Many financial advisors quote research that indicates a 2.8% to 5% yearly drawdown is likely to preserve portfolio assets over a long retirement. The initial withdrawal rate is followed by increases to match inflation. A 4% withdrawal rate, for example, is estimated to have about a 90% chance of lasting 25 years. The question is, would you get on an airplane that has a 90% chance of arriving safely at its destination? If the answer is no, you may want to consider 3½% or 3% as an acceptable withdrawal rate.
If 4% seems too low or too conservative, take a look at our “sequence of returns” analysis. As assets are systematically withdrawn from an investment account with inflation, they tend to deplete faster that what is intuitive especially in the later years. (Refer to “How Long Will My Retirement Assets Last?” below).
Let’s see how our options compare with the help of two imaginary retirees.
Bill retires at 65 with $1.0 million in his retirement account. In Year One, he takes out his 4% which is $40,000. Bill boosts his withdrawal each year by the inflation rate. It is likely that he will be able to do so for about 25 years without running out of money, depending on the performance of his portfolio assets. (Again, refer to “How Long Will My Retirement Assets Last?”).
Jim also retires at 65 having saved $1.0 million, but he’s got a few more expenses and wants to spend more than $40,000 a year. Jim chooses to put his money into an indexed annuity which guarantees him income for the rest of his life – however long that may be.
An indexed annuity payment on $1.0 million for a man Jim's age would be about $4,723 a month. That's $56,680 a year, or about 5.6% of his $1.0 million nest egg. (Review your personalized Indexed Annuity Illustration. Yours may show different results. If you don't have an illustration, contact us).
Which retiree took the better approach? Certainly $56,680 a year is better than $40,000 and the lifelong guarantee is very reassuring for Jim. What’s more, the additional yearly cash flow will allow Jim to defer Social Security until he reaches 70 providing a larger benefit for himself and his spouse.
Nevertheless, Bill has more control over his finances. He can take more or less than the scheduled amount from his retirement account each year depending on his personal needs and investment performance. If he chooses, he can access larger sums from his account as well.
If Bill sticks with his plan, his withdrawals will keep pace with inflation. If inflation is 3% a year, his yearly withdrawal will top Bill's $56,680 payout in about 13 years at age 76. (Once again, refer to “How Long Will My Retirement Assets Last?”).
Going forward, Bill will have more cash flow than Jim when they are elderly which can come in handy if long-term care is needed. However, should the retirees live longer, Bill may start to worry that his nest egg will be depleted. Watching his account value get closer and closer to $0 could be a significant source of anxiety.
Bill's 4% solution offers access to capital and income growth potential, but it lacks guarantees. Poor portfolio decisions or untimely bear markets could force him to reduce annual withdrawals or even run out of money in the later stage of his life.
Best of Both Worlds
Both Bill and Jim chose approaches with distinct strengths and weaknesses.
Fortunately, we are not locked in to one path or the other like our hypothetical retirees. By choosing to combine an indexed annuity with lifetime income and a diversified portfolio of stocks, bonds and real estate applying the 4% approach, you can maintain flexibility and have an income stream guaranteed for life.
To compare all three models: 1) Annuity Only, 2) Portfolio Only, and 3) Hybrid of the both models, refer to the attached Excel Annuity-Portfolio-Hybrid-Analysis-Spreadsheet.
Call Charles Farrell at 888.657.3847 if you have any questions.
The above is a hypothetical example provided for illustrative purposes.