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Reversing the Flow – Withdrawal Strategies for Your Retirement

One of the biggest shocks that folks often experience is when they make the transition from “accumulation” to “decumulation”.  Suddenly the monthly habit of saving and putting money away becomes one of pulling money OUT of the accounts.  Those balances that you have watched for years and have given you the sense of security now are heading the WRONG way.  To make it even worse, you don’t have a paycheck or income any more.  It’s quite uncomfortable.

Don’t panic, the feelings are normal and to be expected – it’s a big change from savings to spending.

Rule #9 – You need to have a withdrawal strategy PRIOR to retiring and starting withdrawals.

It is absolutely critical that you develop your strategy BEFORE retirement.  In so doing you’ll

  • Know how much your “retirement paycheck” will be.
  • Avoid withdrawing too much OR too little from your hard earned saving

There are several strategies available that are normally recommended:

  • The 4 percent rule.  Perhaps the most common approach – although not without its critics — is to withdrawal 4% of your ORIGINAL principle and allow for annual adjustments for inflation.
    • If you start with $500,000 you would withdrawal 4% * $500,000 or $20K the first year.  If inflation went up by 2% this year, you’d withdrawal $20,000 * 1.02 or $20,400 in the second year.
    • The general consensus is that this strategy is relatively safe if you’re looking to withdrawals to last for thirty years.  However, there are certain situations that make this static strategy dangerous.  The biggest of these risks is that a significant downturn in the market in the early years of your retirement will cause your portfolio to be depleted prior to the targeted 30 year time frame.
  • The “one over N” rule.  Here you look at how long you want your portfolio to last (think the number of years until you depart this dear earth), divide your portfolio by that number and withdrawal that amount each year.  So if you start with 30, you’d withdrawal 1/30 the first year, 1/29 the second year, and so on.  The beauty here is that at any time you can revise your number to allow your portfolio to last the targeted number of years.
    • While this method works well for the “early” years of retirement / when you have 20 – 30 years of targeted withdrawals, it becomes significantly more risky when you get to the later stages of retirement – withdrawal 1/10th of your portfolio the same year the market is down by 20% and your next year’s withdrawal goes down dramatically!
    • If you always “slide-out” your expected number by one, you can use this method to never “run out” of money.
    • If you chose to always assume that you’ll live 25 more years, your withdrawal rate becomes the same 4% as in the previous rule (albeit without inflation adjustment).
  • Dynamic withdrawal rules.  These strategies involve changing the withdrawal rate based on some set of rules.  There’s multiple ways that you can implement  a “dynamic” strategy; and, in most cases, it is probably the most prudent approach.  A few thoughts on how to implement one such a strategy:
    • Start with a reasonable rate – 4% for a 30 year time frame is a good starting point – and determine your withdrawal rate.  For arguments sake, let’s say this is $40,000 or % of a $1,000,000 portfolio.
    • Determine the next year’s withdrawal rate by adjusting for inflation (i.e. if inflation was 5% you get $40,000 * 1.05 = $42,000.
    • Now adjust your withdrawal rate up or down if things go REALLY well or REALLY poorly:
      • For example if portfolio value went up by more than 15%, you could adjust your withdrawal amount upwards by 5% (i.e. $42,000 * 1.05 = $44,100).
      • Conversely if the if portfolio value went down by more than 15%, you could adjust your withdrawal amount downward 10% (i.e. $42,000 * 0.95% = $37,800).
      • You can think of the adjustments as either a “pay cut” or “pay raise” if your portfolio did really poorly or really well – which is what you would “expect” to do in bad times or good times respectively.  Notice that we take bigger pay cuts than we do raises – that’s because “the company” (e.g. our portfolio) doesn’t have a white knight in waiting to bail it out if we go bankrupt!  These adjustments normally protect you from either under-withdrawing (also known as under living) or over-withdrawing from your portfolio.
    • Finally these strategies will often perform one last check to ensure that in “disaster scenarios” (i.e. the market has been down for multiple consecutive years) you’re not withdrawing too much.  One possible strategy.
      • Determine the number of years that you need your portfolio to last.  Call that “N”.
      • Take your portfolio value and divide it by the new withdrawal amount.  Let’s call that number “n” (say “little n” as it’s the number of years our portfolio would last if we took the current withdrawal rate from a cash account).
      • Take the difference between these two values “N-n”.  That represents the number of years you are “short”.  Call this value “S”
      • Now make an adjustment in your withdrawal rate depending on how big “S” is relative to “N” – in other words, how many years short you are relative to the time you need your portfolio to last:
      • If 20 < N < 30 and S > 5, set your withdrawal rate at a maximum of 5% of your remaining portfolio.  Put another way, if things have gotten so bad that your withdrawal rate has you “five years short”, cap your withdrawal rate at 5% if you expect to need your funds for more than 20 years.
      • If 10 < N < 20 and S > 4, set your withdrawal rate at a maximum of 7.5 % of your remaining portfolio.  Put another way, if things have gotten so bad that your withdrawal rate has you “four years short”, cap your withdrawal rate at 7.5% if you expect to need your funds for between 10 and 20 years.
      • If 1 < N < 10 and S > 3, set your withdrawal rate at a maximum of 10% of your remaining portfolio.  Put another way, if things have gotten so bad that your withdrawal rate has you “three years short”, cap your withdrawal rate at 10% if you expect to need your funds for between 1 and 10 years.  Notice in this last case we essentially change to the 1/n strategy with an assumption that we’ll live at least ten years more.
      • Applying the above “disaster scenario” check will “dial back” your withdrawals and ensure that you won’t run out of funds – although you may see a significant pay cut if you encounter a dramatic market downturn early in the withdrawal phase AND if you live beyond your expand you l

There are literally tens of thousands of pages of writing on withdrawal strategies.  In this article we have highlighted several of the more common.  The key points are:

  • You need to recognize that the withdrawal phase is different than the accumulation phase.
  • You need to recognize that errors are much more costly in this phase; and, accordingly, you need to fully understand and execute a well-defined plan.
  • There’s a non-trivial probability that things could go badly during the withdrawal phase.  If this takes place, you would be well advised to have a strategy in place that “dials back” withdrawals sooner rather than later.

ACTION ITEM:  Take the time to re-read this article.  Think about how you’ll feel if you no longer had an income / if any income you had was not sufficient to cover your expenses / if you had to withdraw from your savings.  Now work through each of the above strategies and see what a potential 30 year retirement might look like under various market performance scenarios.  If you cannot perform these above tasks, you would likely benefit from sitting down with a financial planning professional and having him/her help you to craft a strategy that allows you to sleep at night.


[author] [author_image timthumb=’on’]×300.jpg[/author_image] [author_info]F5 Financial Planning, L.L.C. (F5FP) is a comprehensive, fee-only, financial planning firm serving Naperville and surrounding communities.

Led by Curt Stowers, F5FP focuses on providing corporate executives, entrepreneurs, and families with comprehensive financial planning that leads to financial security, simplicity, and success. As an executive with Caterpillar for 18 years, Curt brings real, practical experience to financial planning. Curt has successfully passed the examination to be awarded the CERTIFIED FINANCIAL PLANNER™ credential.[/author_info] [/author]

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Curt Stowers

Curt Stowers

Curtis Stowers helps individuals and families across the United States grow their financial assets, particularly in the Naperville, IL region. He is a Certified Financial Planner, holds a Ph.D. in Industrial Engineering from the University of Illinois, and is the founder of F5 Financial.