Most of us have to worry about outlivingour nest eggs. We can do several things inour early years to avoid this outcome,but once we retire, few options remain.Thus, it's important that we're aware of two postretirementoptions: making reasonable annual withdrawalsand avoiding the ravages of reverse dollarcost averaging (RDCA).
You've probably heard the rule that says youshould not withdraw more than 4% to 5% of yournest egg annually. What does this popular rule ofthumb mean? It means that if you retire with a $1-millionnest egg and expect to earn a real (ie, inflationadjusted)return of 5% per year, then you can withdraw$50,000 pretax every year.
So, if the inflation rate is 3% per year, you will beable to withdraw $50,000 the first year, 3% more the2nd year, 3% more the 3rd year, and so on. Also, atthe time of your death, your portfolio will still containthe original $1 million in real terms. Remember, yourannual withdrawal is a pretax number on which youhave to pay taxes.
The actual return you earn on your portfolio equalsthe real return plus the rate of inflation. Because youwithdraw only the real return, your principal grows atthe rate of inflation. So you are effectively not touchingthe principal. Even if you are willing to use up all of yournest egg and not leave anything behind, you still cannotsafely withdraw much more per year unless you assumethat you're going to die fairly early in retirement.
Rule of thumb:
If you think you will only be able to earn a 4% realreturn per year, which may be more realistic over the next20 to 30 years, then you can safely withdraw only$40,000. This rule for annual withdrawals also gives youan idea of how much you will have to accumulate by thetime you retire to support your lifestyle. You need $1 million in savings for every $40,000 of realpretax annual income you want.
There is one thing that will almost certainly happento your portfolio during retirement no matter howmuch you have saved. If the market provides an averagereal return of 4% per year, your portfolio will earna much smaller average return due to the effects ofRDCA, unless you specifically manage your withdrawalsto mitigate this effect.
What is RDCA? Stock market returns do not comein a constant stream; they vary widely year to year. If yourun into a bear market in the early years of retirementand keep selling stocks during those years, by the timethe market turns around and provides higher returns,you will have much less money invested in the stocks.The return you earn on a portfolio invested instocks and bonds from which you steadily withdrawmoney will be less, often as much as 50% less, than theaverage market return.
The only way to mitigate the ravages of RDCA thatI know of is to start retirement with a good part of yourportfolio in safe fixed-income investments. Then, duringdown-market years, withdraw money entirely from thefixed-income part; in normal years, sell a mix of stocksand bonds; and in good years, sell enough stocks tocover the current year's expenses and replenish the fixedincomeholdings. I call this opportunistic selling.
For many reasons, this is not something mostinvestors can do on their own; unfortunately, mostinvestment advisors aren't aware of the RDCA problemand how to handle it correctly. But this is a seriousproblem that you must address in your planning and beprepared to handle during your golden years to ensurea comfortable retirement.
author of The Only Proven
Road to Investment Success (John Wiley; 2001)
and Financial Modeling Using Excel and VBA
(John Wiley; 2004), currently teaches finance at
the Fordham University Graduate School of
Business and consults with individuals on financial
planning and investment management. He welcomes
questions or comments at email@example.com.