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What Should Your Withdrawal Rate Be in Retirement?

By Chuck Yanikoski

Investment companies, such as 401(k) providers, are fond of helping you figure out what your "withdrawal rate" should be. In other words, how much can you safely withdraw from your retirement account on an annual or monthly basis, allowing for some inflation over the years?

The operative word here is "safely." The mathematical models that underlie these calculations are taking into account two key risks: (1) the risk that your investments won't do as well as you would like or expect, and (2) the risk that you will live beyond the normal life expectancy for someone like you, which means that your money will have to last longer.

Models like this have been around for a decade or so, and the consensus is that, in order to be reasonably safe with a moderately aggressive investment portfolio, you can withdraw only about 4% of the initial amount. So if you have $100,000 in your retirement account, you can withdraw only about $4,000 a year, or $333 a month.

Or to put it another way, if you are a working class person who needs $2,000 a month on top of Social Security in order to live the way you used to before retirement, you will need to have a nest-egg starting out at $600,000. If you have been earning more during your working years and need to withdraw, say, $5,000 a month in retirement, you'll need to start with an account balance of $1.5 million.

Of course, all that assumes that this is the right way to think about your retirement finances - which it isn't. More on that in a moment.

But first, you should also consider that these models are seriously flawed in that, for the most part, they take account of only two kinds of risk: investment risk, and "mortality" risk (i.e., the risk of dying other than at normal life expectancy).

A study in the November 2010 Journal of Financial Planning takes this kind of analysis a step further, noting that over a period of two or three or even four decades of retirement, chances are that unexpected needs for significant cash will arise. And if you take into account this additional risk of unforeseen emergencies, the amount that you can "safely" withdraw from your retirement funds falls to about 3% a year, instead of 4%.

This means that your $100,000 savings will yield only $3,000 a year, or $250 a month (about $8 a day). And that if you need to withdraw $2,000 a month, you will need to start out with $800,000 instead of $600,000. Or to withdraw $5,000 a month you will need two million instead of "only" one and a half.

Good luck with all that, by the way.

Fortunately, these financial tools are pretty worthless. First of all, you probably shouldn't be investing in risky investments at all during retirement, unless you already have enough money so that you can afford to lose a good chunk of it. Second, there is virtually nobody who retires and then continues for twenty, thirty, or forty years to need the same amount of money (or a smoothly inflating amount) year after year.

Mortgages get paid off, illnesses crop up, people move, they stop traveling and going out for rich meals when they reach a certain age. Instead of having two cars, they have one car, and eventually no car. One spouse dies before the other, with all kinds of financial consequences. And so on.

Models that calculate your "withdrawal rate" are a sham, and they probably ought to be illegal. Since they take into account so little of reality, they produce accurate results only in rare cases by blind luck - and of course, you don't find out until you die whether you were a winner or a loser.

But when the results are likely to be highly inaccurate in one direction or another, you really lose either way. If you are given too high a number, and you withdraw too much, you will probably run out of money before you die. If you are given too low a number, you probably won't run out of money, but you will end up scrimping through the early years of your retirement, when you are probably still healthy and vigorous enough to be enjoying yourself. By the time it becomes clear you could have been spending more, you're a lot older and maybe have missed your best opportunities. If you have a spouse or partner, maybe that person has even died, or become ill, in the meantime, and has totally lost out on what could have been.

The kind of model you really should be using is much more detailed, so that it can estimate far more accurately what your future income and expenses are likely to be. In that kind of model, as in real life, the amount you withdraw every year or month should be the amount you really need in order to maintain your life style. And since that amount is the difference between one number that can change quite a bit (your income) and another number that can change quite a bit (your expenses), the amount you need can fluctuate wildly from year to year. Or even if it is reasonably constant, it can shift suddenly to a very different level and stay there for a while, as your life changes.