How much money can you safely withdraw from your retirement portfolio?
Until recently, the commonly-accepted rule of thumb said you can withdraw 4 percent each year.
Why 4 percent? A 1994 study by financial advisor Bill Bengen showed that if retirees withdrew 4 percent from their portfolio each year, and kept their portfolio conservatively invested (producing enough annualized returns to keep pace with inflation), the retiree's principal investment would stay mostly intact.
Yes, that principal will dwindle over time, but it will happen at a pace that's so slow that the retiree is statistically likely to maintain his portfolio throughout his life.
Read More:Learn how to apply the 4 percent rule to your retirement portfolio.
For decades, 4 percent has been the standard protocol in determining how much you need to save for retirement. A $1 million retirement portfolio will land you a retirement income of $40,000 per year ($1,000,000 times 0.04 equals $40,000). A $700,000 portfolio will land you a retirement income of $28,000 per year ($700,000 times 0.04 equals $28,000). And so on.
Unfortunately, today's market returns are calling the 4 percent rule into question. Some financial advisors are worried that 4 percent is too aggressive of a withdrawal rate, and have ratcheted their recommendations down to a 3 percent rate.
Why? Two reasons: inflation and lower portfolio values.
What's Inflation Got to Do With It?
When Bengen performed the benchmark 4 percent study in 1994, the return that you could get from conservative investments like bonds, CD's and Treasury bills was decent. In 2012, however, the return on these conservative investments is next-to-nothing.
Of course, that might be a moot point. In 2012, inflation is also next-to-nothing, so it's appropriate that "safe returns" are aligned with inflation. In other words, returns relative to inflation are similar, even though the raw numbers have changed.
But 2012 is an abnormality: interest rates can't stay this low forever. There's a chance - not a guarantee, but a chance - that inflation could rise, perhaps quite rapidly, in the coming years, as a result of having such low interest rates today.
If that happens, there's also a chance that the returns on safe/conservative investments won't keep pace with inflation. In that circumstance, 4 percent might be too aggressive of a withdrawal rate.
What About Lower Portfolio Values?
The value of your portfolio is volatile: it depends on how well the market is doing. If you adhere to the 4 percent rule, you'll adjust your lifestyle based on market volatility.
In other words, during a bull run, your portfolio may stand at $1 million dollars, meaning you'll live on $40,000 per year. During a market tumble, however, your portfolio may sink to $850,000, meaning that if you adhere to the 4 percent rule, you'll live on only $34,000 that year.
But what happens if you can't live on that smaller sum? If you need $40,000 to pay your bills, you'll end up selling more of your portfolio when the market is down - which is the worst time to sell.
That's partly why today's financial advisers are telling people to plan for a 3 percent withdrawal rate. This advice follows the idea of "hope for the best, plan for the worst." Plan your baseline expenses - your needs - at 3 percent. Then if stocks tumble, and you're forced to withdraw 4 percent to cover your bills, you'll still be protected.
What Does This Mean?
This means that same $1 million portfolio will generate you an income of $30,000 per year rather than $40,000.
Don't panic if you're nearing retirement and your portfolio isn't close to one million or more. This is for planning purposes only; other factors like your pension, Social Security, royalties and rental properties will alter your calculations.
Your expenses in retirement might also be lower than you think. If your mortgage is repaid and your children are adults earning their own money, your bills will be much smaller than you're used to. Your tax rate during retirement might also be lower than your current rate.
The bottom line? Prioritize saving for retirement. Save aggressively through 401(k) plans, Roth IRA's, and other long-term investments like owning rental properties. You'll thank yourself when you're older.