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How Much Annual Income Can Your Retirement Portfolio Provide?

Your retirement lifestyle will depend not only on your assets and investment choices, but also on how quickly you draw down your retirement portfolio. Figuring out an appropriate initial withdrawal rate is a key issue in retirement planning and presents many challenges.

Why is your withdrawal rate important?
Take out too much too soon, and you might run out of money in your later years. Take out too little, and you might not enjoy your retirement years as much as you could. Your withdrawal rate is especially important in the early years of your retirement as it can have a significant impact on how long your savings will last. Gains in life expectancy have been dramatic. Individuals who reached age 65 in 1950 could anticipate living an average of 14 years more, to age 79; now a 65-year-old might expect to live for roughly an additional 19 years. Assuming rising inflation, your projected annual income in retirement will need to factor in those cost-of-living increases. That means you'll need to think carefully about how to structure your portfolio to provide an appropriate withdrawal rate, especially in the early years of retirement.

Conventional wisdom
So what withdrawal rate should you expect from your retirement savings? The answer: it all depends. A seminal study on withdrawal rates for tax-deferred retirement accounts (William P. Bengen, "Determining Withdrawal Rates Using Historical Data," Journal of Financial Planning, October 1994) looked at the annual performance of hypothetical portfolios that are continually rebalanced to achieve a 50-50 mix of large-cap common stocks and intermediate-term Treasury notes. It found that a withdrawal rate of slightly more than 4% would have provided inflation-adjusted income for at least 30 years. More recently, Bengen used similar assumptions to show that a higher initial withdrawal rate--closer to 5%--might be possible during the early, active years of retirement if withdrawals in later years grow more slowly than inflation. Other studies have shown that broader portfolio diversification and rebalancing strategies also can have a significant impact on initial withdrawal rates. Don't forget that all these studies were based on historical data about the performance of various types of investments, and that past results don't guarantee future performance. Given market performance in recent years, many experts are suggesting being more conservative in estimating future returns.

Inflation is a major consideration
For many people, even a 5% withdrawal rate seems low. To better understand why suggested initial withdrawal rates aren't higher, it's essential to think about how inflation can affect your retirement income. Here's a hypothetical illustration; to keep it simple, it does not account for the impact of any taxes. If a $1 million portfolio is invested in an account yielding 5%, it provides $50,000 of annual income. But if annual inflation pushes prices up by 3%, more income--$51,500--would be needed next year to preserve purchasing power.

Volatility and portfolio longevity
When setting an initial withdrawal rate, it's important to take a portfolio's ups and downs into account—and the need for a relatively predictable income stream in retirement isn't the only reason. If it becomes necessary during market downturns to sell some securities in order to continue to meet a fixed withdrawal rate, selling at an inopportune time could affect a portfolio's ability to generate future income. Making your portfolio either more aggressive or more conservative will affect its lifespan. A more aggressive portfolio may produce higher returns but might also be subject to a higher degree of loss. A more conservative portfolio might produce steadier returns at a lower rate, but could lose purchasing power to inflation.

Calculating an appropriate withdrawal rate
Your withdrawal rate needs to take into account many factors, including (but not limited to) your asset allocation, projected inflation rate, expected rate of return, annual income targets, investment horizon, and comfort with uncertainty. The higher your withdrawal rate, the more you'll have to consider whether it is sustainable over the long term. Ultimately, however, there is no standard rule of thumb; every individual has unique retirement goals, means, and circumstances that come into play.