In retirement planning you need to understand the answer to the question, "How much can I withdraw from my retirement funds without depleting the account during my lifetime?"
There are two primary strategies for withdrawing income from investments. The first is the income-only strategy. The most commonly used strategy is to live on investment interest and dividend income only. It's the "I will never touch my principal" approach. However, with the interest rates on bonds and CDs near 45-year lows and high-quality, dividend-paying stocks yielding approximately 3%, this may not produce the income needed during your retirement. It also leaves you at the mercy of ever-changing interest rates.
The other withdrawal approach is the total return strategy, which includes systematic or periodic distributions of a portion of your capital appreciation in addition to interest and dividend income. With this approach, the investor aims to generate an inflation-adjusted total rate of return for the portfolio that is greater than their withdrawal rate. The withdrawal rate is simply the amount of dollars withdrawn from the portfolio in a year divided by the portfolio balance at the beginning of the year. For example, if your beginning investment account balance is $1 million and you withdraw $50,000 during the year, your withdrawal rate is 5%. From a retirement planning standpoint, the initial withdrawal rate, in this case $50,000, becomes the minimum annual distribution. As the account value grows over time, larger annual distributions are taken if needed
Let's look at an example showing the effect of variability in returns for three scenarios. In each scenario, we will begin with an initial investment amount of $1 million. We will assume that our investments earn an average rate of return of 8%, so we have decided to withdraw $80,000 per year for our living expenses each year for the next 10 years. In Scenario 1, we will assume we earn 8% each year. In Scenario 2, we will assume a range of returns averaging 8% with the best returns coming first. In Scenario 3, we will reverse the order of the Scenario 2 returns so that the worst returns come first, while still averaging 8% over the 10-year period.
In Scenario 1, your earnings and withdrawal rates are the same, thus maintaining the original value of your investment. In Scenario 2, we have assumed a range of returns with the best returns coming first. At the end of the 10th period, we have withdrawn the same $80,000 per year, but in this case, our portfolio has gained $184,135 in value. In Scenario 3, we reversed the assumed returns of Scenario 2 so that the worst returns came first. This time the results are quite negative, resulting in the depletion of your account.
The bottom line:
A withdrawal rate equal to the average rate of return cannot be relied on to ensure success. You must monitor changing portfolio values along with current and future projected portfolio withdrawals.
Stewart H. Welch III, founder of The Welch Group, has been rated one of the nation's top financial advisors by Money and Worth. He welcomes questions or comments from readers at 800-709-7100 or www.welchgroup.com. Reprinted with permission from the Birmingham Post Herald. My thanks to Hugh Smith, CPA, CFPÂ®, for his substantial assistance with the preparation of this article. Mr. Smith is a senior financial advisor with The Welch Group, LLC.