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Morningstar.com's Interactive Classroom

Course 310
How to Withdraw from Your Portfolio in Retirement

Introduction

Imagine if you could draw your final breath at the same time you spent your last dollar. Okay, so maybe you don't want to contemplate exhausting either one. But giving it some thought is a darn sight better than running out of money before you run out of time.

There are a host of factors involved in figuring out a safe rate for drawing down your nest egg and for calculating how much you can spend in retirement. This course and the accompanying worksheet will guide you through the process.

Download and print Morningstar's Income Worksheet for Retirees at http://news.morningstar.com/pdfs/Income_Worksheet_Retire.pdf. (Note: The worksheet is available as a PDF file. You will need Adobe Acrobat Reader to view and print it.)

Find Your Asset Mix, Time Horizon

The right mix of stocks, bonds, and cash is going to depend upon how sure you want to be that your money doesn't run out prematurely.

On the worksheet, circle which asset mix comes closest to your current allocation.

Your time horizon is how long you expect to draw on your portfolio. In other words, it's how long you expect to live once you retire.

Keep in mind that Americans are living longer, healthier lives than ever before. A woman who is now 65 can expect to live another 20 years, while a 65-year old man likely has another 17 years to look forward to.

Subtract your expected retirement age from your life expectancy to figure how long you'll be tapping your portfolio. Circle the number of years that come closest on the worksheet.

Determine How Confident You Want to Be

Both investors and financial advisors used to calculate withdrawal rates by assuming that a portfolio would earn some average annual rate of return over a period. For example, you might assume that your portfolio would earn 8% per year for 30 years.

Recent studies show how wrong that approach can be. The actual returns you experience each year in retirement make a huge difference in how much you can spend each year. Average numbers aren't enough.

Here's a historicalexample, courtesy of a study by T. Rowe Price. Assume you had a $250,000 portfolio in 1969 that was invested 60% in stocks, 30% in bonds, and 10% in cash. That portfolio earned an average of 11.7% per year over a 30-year retirement period from 1969 to 1998.

Let's say you needed to withdraw 6% of your portfolio each year. Given that 6% is only a bit more than half of your "average" return, you'd have more than enough money to last your retirement, right?

Wrong. Because a bear market occurred early in the cycle (in 1973 and 1974), your nest egg would have been depleted by 1994. Had that bear market come in the 25th and 26th years of your retirement, however, you would have found yourself with a $2,000,000 portfolio at the end of 30 years.

These examples don't mean that calculating a withdrawal rate is a fruitless activity, though. Computers can run thousands of possible return scenarios, allowingyou to use probability testing to make sure your spending rate will hold up whenthe nextbear market comes.

For some of you, certainty is crucial. You want your withdrawal rate to survive most if not all worst-case scenarios 95% to 100% of the time. Other investors may be comfortable with a lower probability of success--maybe you don't think we'll hit every economic disaster that these probability tests include. Or perhaps the spending rate at a 95% confidence level is just unacceptably low for you.

On the worksheet, choose from among three confidence levels. If you choose a 95% confidence level, there would only be a 5% chance that your withdrawal rate wouldn't last throughout your retirement period. An 85% confidence level means that 15% of the time, your portfolio may expire before you die. And a 50% confidence level means there is a 50% chance you will run out of money too soon.

Find Your Withdrawal Rate

On the worksheet, find where all three lines--your target asset mix, number of years expected in retirement, and level of confidence--intersect. This is your withdrawal rate given those parameters.

Two things to consider:

  1. If your estimated or remaining years in retirement falls between two numbers, you'll need to estimate a mid-way point for your withdrawal rate. For example, if you expect to spend 25 years in retirement, you'll need to estimate a withdrawal rate that is half way between 20 and 30 years.
  2. If you aren't satisfied with the rate you're getting, consider altering your asset mix. Or experiment with other confidence levels. Or put off retirement (thereby shortening the number of years expected in retirement) so that you can accumulate more assets. Finding the best withdrawal rate for you is about trade-offs.

Estimating How Much of Your Portfolio You Can Spend

You now know what percentage of your portfolio you can spend in retirement. Next you need to determine what that means in dollar terms.

To do that, tally the value of your retirement portfolio. Include all taxable account balances, as well as money in your tax-deferred accounts, such as IRAs and 401(k)s.

Fill in those figures on the worksheet.

Next, multiply your withdrawal rate factor by your total investable assets. The result is how much of your portfolio you can spend your first year in retirement.

Let's take an example. Say you have $500,000 in total investable assets, a 20-year time horizon, a mix of 50% stocks, 35% bonds, 15% cash, and an 85% confidence level. You'd multiply approximately 6% by $500,000. That would equal a pretax withdrawal rate of about $30,000 per year. Each year, you'd increase that withdrawal rate by the rate of inflation over the prior year.

Other Sources of Income--and Taxes

Many retirees rely on some fixed sources of income--things like Social Security, pensions, or annuities. The more fixed sources of income you have, the loweryour withdrawal rate from your portfolio can be.

The only trouble with fixed sources of income: inflation. Unless your fixed sources of income inch up as inflation does, you'll need to adjust your withdrawal rate over time to compensate for the income "lost" to inflation.

Enter your fixed sources of income on the worksheet. Add them to your withdrawal amount from the first year.

Let's go back to our previous example. If you expected to receive $12,000 per year from Social Security and another $10,000 per year from your pension, you would have total pretax income of $52,000--your withdrawal plus Social Security and pension payments.

Of course, that's before taxes. Subtract the amount you owe in taxes from your total income on the worksheet. This figure is the total income you'll have your first year in retirement after taxes.

Making Refinements

If you aren't satisfied with this final dollar amount, see if you can change your withdrawal rate by altering your asset mix, your confidence level, or your number of years in retirement.

If you are satisfied with what you've found, congratulations! But, unfortunately, the work doesn't end here. Your spending rates will probably change over time. Later in life, for example, you may be less active, and may therefore spend less on travel and entertainment.But you may need to spend more for medical attention. The key is to plan for flexibility.

Further, if these worst-case scenarios don't materialize, you may leave a larger estate behind than you intended to.

For example, if you choose to be 95% sure that you'll have enough money to last 20 years with an asset mix of 50% stocks, 35% bonds, 15% cash, and an initial portfolio balance of $1,000,000, there would be about a 50% chance that your final estate will top $800,000.

That's just one reason why you'll want to monitor and adjust your spending amounts throughout your retirement.

Quiz 310
There is only one correct answer to each question.

1 You want to withdraw 6% per year from your portfolio over the next 30 years, which you expect to return 8% per year. Will your portfolio last your lifetime?
a. Yes, because 6% is less than 8%
b. No, because 8% is more than 6%
c. Maybe--it depends on the actual returns you experience each year
2 What does a 50% confidence level mean?
a. There's a 50% chance that your portfolio will expire before you do
b. There's a 50% chance that your portfolio will not lose money while you're retired
c. There's a 50% chance that your portfolio will return more than the market does
3 If you aren't satisfied with your withdrawal rate, what can you do?
a. Retire sooner
b. Accept a lower confidence level
c. Go for a higher confidence level
4 How do most retirees cover their expenses?
a. With their investments only
b. With fixed sources of income only
c. With a combination of their investments and fixed sources of income
5 Which statement is true?
a. Your spending rates in retirement will never change over time
b. Your spending rates in retirement will likely change over time
c. Your spending rates in retirement will definitely rise over time
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the quiz page.
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