Step 2 of 4: Understanding Different Withdrawals Methods
KEY TAKEAWAYS
An overview of Step 2 of the 4-Step process to determine YOUR personal retirement income and withdrawal plan, including 3 different withdrawal methods – 1) Budget Shortfall, 2) Portfolio Income and Gains, and 3) "Safe" Withdrawal Rate.
Specific withdrawal methods are better for maximizing your spending, whereas others are better for preserving your nest egg for legacy; others are for middle-of-the-road spending and asset preservation.
For individuals who hope to maximize spending and ideally use up their nest egg by the end of life, you must decide if you will earmark dollars for life events that may or may not happen or accept less-than-ideal living conditions if things don't work in your favor.
For those who want to spend some of their nest egg but keep enough buffer for the unexpected, most withdrawal strategies cater to this goal via versions of the "safe" withdrawal rate.
If legacy is important to you, strategies need to prioritize principal preservation. Generally, you can accomplish your goal by accepting varying income over your lifetime, as investment experience varies.
This article is entry #3 in our Retirement Income Series and is Step 2 of a 4-Step planning process that we employ. As a refresher, that 4-Step process includes these steps:
Begin with the end in mind: what's your ultimate nest egg goal?
Understand different withdrawal methods that tell you how much money you can take out.
Perform multi-year tax planning to minimize taxes in retirement.
Get to know YOUR retirement building blocks and when and how to use them for maximum effect.
Hopefully, you've taken some time to review the article on Step 1 and now have a sense of your own goals for your nest egg. Whenever you are “beginning with the end goal in mind,” the objective is to determine whether your retirement assets are intended for: 1) only you and your retirement, so you intend to spend it all during your lifetime – we call this the SPEND DOWN GOAL; 2) your retirement but with some money left over for other goals or because you'd prefer to have a cushion – known as the SAFE SPEND GOAL; or 3) you, while also prioritizing leaving behind a sizable legacy to whoever comes after you, whereby those assets can financially support that person – the LEGACY MAX GOAL.
With your nest egg goal clearly defined, you are ready to move on to Step 2: figuring out how much money to take out and deciding what method is best suited. To determine which method is appropriate, we first need to know what methods are available. As it turns out, there are three methods that we will be covering among a number of withdrawal strategies that are available: 1) Budget Shortfall, 2) Portfolio Income and Gains, and 3) "Safe" Withdrawal Rate. Let's take a closer look at each of these methods so that you can understand how to apply them to your overall retirement income goal.
Budget Shortfall
The simple way to start with this strategy is to take your monthly expenses and subtract your monthly fixed income (e.g., social security and pensions) to determine your monthly withdrawal amount. Put another way, this is your income shortfall and represents the amount that needs to be taken out of your nest egg. If there is enough in the nest egg accounts for whatever amount of time you hope to live in retirement, then everything works out as intended, and you've accomplished your goal.
However, the challenge with this method is that there are no guardrails on what a safe level of spending might be before you run out of money, which is why we commonly align this withdrawal strategy with a SPEND-DOWN GOAL. Be mindful that when the portfolio's growth can no longer sustain the withdrawals being taken out, you may need to reduce your overall spending later in life to keep your nest egg afloat. On the other hand, if you have accumulated a lot of assets and your goal is to bounce your last check, you might not be spending enough and could have lived a more extravagant lifestyle than you did.
Portfolio Income and Gains
The Portfolio Income and Gains withdrawal strategy provides income from the dividends, interest, and gains generated from the total balance of your retirement accounts, allowing you to keep the principal intact and MAXIMIZE YOUR LEGACY. If leaving a certain level of inheritance behind for your loved ones is important, this retirement income strategy will be most effective.
The issue for some is that to produce a meaningful enough income to support your lifestyle, you must set aside a significant nest egg, which means that for the average retiree, this method is best used for discretionary spending. These are things you want but don't need – travel or home upgrades serve as a couple of examples.
The other challenge is that the income amount will vary year-to-year because growth in the stock market is unpredictable, and bond and cash interest rates change over time. The bottom line is that there are some years you might not see any growth; therefore, you may end up not taking any income that year, unless you are willing to spend down your principal.
"Safe" Withdrawal Rate
If you are someone who looks at the Budget Shortfall method and says, "I don't like the idea that I might run out of money, or I don't want to find myself in a position where I will have to cut back on my lifestyle at some point substantially," then the "Safe" Withdrawal Rate income strategy may be more suitable to meet your needs. We label this the SAFE SPEND GOAL. In other words, this method effectively addresses your fear of running out of money before running out of life. It's also the middle ground between the other two methods because it also allows you to pass on some of your assets to the next generation, albeit to a lesser degree than the Portfolio Income and Gains method.
Research studies suggest that as a rule of thumb, 4% of your nest egg account value is considered the "safe" annual withdrawal rate a retiree can rely upon and not worry about running out of money. For example, if you have a $1M nest egg, your "safe" withdrawal amount for the year would be $40,000. Keep in mind that your withdrawal amount must be adjusted each year according to the account value. Therefore, your income will fluctuate up and down with your portfolio value. However, the hope is that through enough portfolio growth, you will receive pay raises over time that will keep pace with inflation.
Where some retirees might take issue with this strategy is that there are many exceptions to rules of thumb. For some, a safe withdrawal rate is 2% -3%. For others, it could be as high as 5%. Much of what is considered safe will depend on the growth of your portfolio (the stock market and interest rates), inflation, and longevity. If your portfolio is positioned for preservation and less growth, and you expect to live to 100, your safe withdrawal rate will likely be closer to 3% or less. Conversely, if your portfolio is positioned for growth in a low-inflation environment, it's possible to withdraw as much as 5%, and it be considered safe.
Connecting the Dots with STEP 1 and STEP 2
To conclude our discussion, it's critical to understand how Steps 1 and Step 2 of the retirement income planning process work together. To that end, PARAGON has created the table below to summarize the three nest egg goal types, the corresponding strategy to consider, and the pros and cons to evaluate for that strategy.
Coming Up Next
Stay tuned for Step 3 of our 4-Step Planning Process to YOUR Retirement Income Plan, where we will review how multi-year tax planning can help you optimize your taxes and reduce what you pay to Uncle Sam.
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