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The ultimate retirement-distribution strategy is here

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With several years of retirement under my belt, I’m more confident than ever about the truth of something I wrote some time ago: The ultimate financial luxury for a retiree is simple: Having more than enough money to meet your needs.

It’s not necessarily easy to achieve, but when you’re retired, having a comfortable margin of extra savings is about as good as it gets. Let’s look at some numbers to see what I mean.

Last week, I wrote about taking fixed distributions in retirement, a discussion built on the assumption that you will need all the retirement income you can get without taking the risk that you could run out of money.

Today I want to explore a variation on that theme: How much can you take out if you start your retirement with significantly more savings than you really need?

Making it work

If you have more than you need, I believe you should be able to function comfortably with retirement distributions that go up and down to reflect the returns on your investments.

I’m going to show you a flexible distribution plan that adjusts your cash flow from year to year as the value of your portfolio goes up and down. In doing that, this plan automatically does something that most smart retirees would naturally want to do if they could: Take out more money after good years and scale back their spending when their investments are struggling.

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

The ups and downs of investing

The very first column I wrote here at MarketWatch was called “How to double your retirement income in five years.” It had a very high readership, and it’s very relevant to the current discussion.

As we go through this topic, it will help if you follow along while looking at some tables of historical returns and hypothetical flexible withdrawals.

These tables show what could have happened to somebody who retired in 1970 with a $1 million portfolio. I’d like to start with Table 7, which is based on the assumption that at the start of every year, a retiree takes out 5% of the portfolio’s value from the end of the prior year.

This table shows several investment allocations, varying from 40% stocks and 60% bonds up to 100% global stocks. For comparison, I’ve also included the S&P 500 Index.

You will see that, after 46 years, none of these portfolios was anywhere near the danger zone of running out of money as 2015 came to a close.

The true cost

But our imaginary investor paid a price for this. If you study the top figures in 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.

With the benefit of hindsight, we can see that everything worked out well after 1975. But back then, our hypothetical retiree had no way to know that. Would any intelligent retiree knowingly embark on a withdrawal plan like this?

In fact, this plan could make a lot of sense to a retiree who had over-saved. Imagine that you had $1.5 million in your portfolio (instead of “only” $1 million) and your needs did not exceed $50,000. You could then multiply each of the withdrawals in the table by 1.5. In 1970 you would take out $75,000 instead of $50,000. What a nice kickoff.

At the low point (1975), you would have withdrawn $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.

How it gets better

For the retiree with ample savings, things get even better. That’s because this person most likely could afford to take out 6% instead of 5%. You can see the results of this in Table 8. Table 8 shows that the lowest distribution, in 1975, of the 60% equity allocation was $49,466, just barely below this retiree’s assumed cost of living of $50,000 five years earlier.

But for a retiree who started with $1.5 million and took out 6%, we can multiply all the distributions in Table 8 by 1.5. That brings the 1975 distribution to $74,199, well above this retiree’s $50,000 basic needs even after adjusting for inflation.

The next dozen years were even kinder to the retiree who could afford to take out 1.5 times the figures in Table 8: $123,918 in 1980; $173,077 in 1985; and $306,655 in 1990.

If you carefully compare the 60% equity column in Table 7 (5% withdrawals) and Table 8 (6% withdrawals), 1you may notice something interesting in the withdrawal amounts in the year 1990.

At a rate of 5%, our retiree gets to spend $210,478 in 1990; at a 6% withdrawal rate, the comparable amount is only $204,396. Can that be right?

Less is more

In fact, it is quite correct, an example of how “less” can eventually become “more.”

Here’s why: 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 follow the numbers in the tables out another 10 years, to the year 2000, the 6% table gives our retiree $246,217; in the 5% table, he gets to spend $281,844.

Is this a bad deal for the retiree taking money out at 6%? 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. Each of the withdrawal figures I just cited would cover that need.

More to my point here, the person who had started retirement with $1.5 million could multiply either of those figures by 1.5, providing 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.

What if you’re frugal?

I have known many retirees who are very conservative and who don’t want to take out even 5% of their money if it’s not essential.

Table 5 and Table 6, respectively, show the result of taking out only 3% and 4%.

In both of these tables, you see the first decade provided fairly low distributions. But after 20 years, the distributions become significantly larger than the corresponding ones from the 5% withdrawal schedule. Here, “less” eventually becomes “more.”

At the bottom of the tables, the values at the end of 2015 are also significantly greater when withdrawals are 3% or 4%.

There are some important trade-offs, of course. It’s great to have big payouts in your later retirement years and lots of assets to leave in your will. But in real life, most retirees want to spend more money in the early years of retirement when their health is likely to be better.

More than anything else, I think this analysis emphasizes the value of saving more than you think you will need. And it underscores the value of thinking carefully ahead of time about your priorities as you plan for retirement.

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.

You now have the recipe for what I think of as the ultimate retirement luxury.

For a more detailed discussion of how to use these tables to find the right withdrawal strategy for you, check out my podcast, “The ultimate retirement distribution strategy”.

Richard Buck contributed to this article.