The Financial Reader

Like all investors, persons who are living off of their retirement savings need a blueprint to construct a successful portfolio. But the blueprint that works for the classic investor who is saving for retirement won’t work for those who are living off of their retirement savings. That’s because the goals of these two types of investors are not quite the same. Investors want utmost returns on their savings. But those living off of their retirement savings are also “savings consumers” who use their savings to support themselves. These investors typically have two goals:

The First, Savings That Last: One goal is that your savings need to provide you with your living needs throughout your entire lifetime. In other words, your savings need to last at least as long as you do, through all kinds of market conditions. The Second, Savings that offer Large Annual Paychecks: The other goal is that your savings should provide you with enough financial resources so you can do the things you want to do during retirement. In other words, you want your retirement savings to provide you with as large an annual paycheck as possible.

Unfortunately, this presents individuals living off of their retirement savings with a dilemma: Their two savings goals are actually working against each other. If you are living off of your savings, how do you balance those goals? To be more specific: How do you find the point at which you can spend the greatest amount of your retirement savings each year, and still be sure that you will have enough savings to support you for the rest of your life? There are three key elements that will help you keep these goals in balance and allow you to maintain a successful retirement portfolio one that you can comfortably live off of, and that can survive during unpredictable markets:

You need an appropriate systematic withdrawal approach that focuses on realistic rates of withdrawal. You need an appropriate asset allocation that includes diversification among the three major asset classes (stocks, bonds and cash) and diversification within the most volatile categories. You need an appropriate monitoring system that includes: A) Rules regarding annual spending amount increases and decreases to help ensure that you stay on course; and B) Periodic reassessments of your asset allocation and rebalancing.

First you have to settle on the approach you are going to use to determine your annual withdrawal amount. The approach that you choose is critical, because it will have a big impact not only on the obvious issues of how much you can withdraw each year and on protecting your savings so they last your lifetime, but also on your asset allocation strategy. One relatively popular rule is to withdraw only the income generated from your investments. This approach is popular because it seems like a good way of “protecting” your principal value. Nonetheless, the typical impulse is to maximize income by putting a large amount in higher-yielding investments, such as bonds. The downside to this approach is that, over the long term, both your savings and the income it generates may not be able to grow in real terms to keep pace with inflation, and eventually you may be forced into a lower standard of living. One way around this problem would be to simply invest your assets for maximum return and live off of your portfolio’s real rate of return each year. This approach encourages a heavier stock commitment, which maximizes long-term growth, but the returns over the last few years illustrate perfectly the mayhem this approach can wreak to your income: Using this approach, your income tends to fluctuate outrageously year to year. It does not produce a steady source of income.

A more useful approach is to basically create an immediate annuity out of your savings portfolio. To do that, you: Total up all of your investable assets, estimates your life expectancy, and determine a “first-year” withdrawal rate for that portfolio. The withdrawal rate takes into consideration all of the earnings that will be received on all amounts of your remaining invested savings until the portfolio are exhausted, and it divides everything up equally over the time horizon. This basically allows you to withdraw both principal your original savings, as well as earnings on that principal amount, over your lifetime. That first-year withdrawal rate is translated into a dollar amount, which becomes your first-year “income”—the actual dollar amount that you can withdraw from your portfolio. The next year, you are allowed to withdraw your prior year dollar amount increased by the rate of inflation. With this approach, in your first year of retirement, a first-year “withdrawal rate” is determined that is a percentage of your first-year investment portfolio; that percentage rate translates into a specific dollar amount that becomes your first-year withdrawal. The withdrawal amount does not take into consideration taxes due based on the source of the withdrawal.

The advantage to this approach is that it allows you to separate your asset allocation decision from your withdrawal needs, so that you are not focusing too much on one particular need at the expense of another. This tends to encourage you to invest for the long term, since the withdrawal rate does not depend on any income component. Therefore, higher-growth potential investments such as stocks are less likely to be pushed aside in favor of higher-income but lower long-term growth investments. You do need to keep the withdrawal rate realistic, that means taking not more than 4% each year if you want your portfolio to survive throughout retirement.

Keep in mind that this doesn’t mean you can select a realistic withdrawal rate and then put your portfolio on “autopilot.” You still need the other elements of portfolio management: a proper asset allocation that includes commitments to all three major asset classes, and a portfolio monitoring system that includes spending adjustments. But setting a realistic withdrawal rate is the first step toward reaching your ultimate goal of striking the fine line between spending the maximum amount of your retirement savings each year and being assured you will have enough savings to support you for the rest of your life.