As a wise person once said, “If you think saving for retirement is hard, wait until you figure out how to take money out in retirement!” Yes, retirement withdrawal strategies are complicated and confusing for many reasons including:
- Tax issues
- Required Minimum Distribution (RMD) rules
- Social Security
- Un-known health care costs
- Potential for long term care costs
- Fear of outliving your money in retirement
- Not having the security of a regular paycheck.
These are just some of the issues and you could probably name twice as many, right? They all add up to one word: UNCERTAINTY. And in my opinion, if there is one thing humans dis-like, it’s un-certainty.
Therefore, you will probably need to take money out of your retirement savings. Note this is after you have considered retirement income floors like Social Security, pensions, and rental income.
Here are the three main approaches to withdrawing money from your retirement savings. There are many variations on each method, and each has its pros and cons. No one approach is right for everyone. You will need to find the right system for you, and I recommend you discuss this topic with your financial advisor.
Withdrawal Strategy #1: Living off dividends and interest
This approach uses dividends paid from stocks and interest paid from bonds to create your retirement cash flow. This method has the benefit of preserving your principal savings. Plus, it has a major psychological benefit because receiving regular payments from stocks and bonds is comforting. It feels like you’re replacing your paycheck.
Unfortunately, living off dividends and interest is not possible for most retirees. Most retirees would need a very large savings nest egg to produce income. For example, if you need $100,000 of retirement income, it will take savings of $2,500,000 generating 4% in interest and dividends to attain this amount. Plus, a portfolio structured to generate 4% of income may not be able to keep up with inflation and therefore your purchasing power will decline over time.
Thus, the idea of living off dividends and interest has many challenges, and most retirees will need another approach.
By far, this is the most common approach to receiving income from a retirement portfolio that we see. Using this method, you would withdraw a certain percentage of the portfolio each year. For example, you might start by withdrawing 3.5% of the value in year one and increase it in year two by an inflation factor. You would increase the withdrawal by the same % each year.
This total portfolio approach has several advantages. It’s simple, potentially keeps up with inflation, and is flexible.
However, the main challenge to the total portfolio distribution method occurs if your portfolio goes down in value. In this case, you may have less income and will need to reduce your spending. For example, if you have $1 million in savings and withdraw 3.5% in year one, you will have $35,000 for your living expenses. However, if your portfolio goes down by 20% in year two and you keep your withdrawal percentage at 3.5%, you will have only $28,000 for your living expenses. Or if you want to maintain the same dollar amount, you will withdraw 4.38% of the portfolio. This withdrawal percentage may not be sustainable, that is, you may outlive your money.
You must also take into account the potential for investment growth. If you have $1 million in savings and it grows by 20% in one year, will you maintain your withdrawal rate at 3.5% and remove $42,000 from the portfolio? Or will you lower your withdrawal rate to 2.92% to maintain a withdrawal amount of $35,000.
As with the previous strategy, this method may also be too rigid to be sustainable.
Withdrawal Strategy #3: Time Segments (aka a bucket approach)
In 2002, a Minneapolis-based CPA by the name of Paul Grangaard wrote a book titled “The Grangaard Strategy” and the bucket approach created a third approach withdrawing money in retirement. The basic idea of a time segment system is to segment your retirement assets into the time periods in which you will likely need them. Assets you will need sooner are invested more conservatively and assets you will need later are invested more aggressively.
For example, in the first ten years after you retire, you want your assets to be protected against a sudden downturn in value. Thus, the assets you need for the first ten years might be invested in short-term government bond funds. Assets you will need in years 11-20 (when you are potentially age 75 to 85), might be invested in a mix of bonds and stocks. And assets you will need for you in years 20+ (ages 85+) will be invested the most aggressively and be mostly invested in stocks.
The advantage of the bucket approach is it protects you from a large portfolio decline in the first ten years of retirement when your portfolio is most vulnerable to market declines. In addition, the time segment is easy to understand.
One disadvantage to the bucket approach is that it requires a relatively large portion of your investment portfolio to be invested in low-yielding and low or no growth bonds in the first ten years. It also requires you to divide your accounts into three segments – fixed income, slow growth, and maximum growth. If a large portion of your investment portfolio is in one or two accounts – for example, one or two large IRA’s – it can get confusing.
Figuring out the right retirement income withdrawal approach for you is not easy and it’s critical to get it right. There is no one perfect way to do this and therefore I strongly urge you to consult with a financial advisor who is an expert in retirement income planning.
Of course, if you’d like to speak with one of our financial advisors who are experts in this area, please click on the button to make an appointment on the website. We’d be happy to have a 30-minute free Get Acquainted discussion with you.