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What Withdrawal Rate?

AS BOND YIELDS have fallen in recent decades and stock market valuations have climbed, some experts have suggested that the standard 4% portfolio withdrawal rate may be too high—and that retirees who spend that much risk running out of money.

A refresher: The 4% rule assumes retirees withdraw that portion of their nest egg’s value in the first year of retirement. Any dividends and interest payments that are spent count toward the 4%. After the first year, retirees are assumed to step up the annual dollar amount they withdraw along with inflation.

For instance, if you retired with $600,000, you would withdraw 4% of that sum—or $24,000—in the first year of retirement. If inflation was climbing 2% annually, you’d increase the amount withdrawn to $24,480 in year two, $24,970 in year three and so on. A famous 1994 study found that, based on historical returns, those who pursued this strategy over a 30-year retirement wouldn’t run out of money.

But what if returns are worse than history suggests, because today’s valuations are so rich? That’s prompted some experts to argue that today’s safe withdrawal rate may be just 2% or 3%, and perhaps less. If true, this is hard to stomach: Imagine you scrimped and saved to amass a $1 million nest egg, only to be told you could withdraw just $20,000 or $30,000 in your first year of retirement.

Before you get discouraged, however, ponder this: Perhaps, in wrangling over the right withdrawal rate, we’re seeking to solve the wrong problem. The underlying assumption is that retirees would robotically increase their annual portfolio withdrawals along with inflation, no matter how bad things get in the financial markets. This is a dubious assumption: If faced with a 50% drop in share prices, most folks would instinctively cut back their spending—and rightly so.

Indeed, you might adopt a strategy that forces you to spend less during rotten markets. One simple approach: Each year, withdraw just 4% or 5% of your portfolio’s beginning-of-year balance. That way, you’d never run out of money, because you’re always withdrawing a fixed percentage of whatever remains—and you’re compelled to spend less if your portfolio’s value fell over the prior year.

An alternative strategy: Once you reach age 70, you might base your annual withdrawals from your entire portfolio on the IRS table that’s most commonly used for required minimum distributions from retirement accounts. This approach, which adjusts withdrawals based on both your portfolio’s value and your shrinking life expectancy, was endorsed by a 2017 study.

Let’s say you’re age 77 and you finished the previous year with $600,000 in your taxable and retirement accounts combined. The IRS table puts your “distribution period” at 21.2. You would divide your $600,000 by 21.2. That means you could withdraw $28,300 that year, equal to 4.7% of your portfolio’s value. In the years that follow, the percentage withdrawal rate increases as your life expectancy shortens—but you would be compelled to withdraw less in dollar terms if your portfolio shrank over the prior year.

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