How much of my retirement savings can I spend every year after I retire?
“How much should I save to have a comfortable retirement?” – This is one of the biggest questions that perplexes individuals when it comes to retirement planning. Depending on the time you retire, retirement can last for 25 years or more. You need to ensure that you do not run out of money in retirement, else you may be in big trouble. As such, you need to prudently plan your finances and your annual withdrawals from your retirement portfolio to maintain your desired lifestyle.
The general rule of thumb is to withdraw 4% of your savings during the first year of retirement and then increase the withdrawals as per inflation. So, if you have a portfolio valued at $1 million, you can withdraw $40,000 during the first year. This amount increases in line with inflation. As such, if the inflation is 2%, then the withdrawal during the 2nd year would be $40,800 and so on. However, this strategy has its own risks and depending on your personal situation, you should determine this drawdown rate, rather than going by the general rule.
An important factor to consider when determining the withdrawal rate is the number of years into retirement. The longer the retirement period, the lower would be the withdrawal rate. As an example, if you plan to work longer and retire at the age of 70, your retirement period would be lower and thus you can have a higher withdrawal rate of 4.9%. On the other hand, if you plan to retire early at 60 years, the retirement period would be longer, and your withdrawal rate would be lower at 4.3%.
Source: Fidelity Viewpoints
Your withdrawal rate would also depend on the value of your savings at the start of your retirement. So, if you have a portfolio of $1 million, your withdrawal rate would be lower than the withdrawal rate associated with a portfolio of only $400,000. If you estimate that you need $25,000 to fund your first year into retirement, the withdrawal rate for the $1 million portfolio would be 2.50% while it would be 6.25% for the portfolio of $400,000.
The higher withdrawal rate of 6.25% also suggests that you may run out of money faster with the $400,000 portfolio. This rate of 6.25% suggests that your savings can suffice for only 16 years of retirement. On the other hand, the withdrawal rate of 2.50% suggests that your savings can fund 40 years of retirement. Thus, the probability of running out of money is much lower with this lower withdrawal rate. The withdrawal rate is basically a function of both the value of savings and years into retirement.
Withdrawal rate is also influenced by the composition of the retirement portfolios. Historically, equity-oriented portfolios have generated better returns in capital appreciation than the conservative portfolios, which are heavily invested in bonds and cash. Growth-oriented portfolios are generally characterized with lower withdrawal rates and you should aim to synchronize your withdrawal rate with the growth prospects of your portfolio.
Check out this handy calculator too, from Money Chimp. Please consult our Certified Financial Planners for advice on this and more.
Priyanka Goel, CFA