How To Reduce Withdrawal Rate Risk In Your Retirement Plan
Oftentimes, people are surprised to learn that in order to avoid running out of money during retirement, there is a limit on how much should be withdrawn from your retirement plans each year.
In this article, we’ll discuss:
What is withdrawal rate risk?
What is the “safe withdrawal rate” rule?
How long will my retirement savings last?
How can I reduce withdrawal rate risk?
By the way, if you’d like to learn how you can protect your assets from market losses, while also growing your nest egg, be sure to watch our free video here.
What is withdrawal rate risk?
This is when a retiree withdraws too much money from their savings in the early stages of retirement. If you take out too much money in those early years, there is a chance that you could run out of funds later on in retirement. Keep in mind that the average age for life expectancy will continue to rise, and with people living longer, the chance of running out of money in retirement also increases. If you’re part of a married couple, then consider looking at joint life expectancy statistics.
It isn’t always easy to plan how to spend your retirement savings, because there are so many retirement risks and even unknown risks that can’t be planned for. You can read more about this in our top 10 retirement planning risks to avoid and how to manage them article.
What is the “safe withdrawal rate” rule?
This rule became an important part of retirement planning calculations because of research by William Bengen, back in 1994. He back-tested a 50/50 stock and bond portfolio to find out what percentage is safe to withdraw each year, so that a retiree would not run out of money before 30 years. His research led to a 4% safe withdrawal rate, adjusted for inflation. But this was back in the 90’s, and things have changed a little since then. New studies show that the safe withdrawal rate might now be as low as 2.8%!
Your investment portfolio might encounter a lot of market volatility, so it’s a good idea to review your retirement accounts annually. This will help prevent your portfolio income producing assets from being overly exposed to risk. Not every certified financial planner will work the same way, so it’s best to work with someone who can help eliminate the risks that are most important to you. Do you want to be worried about stock market performance every day in retirement? If not, then the correct asset allocation is important, and maybe you need to include more fixed income investments to have a more balanced portfolio.
Did you know? Some experts are predicting that tax rates will have to double in the near future. You can read our article here on tax risk. Some of the numbers and information might surprise you!
How long will my retirement savings last?
There are too many moving parts to fully answer this question in today's article, and each person’s situation is also unique to them. But, let’s go through a couple of quick calculations to help you along the way…
Let’s use a common example. Most people have their retirement savings in accounts like 401(k)s and traditional IRAs. Now, would you say that most people consider $1M a great nest egg to retire on? Below, we’ll see what that $1M will provide in retirement income, after taking into account just the safe withdrawal rate and taxes.
Using the new safe withdrawal rate of 2.8%, you can only safely take out $28,000 per year. Next, let’s say that you’re in a tax bracket of 25%. This would leave you with an after-tax income of just $21,000!
If you’d like to learn how you can do these calculations for yourself, in your calculator simply type…
$1,000,000 x 2.8% = $28,000
$28,000 - 25% = $21,000
So, this example shows that if you have $1M in a 401(k) or traditional IRA, once you apply the 2.8% safe withdrawal rate and deduct 25% for taxes, you are only left with $21,000 per year! Now, that doesn’t sound like a lot of money to spend each year in retirement, after working so hard to save up a nest egg worth $1M!
The Internal Revenue Service requires that you pay taxes on certain individual retirement accounts. It’s important to understand how each retirement account works, plan accordingly, and comply with the Internal Revenue Service rules where applicable. Also remember to think about Social Security, as there are ways to maximize this income. You’re able to sign up for an account via the Social Security Administration website for specific information regarding your retirement income.
Tip: Try running these two quick calculations using your own numbers. Will your retirement plan provide you with enough income to live on?
How can I reduce withdrawal rate risk?
The new safe withdrawal rate rule of 2.8% is not set in stone, but like most retirement planning tools, it’s a guide to help you along the way.
Your safe withdrawal rate can actually fluctuate each year, depending on your overall portfolio performance and the value of your account. You might have to withdraw even less than the current safe withdrawal rate in years that the stock market is down, otherwise you could run out of money in retirement!
Here are a few quick ideas to help you reduce withdrawal rate risk and avoid running out of money in retirement:
Don’t have too much of your money at risk in the stock market. You can diversify your retirement portfolio by using different asset classes that are not directly linked to the stock market. (Read more here about how to avoid market risk.)
Have enough guaranteed income to cover your basic living expenses. There are financial products available that can both protect your assets and grow your wealth, without the risk of market losses.
It’s good to be cautious and stick to the safe withdrawal rate rules. If you take out too much money at the start of your retirement, you could run out of money in your most important years.
If you’d like to see how we can help improve your own retirement plan by reducing withdrawal rate risk, then be sure to schedule a free retirement consultation today.
