Suppose that you are retired, or are planning your retirement. You have a substantial retirement fund. In this article I won't talk about how to build a substantial retirement fund -- that's a different subject. Let's just say you have it. How much can you withdraw from it to spend?
There are basically two approaches to this question.
One approach is to try to spend at a rate so that the fund will be empty the day you die. For example, suppose you have, say, $400,000. (If you have a lot more than this or a lot less, that doesn't affect the point here, so don't worry about it.) You expect to live another 10 years. For simplicity for step 1, let's assume you don't invest the money, you're just keeping it in a little tin box in cash. How much can you withdraw each year? Well that's a simple calculation. If you have $400,000 and you want it to last 10 years, you can withdraw $40,000 per yeare.
If you invest the money and make some profits, you could withdraw more.
But there's one gigantic catch to this plan. What happens if, when the 10 years rolls around, you are so unfortunate that you are still alive? Now your retirement fund is gone and you have nothing to live on.
So many retirees take a different strategy: Invest the money, and only withdraw the profits. Keep the principle intact.
So let's assume the same $400,000. Over the course of the last 100 years or so, the stock market has returned an average of 7% per year. That doesn't mean it goes up by exactly 7% every year. Some years it goes up by more. Some years it goes up by less. Some years it goes down. But on the average, over the course of decades, it goes up by 7% per year.
So if you had $400,000 in your retirement fund and it's invested in the stock market, then, on the average, it would give profits of 7% of $400,000 or $28,000 per year. You could withdraw $28,000 per year and your principle would still be $400,000. So you could withdraw another $28,000 the next year, and the year after that, and so on, forever.
There's one big catch to this plan: Inflation. The real buying power of that $28,000 is going to decline, year after year, with inflation. If $28,000 is enough for you to get along on now, in 20 years it probably won't be.
So okay, Inflation has been averaging about 2%. Leave 2% of the profits in your retirement fund, so that it grows by 2% per year, That leaves 7 - 2 = 5% for you to withdraw each year. As the principle goes up to keep pace with inflation, the amount you can withdraw goes up.
So for example, you start with $400,000. The first year you make 7%, or $28,000. You leave 2% in the account, or $8,000. Your principle grows to $408,000. You withdraw the other 5%, or $20,000, to spend and live on.
Next year it grows by 7% of $408,000, or $28,560. You leave 2% in the account, or $8,160. The account grows to $416,160. You withdraw 5%, or $20,400. This $20,400 is 2% more than the $20,000 you withdrew the first year, so if inflation was 2%, you're keeping pace.
The year it again grows by 7%. 7% of $416,160 is $29,131. You leave behind 2%, or $8,323. The principle grows to $424,483. You withdraw 5%, or $20,808. Your withdrawal has grown by 2%, keeping pace with inflation.
You continue this year after year until you die. Your principle and your annual withdrawals grow to keep pace with inflation, so you're purchasing power remains the same.
There's still a catch with this method. For my calculations above I assume that the stock market grows by 7% every year and that inflation is 2% every year. But those numbers aren't fixed, they vary all the time. So what happens if you have some bad luck and the first couple of years the stock market grows by less than 7%, maybe even falls? Because everything is tied to the average 7%, you may never catch up.
The solution is to give yourself some padding. Instead of withdrawing 5%, just withdraw 4%. That way you give yourself a little pad. If the stock market performs poorly this year, you run your account down by a little less. When the market recovers, you have that extra 1% to catch up.
Bear in mind that you're not giving away the 1%. It's just staying in your retirement fund. In good years, the account will grow a little faster so 5% will be a little more.
Many financial planners advocate this plan. They call it "the 4% rule". (Someone must have worked really hard to come up with that name.)
Lest you wonder: I am retired. I rely on social security for over half my retirement income. So I can make do with less than 4%. I am withdrawing 3%. I figure that helps the principle to grow. And if I need cash for something, I have a reserve.
© 2024 by Jay Johansen
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