The precisely right withdrawal rate is elusive, but taking these steps can keep yours on track.
By Christine Benz | 10-10-17 | 05:00 AM | Email Article

The following is part of our 21 Days to Improve Your Financial Life special report.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

If you're investing money in the years leading up to retirement, your savings rate is the make-or-break number: Save too little too late and you'll be hard-pressed to make up ground with savvy investment selections.

When you're retired, your withdrawal rate is the equivalent make-or-break figure. Withdraw too much from your portfolio too early and you'll run the risk of liquidating your retirement assets prematurely. Once the damage is done--especially if those outsize withdrawals coincided with a lousy market environment--you may have few choices but to dramatically rein in spending.

The unsatisfying aspect of the whole thing is that as important as withdrawal rates are, it's impossible to say precisely how much any one retiree should be withdrawing. That's because the appropriate withdrawal amount will be dependent on how long the retiree lives and how the stock and bond market behaves over his or her retirement life cycle, both of which are impossible to predict. The retiree's own spending patterns are in the mix, too: Not every expense can be forecast to the penny. Big out-of-pocket healthcare bills, for example, might force a retiree to withdraw more from her portfolio than she has planned.

Given that, the best you can do is rely on market history and your best guess about your own longevity to help get your withdrawal rate in the right ballpark. As a guiding principle, it's wise to be conservative. Most retirees would rather take too modest withdrawals and end up with money left over than they would run the risk of coming up short.

Setting withdrawal rates is a crucial aspect of retirement planning, and we've written extensively on the topic for Morningstar.com; we've also conducted video interviews with experts such as Morningstar head of retirement research David Blanchett and financial planning guru Michael Kitces

As you formulate your own withdrawal rate strategy, here are the key steps to take.

Step 1: Assess income needs.
Start the process by projecting your annual income needs in retirement. If retirement is close at hand or you're already retired, you obviously have a good idea of what you'll spend in retirement. But if retirement is a few years off, you'll need to consider how your spending might change during your retirement. This article helps you arrive at an annual cash-flow need that factors in housing choices, lifestyle considerations, and changes in your healthcare outlays, among other factors. 

Step 2: Take stock of non-portfolio income sources.
Next, take stock of any income that you'll be able to rely on from nonportfolio sources: Social Security, a pension, an annuity, part-time work, or rental income, for example. If working in some capacity is part of your retirement plan, be realistic about how long you'll be able to work. (As retirement expert Mark Miller puts it, working longer is a worthy aspiration, but it's not a plan.)

Step 3: Arrive at an estimate of your planned withdrawal rate and assess its sustainability.
Armed with an estimate of your total cash-flow/income needs, as well as your expectation about income you'll receive from nonportfolio sources, you can subtract the latter from the former. The amount that's left over is what your portfolio will need to replace. Divide your planned portfolio withdrawal by your total portfolio value. That's your withdrawal rate.

A 4% initial withdrawal--with that amount receiving annual inflation adjustments thereafter--is often considered a "safe" starting withdrawal rate, assuming a portfolio that's at least 50% stocks and a 30-year time horizon. (This article takes a closer look at the 4% guideline.) If your withdrawal rate is in that ballpark, that's a good sign. However, if your portfolio is less than half equity and/or your time horizon could be longer than 30 years, you'll need to be more conservative than 4%. On the other hand, older retirees can reasonably take higher withdrawal amounts than 4%.

Step 4: Understand other systems for calculating and managing withdrawal rates.
Most retirees want to have a fairly stable stream of income in retirement, which is why the idea of taking 4% of a portfolio's starting balance--then inflation-adjusting that initial dollar amount thereafter--is appealing. A retiree's inflation-adjusted withdrawal would be steady from year to year.

But that's not the only way to calculate withdrawals. Some retirees may wish to tether their withdrawals to their portfolios' value, taking a roughly fixed percentage of the portfolio each year, regardless of balance. That's certainly sensible from the standpoint of portfolio sustainability, but it also has the potential to lead to big fluctuations in the retiree's paycheck. This article discusses how to make portfolio withdrawals market-sensitive without causing your cash flows to vary wildly. 

Of course, the classic method for taking cash out of a portfolio is simply to subsist on whatever income your portfolio kicks off: from dividend-paying equities, bonds, and other income-producing securities like REITs or preferreds. That has intuitive appeal, to be sure, but the strategy can also lead to variability in the retiree's cash flows. This article discusses the pros and cons of an income-focused strategy. 

Step 5: Determine whether to use income, rebalancing, or both, for living expenses.
Once you've arrived at your general approach to withdrawal rates, you need to determine the logistics of your withdrawals. Will you use your income distributions for living expenses, or will you employ a strict total return strategy, reinvesting income and using rebalancing to deliver cash flows? Alternatively, you could take a hybrid tack, using income distributions and rebalancing to meet cash-flow needs.

There's no single right answer, but I like the idea of maintaining a cash "bucket" alongside the portfolio's long-term holdings, then periodically refilling the cash bucket with income distributions and harvested capital gains. This article discusses the pros and cons of various approaches to extracting cash from a bucket portfolio. 

Step 6: Take tax efficiency into account.
Withdrawing from a single portfolio seems straightforward, but the reality is that you likely have multiple portfolios geared toward retirement--IRAs, company retirement plans, and taxable assets, to name some of the biggest categories. In that case, you need to sequence your withdrawals based on the tax treatment of your various pools of money. This article discusses sequencing withdrawals generally, and this one looks at how people can apply the bucket strategy to multiple retirement accounts.

Step 7: Revisit it periodically and adjust based on market conditions.
Finally, plan to revisit your withdrawal rate periodically, taking into account your portfolio's performance, its asset allocation, and your time horizon, among other factors. Blanchett has also found that retirees' spending tends to vary based on life stage; spending is higher in the early retirement years, might tend to level off in the midretirement years, then increases a bit later in life along with higher healthcare outlays. 

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