Do a quick search on the Internet, and you'll find dozens of calculators that show how much you need to save for retirement. But most of them don't tell you how much you can safely withdraw each year once you do retire so that you don't outlive your money.
In many ways, it's a knottier problem than saving for retirement. Younger savers have time to make corrections and adjust for underinvestment or disappointing returns. Those who are living off their accumulated wealth have less flexibility to make up for bad financial decision-making.
For starters, financial advisers generally recommend you don't take more than 5% of your stash the first year after you retire. You want to keep as much invested as possible. The power of compounding means your earnings in your first years of withdrawal have a far bigger impact than those in your later years.
Use that number merely as the starting point. The amount of money you withdraw annually would depend not only on how much you've saved but also on your lifestyle, inflation, and of course, the earnings on the untouched portion of your money.
Consider the question of how much income you'll need. In the past, you might have been told to aim for a retirement income equal to 70% of what you earned while working. That assumption doesn't necessarily hold true for more active retirees. It certainly doesn't apply to Margaret Schaefer, a retired fifth-grade teacher in Dearborn, Mich. Like many other retirees, Schaefer, 64, has stepped up her traveling--and that has boosted her overall spending.
Whether you can maintain your lifestyle depends on inflation as well as your investment earnings. To see how much havoc inflation can wreak, consider someone with a $500,000 retirement kitty who withdraws $25,000 a year. If inflation averages 4% a year, that $25,000 will have the buying power of $11,050 in 20 years.
You can adjust for inflation by increasing the amount you withdraw by 4% or so each year. If you're earning healthy returns on your investment--say, 10% a year--you can do this and still count on having something in the bank 35 years from now. For example, a retiree with $500,000 in a fund that earns 10% a year can withdraw 5%, or $25,000, the first year and increase that amount by 4% annually and still have $1.4 million saved by year 20. But if the account earns just 5% a year, he may have to refrain from giving himself a yearly inflation increase so his nest egg lasts longer. Otherwise, after 20 years, he'll have only $113,000 in his account (table).
The stock market's unpredictability makes calculations more difficult. A few years ago, it seemed reasonable to assume stocks would deliver at least a 10% annual total return. That doesn't seem so reasonable anymore. If bond yields were in the high single-digits, that would take up some of the slack. But with the 30-year U.S. Treasury bond at 5.4%, there's little comfort there, either.
If your retirement fund takes a big loss at the start of your withdrawal period, the effects are devastating and long-lasting. Let's say your $500,000 investment portfolio suffers a 35% loss in your first year of retirement and then earns 11.5% for the next 29 years. If you withdraw 5% in the first year and increase the amount by 4% annually, your bank balance will be zero at the end of 30 years. But if the market takes the hit in year 5, you'll end the 30-year period with $870,000.
So what's a retiree to do? Apart from taking a hard look at your spending, keep a cash reserve. Tap that first if the stock market slides in your early retirement years. That way, you conserve your investment. "That's your ultimate safety net," says Malcolm Makin, a financial planner in Westerly, R.I., who recommends holding a year's worth of living expenses in reserve.
Another strategy is to take a fixed percentage of your assets each year, rather than a fixed amount. That's what William Bernstein, an investment adviser in Coos Bay, Ore., and author of The Four Pillars of Investing (McGraw-Hill, $27.95), recommends to his clients. Using this approach, you'll never outlive your money. There is a drawback, however: Your income can fluctuate sharply from year to year, depending on the value of your investments. Consider a retiree who started in 1995 with $500,000 in the Standard & Poor's 500-stock index and withdrew 5% of his account a year. Withdrawals would have dropped from $71,000 in 1999 to $52,000 in 2001.
Finally, go with occasional inflation adjustments, rather than annual ones. Adjusting annually for changes in the consumer price index could make you withdraw more than you need, depleting your savings sooner. The CPI tends to overstate inflation by about 1% a year, says Philip Cooley, a business professor at Trinity University in San Antonio. Over 30 years, that adds up to real money. And that's what you need to fund your retirement.
By John Waggoner
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