withdrawal rate, $315,780. What gives?

This relatively small difference results from the cumulative effect of the higher withdrawal rate. Taking out more (6% in this case instead of 5%) ultimately leaves you with less. If we calculate the numbers in the tables out another 10 years, to 2000, the $1.5 million saver taking out 6% gets $369,058, while the one taking out 5% gets $422,460.

Is this a bad deal for the retiree taking money out at the higher rate? I don’t think so, and I’ll tell you why. Because of inflation, a retiree would have needed $224,026 in the year 2000 in order to replace $50,000 of spending in 1970 dollars. Whether the retiree had $422,460 or “only” $369,058, he had a very ample cushion above his inflation-adjusted basic needs.

In addition, the higher withdrawal rate that was made possible because of ample savings provided significantly higher withdrawals for the first 10 years of retirement. Those are the very years when many retirees are most likely to want to travel and follow other potentially expensive pursuits.

More than anything else, this analysis emphasizes the value of saving more than you think you will need. For a more detailed discussion of how to use these tables to find the right withdrawal strategy for you, check out my recent podcast on this topic.

If you can retire with more than enough money to meet your basic needs — enough to follow this flexible plan — then you will be in great financial shape. It’s worth a bit of extra savings when you’re working. It’s worth working a little longer if you can. And it’s worth keeping your cost of living under control.

This is the ultimate retirement luxury.

Richard Buck contributed to this article.