Retirement: When your portfolio starts paying you » PRINT

By Paul Merriman
May, 2007

When you reach retirement, four major decisions will determine the bulk of your financial future. This article is about two of those decisions:

• How much money do you need or want from your retirement portfolio?
• Do you need a fixed income or can you tolerate a variable income?

You may have saved for many years and invested your money carefully. But when the money has to flow in the reverse direction, suddenly you are faced with a whole new set of challenging choices.

This article is built around four tables of numbers that should be of interest to everyone who's retired or contemplating retirement. The tables are extremely useful when we work with clients, and this whole topic is a highlight of my popular workshop, "Live It Up Without Outliving Your Money."

Before we get to the meat of the discussion, let's back up for just a moment. I mentioned four major financial decisions that will shape your future after you retire. In addition to the questions we're examining here, the other two are:

• How will you invest your money?
• How much risk will you take?

These last two questions are related. You'll find our recommendations for how to invest, and the reasons for them, in an article called "The ultimate buy-and-hold strategy." That article tells you what stock funds and bond funds are most likely to give you the best long-term returns. But it doesn't tell you how much of your portfolio should be in stocks and how much in bonds. That's related to how much risk you are willing to take. And that is the subject of another important article, "Fine tuning your asset allocation."

Back to the topic at hand: How much you need or want from your portfolio - and whether you can handle an income that's variable and might go down in some years - are questions that only you can answer. You'll probably get the best answers with the help of a financial planner. However, I hope this article will give you a head start in finding those answers.

Taking money from your portfolio

The four tables in this article will reveal something that retirees should think carefully about: Taking more money from your portfolio early in retirement can leave you with less money - or even no money - later in life. On the other hand, taking out less money early in retirement can leave you with more later - if you live long enough to enjoy it. But, while you wait, taking out less could mean that you won't be able to enjoy all the things you have saved for and looked forward to. There isn't a right answer for every person, and these issues deserve careful thought and attention.

One major fork in the road is whether you choose a fixed withdrawal plan or a flexible withdrawal plan. Another is whether you choose to withdraw more or less. These two decisions result in four possible choices, illustrated by the four tables of this article.

Here's the difference between the fixed and flexible plans. A fixed plan gives you a set amount of money to spend every year, and you can adjust it upwards to match a presumed rate of inflation. (We assumed inflation of 3.5 percent in our calculations.) This way you know in advance exactly how much you will have every year, and you can plan your life accordingly.

A flexible plan lets you withdraw a set percentage of the portfolio's prior year's ending value. There is no adjustment for inflation; you must rely on portfolio growth to keep you ahead of inflation.

As for how much money you take from your portfolio, of course you would want to withdraw more. But there are some tradeoffs involved.

To view a PDF of these tables, click here.

In each of the four tables, we assume an investor retires with $1 million in January 1970 and takes one withdrawal at the start of every year, starting in 1970.

In Table 1, the initial withdrawal is $60,000, an amount that will be increased by 3.5 percent every year (see column labeled "Distributions"). The drawback of this arrangement, as you can see, is that you can run out of money if your investments don't grow fast enough to keep up with the relentless 3.5 percent increases.

In Table 2, we assume you can get by with $40,000 the first year, increased annually by 3.5 percent. This lower withdrawal rate would have been sustained by every investment combination. Most of the portfolios would have accumulated large amounts of money, more than $10 million in nine cases, while restricting the investor to withdrawals of less than $140,000 a year.

One striking difference between Tables 1 and 2 is the ending value of the S&P 500 portfolios. In Table 1, the $1 million would be gone after 35 years; in Table 2 that same $1 million would be worth almost $17 million after 37 years. The difference isn't the market or asset allocation. The difference is much lower spending, something that to some extent is within every investor's control.

Tables 3 and 4 look very different. They show a flexible plan starting with the same $1 million. Each year, 6 percent (Table 3) or 4 percent (Table 4) of the portfolio would be drawn out; creating a retirement income that fluctuated with the ups and downs of the market.

Comparing the plans

• If you choose a fixed plan, your choice between higher or lower withdrawals can determine whether (or when) your portfolio runs out of money.
• If you choose a flexible plan, you take the risk that a bear market will require you to take out less money than you need.

In a flexible plan, the higher or lower withdrawal percentage (6 percent or 4 percent) determines whether you are likely to have more to spend early in retirement or more to spend later in retirement. Eventually, less becomes more and more becomes less.

You can see this if you compare the 50% Global Equity/ 50% Bond (50/50) columns in Tables 3 and 4. For the first 19 years, the 6 percent plan would produce higher withdrawals. But starting in the 20th year, 1989, the 6 percent plan would pay out less than the 4 percent plan.

The reason is easy to understand: For 19 years, money would have been left to grow in the 4 percent portfolio instead of being spent. From that point on, the portfolio that gave less (in percentage terms) would actually give more (in dollars).

Assuming a retirement age of 60, this 19-year turning point would come at age 79. Retirees who lived longer than age 79 would be rewarded for taking out less during their earlier years of retirement. However, as retirees grow older, their health and vigor usually decline. Many retirees who postpone spending until age 79 won't be able to take full advantage of having more money later.

Even worse, retirees who are too optimistic about their investments and spend more in the early years may have to cut back significantly as they live longer.

If I were on the brink of retirement and my financial advisor said I had to choose among these four tables for a distribution plan, what would I do?

The fixed plan

First, I would not want any plan that would have run out of money. Look at Table 1, the fixed plan that starts with a $60,000 withdrawal. Look at the bottom of the three columns on the left: the 100 percent investment in bond funds, the 90 percent column and the 80 percent column. The numbers all end before the 37th year; that means these portfolios would have gone broke. In the worst case (see the "100 percent fixed income" column), the $1 million would be gone after only 25 years.

There are several portfolios in Table 1 that I would consider. The 40 percent, 50 percent and 60 percent global equity portfolios all look to me like good choices. With total retirement distributions of $4.4 million and ending portfolio values between $5 million and $15 million, these didn't come close to running out of money.

Second, I would not want a plan that exceeds my comfort level, even if it did well in this hypothetical scenario. While the 70 percent and higher global equity portfolios in Table 1 look good, I believe they are beyond the risk tolerance level of most retirees.

Next, let's look at Table 2, the fixed plan that starts with a conservative $40,000 withdrawal. All of the portfolios in Table 2, including the S&P 500, would do just fine. Even a retirement portfolio 100 percent invested in bond funds would result in a year-end value of $3.2 million after 37 years. So, why wouldn't I just choose one of these portfolios? Because I am hoping there might be a way my portfolio could pay me more. I think the solution may lie in Tables 3 or 4.

The flexible plan

When I compare the 50/50 portfolio in Table 2 with the same portfolio in Table 4 (the 4 percent flexible), I see Table 4's lowest yearly withdrawal would be $39,012 in 1975. Table 2's withdrawal that same year would be $47,507. This seems like a pretty good reason to choose the fixed (Table 2) over the flexible (Table 4).

But 1976 is the last year that the fixed plan would have paid out more than the flexible. When I look at total distributions, the flexible plan would give me $6.9 million to enjoy in the first 37 years of my retirement - $4 million more than the fixed. Of course, my estate would be smaller with the flexible plan... Oh, my poor mistreated heirs!

Let's say I like a flexible plan. What would happen if I took out 6 percent instead of 4 percent?

Turn to Table 3 (the 6 percent flexible), and look at the 50/50 portfolio. Increasing the flexible distribution rate from 4 percent to 6 percent would decrease the total distributions over 37 years by approximately $800,000 ($6.1 million versus $6.9 million). But that is not a very big drawback, especially considering how much I could spend in the early years of retirement.

Beyond the numbers

It may shock you to hear me say this, but the numbers in this article aren't enough to make your decision. You have to look beyond them to see which of your emotions might be involved.

For example, look again at the year 1975 in Table 3 - the 6 percent flexible plan - and compare the withdrawal amounts of $52,572 (the 50/ 50 portfolio) and $39,099 (the S&P 500 portfolio), two portfolios that had almost identical long-term returns. Six years into a retirement that started with a $60,000 payout, which amount would you rather explain to your spouse?

Or, consider this: If you didn't look at anything but the bottom line of those two columns, you'd probably think they were about the same. One ends with $5.4 million and the other with $5.2 million.

But along the way, the 50/50 portfolio dropped to a low of $876,192 at the end of 1974; a loss of 12% of its initial value. The S&P 500 portfolio dropped to $651,645 that same year; a loss of almost 35 percent.

I've been asking people for over 20 years how much money they'd be willing to lose. It's very rare that someone is willing to lose more than 20 percent. Maybe one out of 100 investors would stay the course after seeing $1 million drop to $651,645. You may be comfortable with that, but I doubt that your spouse is.

Many couples include one spouse who is a saver and one spouse who is a spender. The flexible distribution strategy works for a saver/spender couple. It promises the saver the security of lower withdrawals after a market decline, and it promises the spender higher withdrawals after the market goes up.

As these tables show, planning a carefree retirement is a series of tradeoffs. Winding your way through them requires careful thought and discussion. Unless you have more money than you think you'll ever possibly need, you must make some difficult decisions, the outcome of which will depend partly on future developments beyond your control.

But if you choose carefully among the alternatives and invest intelligently while controlling your risks, you can indeed make your retirement dreams come true.

Disclosure for Tables

Returns in Tables 1 through 4 are based on Dimensional Fund Advisors institutional index funds and are net of assumed 1% annual management fee and annual custodial fees assumed at 10 basis points.

The hypothetical results shown in the tables in this article do not represent actual performance. They are based on transactions that were not made but were simulated after the fact and thus with the benefit of hindsight. Future results of these strategies will be different - and may be lower - than what is presented here.

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