Rule of thumb may not be enough for retirement

Are you concerned about outliving your retirement portfolios?

That nest egg may have to fund a retirement lasting 30 years or more, which makes calculating a safe withdrawal rate very important. Withdraw too much and you risk running out of money early. Withdraw too little and you may deprive yourself unnecessarily of the retirement lifestyle you desire.

For decades, the rule of thumb has been to start by withdrawing 4 percent of your portfolio the first year of retirement, adjusting the percentage for inflation in the remaining years.

But in today’s economic environment, with low interest rates and looming health care costs, that may not be sustainable.

A sustainable withdrawal rate is the percentage that can be maintained throughout retirement with reasonable certainty of not running out of money, and varies for different individuals. With foresight, discipline and planning — the same virtues that allowed you to save for retirement in the first place — you can establish a withdrawal strategy that will help you enjoy a comfortable retirement.

Common Approaches

There are three common approaches to setting a withdrawal rate:

A fixed rate percentage, such as 4 percent, remains the same every year, except for inflation adjustments. This is the most common approach and is usually based on your expected lifespan, the portfolio’s rate of return and inflation.

A performance-based withdrawal rate may vary each year depending on how your portfolio performs. If the portfolio’s return exceeds the percentage withdrawn, you may decide to enjoy a larger percentage the next year. If it is less, you may reduce the percentage, which means spending less too.

An age-based withdrawal rate can work in one of two ways. Some investors withdraw more in their early retirement years to spend on an active lifestyle and travel. Others plan for the larger withdrawal rate in later years, anticipating high health care costs. Some also postpone tapping into their retirement account by accessing other forms of retirement income first, such as Social Security benefits.

Critical Assumptions

There are many factors to consider when determining your sustainable withdrawal rate:

Inflation — The cost of living will likely increase steadily throughout your retirement, possibly eroding the value of your savings. Therefore, it’s important to consider expected inflation when determining your withdrawal strategy. The annual inflation rate over the past 20 years averaged 2.44 percent and analysts expect inflation to hover between 2.0 and 2.5 percent over the next decade.

You may feel inclined to invest more conservatively to preserve cash during retirement, but it’s often wise to keep part of your portfolio in assets that have potential for higher returns, such as equities. These types of growth assets can help your portfolio keep pace with inflation.

Market volatility — Market ups and downs will affect not only the value of your portfolio but also the amount you withdraw. For example, if the market shrinks your $2 million portfolio to $1.5 million over the course of a year, a 4 percent withdrawal rate will mean substantially less to live on that second year. Be prepared for fluctuations.

Taxes — If you expect withdrawals to cover capital gains and ordinary income taxes, plan accordingly. Keep in mind that tax laws can change at any time. I can help you identify tax-minimizing withdrawal strategies.

Expected longevity — Prepare for a withdrawal rate that will allow your portfolio to last throughout your lifetime and, if applicable, your spouse’s. We can look at life expectancy tables and your family history to serve as guides.

Lifestyle — Be realistic about what your withdrawals will need to cover: your living expenses, gifts you want to make and any extras you want to enjoy.

Plan for the Future

The reality is that no one knows what your future holds. Consulting with a financial adviser can help you evaluate the unknown factors and develop strategies, including your withdrawal rate, to optimize your retirement income.

Erin Eddins is a chartered financial consultant, a member of the Financial Planning Association and is a certified financial planner with StanCorp Investment Advisers Inc. She can be reached at erin.eddins@standard.com or 425-212-5986.