Makin' Money

The hardest money calculation of all

Chris Farrell Mar 10, 2011

You’ve saved over the years in 401(k)s, 403(b)s, IRAs, and Roth-IRAs. It’s time to retire. How much can you safely withdraw from your accounts each year? Live too high on the hog early in retirement and the danger is that you’ll be forced to make drastic cuts later on. Spend too little and the risk is that you’ll die with plenty of money and a long list of regrets.

The standard solution: the 4 percent rule. In essence, a retiree adds up all the components of her long-term savings. The first withdrawal is equal to 4 percent of the overall portfolio’s value. The dollar amount of yearly future withdrawals takes inflation into account. The portfolio is rebalanced, too. (The 4% withdrawal rule typically assumes an initial portfolio composed of 60% stocks and 40% bonds.)

Of course, that’s just a starting point. In How to Cash Out in Retirement, the Wall Street Journal looks at four withdrawal strategies.

This point is key:

Financial advisers are rethinking retirement-spending rules of thumb and coming up with new withdrawal strategies that help clients maintain their standard of living regardless of the stock market’s ups and downs…. The key to developing a successful strategy is flexibility, retirement experts say. Given all the variables in retirement spending, advisers suggest that investors regularly revisit their approach rather than religiously following a preset path. Those who are willing to make small adjustments along the way will run the smoothest course through retirement.

For a more conservative take on withdrawals for aging baby boomers, check out this Bloomberg BusinessWeek article. Imagine, wealth depletion is taking place more rapidly for 2000-era retirees than for their peers in the Great Depression and the stagflation of the 1970s. A safe withdrawal rate of 2 percent or less may be more realistic.

The implication is dramatic for an aging baby boom generation…. If these future retirees feel the pressure to switch to a 2 percent withdrawal rate instead of 4 percent to steer clear of the risk of running out of money, they will have to save a lot more money to preserve their lifestyle. More likely, they’ll end up embracing a combination of moves: Cut back on spending, work longer to keep earning an income, and save more.

Still, a major theme even with a more pessimistic turn is flexibility.

To be sure, the 4 percent-plus-inflation mantra is a guideline, a rule of thumb. Actually figuring out a safe withdrawal rate is immensely complicated. Coming up with a reasonably safe number involves making guesstimates of life expectancy, deciding the importance of leaving a financial legacy to the kids, the willingness to put money into stocks and other risky assets, and a judgment about reactions to market implosions and business cycle downturns. What’s more, while the financial services industry often stokes fear, the reality is that most people are remarkably creative at controlling their spending and coming up with ways to make money on the side. The safe withdrawal rate isn’t a static number. It’s dynamic, and it can be adjusted over the years.

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