When an investor reaches retirement, there are many changes and adjustments to be made. One of those changes is transitioning from actively earning money to drawing from the money that has been saved for retirement through a portfolio or other investments.
When considering how income will be supplied in retirement, investors should consider withdrawal risk. Withdrawal risk is the risk of drawing down assets too aggressively to meet spending needs during retirement. If assets are drawn upon at too high of a rate, there is the chance of depleting assets and running out of income well before death.
In order to avoid withdrawal risk, investors can ask a few questions of their financial adviser. The most pertinent is how much money can safely be drawn from their portfolio each year. One way to answer this question is to look at the withdrawal rate, expressed as a percentage of investment assets. Withdrawal rates vary depending on the asset allocation of a portfolio, but they have historically ranged from 4.44% to 6.14%, depending on how long life is expected to be.
Withdrawing 10% or more of a portfolio annually is generally going to deplete a portfolio much quicker than desired. On the other hand, it is also unwise to withdrawal too little from a portfolio due to a fear of running out of funds. Though there is no magic percentage, investors must take the time to calculate what is an appropriate amount to deduct from their portfolio that will allow both a relative ease of lifestyle as well as sustainability.
Generally a withdrawal rate of 4-5% is sustainable for a long retirement horizon. With this in mind, pre-retirees should be planning for retirement based on their reasonable needs. Investors should consider how much will need to be saved in order to sustain a retirement at an approximate withdrawal rate of 4-5%. For many, the savings needed to sustain retirement is much higher than expected. To determine an appropriate withdrawal rate, things to consider are longevity, spending, inflation, asset allocation, and annuitization.
Another type of risk to consider is “point in time” risk. When poor returns happen early in retirement and distributions are taken from the portfolio, there is a higher risk of the portfolio running out of funds. For example, if the market falls at the beginning of retirement, there will be both market losses and personal withdrawals. This will produce a compounding effect and savings will potentially be more rapidly depleted.
On the other hand, an investor that reaches retirement during a bull market will have a better chance of sustaining their portfolio through future market downturns. Though investors cannot time their retirement around a bull market, it is wise to adjust the withdrawal and spending rate each year based upon the returns earned in the previous year. Just because there are poor returns in the first few years of retirement does not mean that a retiree is doomed. Returns can be managed with wise and well thought out withdrawal rates. A financial adviser can help investors determine those rates.
Transitioning to retirement can potentially be both an exciting and fearsome event. Considering withdrawal risk ahead of time is just one way that investors can prepare well for their retirement and enter feeling ready and at peace with their portfolio returns.