How to live it up in retirement without outliving your money

Should you take fixed distributions or variable distributions?

  • By Paul A. Merriman,
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Some years back I wrote a book on the topic of how to withdraw your money once you’re retired.

This is such a big financial step that it could be called “When your portfolio starts paying you.”

This question might sound like a cure for insomnia: Should you take fixed distributions or variable distributions?

But it’s more interesting if you phrase it like this: Should you plan to take out enough money to meet your needs, or should you take out only what your portfolio can “afford” to pay you?

In an ideal world, these numbers would be the same. But in real life, that’s rare.

We’ll go into this in a bit of detail, but here’s the “executive summary” of three main points I’ll argue.

  • If you take out what you need every year and adjust that figure for inflation, you are likely to do fine for a few years no matter what happens. But a string of high-inflation years could make it impossible to continue this for the long haul.
  • If you take out only what your portfolio can “afford” to pay you, you could have to tighten your belt, especially if you run into inflation and poor market returns in the early years of your retirement.
  • If you begin your retirement with ample savings, you are likely to avoid these problems.

In order for me to show how this works, let’s start with a few definitions and assumptions.

In the following scenarios, I will assume you retire with $1 million and you’ve determined that you need $50,000 from your portfolio to meet your needs that first year.

In this case, what you need and what your portfolio can afford to pay you (if you accept a 5% withdrawal rate as affordable) are the same: $50,000.

So in your first blissful year of retirement, things are fine for you financially. You ask yourself: What could go wrong?

In the world of investing, there’s always an answer to that question!

One possible answer is that the stock market could choose your first year (or years) of retirement to go into a dive. If you increase your withdrawals every year to keep up with inflation, you likely won’t feel any pain from poor market conditions — at least not right away. But if on the other hand you have decided to live on 5% annual withdrawals, you will have to reduce your spending.

I’ll show you how this would have played out in a few tables that use actual market returns and actual inflation starting in 1970. I will assume the portfolio was split evenly between the S&P 500 index (.SPX) and five-year government bonds.

This first table shows the first 10 years of your retirement if you took out $50,000 in 1970 and adjusted the amount upward each year for actual inflation.

If you were the one getting those “payments” from your portfolio every year, you might be happy that you didn’t have to tighten your belt.

But notice two things:

  • The annual distributions went up dramatically, the result of steep inflation.
  • In 1979, you were taking out roughly 9.5% of your portfolio, a depletion rate that could not be sustainable forever.

Table 2 shows how you would have fared if your annual withdrawals were based strictly on what your portfolio could afford to pay you each year: 5% of the beginning balance.

These annual payments were just fine for a few years. But starting in 1974, you had to do some belt-tightening. In 1975 if you truly needed $50,000 for living expenses, even ignoring inflation you were in trouble.

What happened later

Subsequent years aren’t shown here, but under this plan you would not have regained your 1973 spending level of $58,342 until 1981.

Even then, your withdrawals would have been far below the inflation-adjusted value of your first-year retirement income of $50,000.

With fixed distributions (table 1), you had plenty to spend, but you were seriously eroding your portfolio’s ability to keep meeting your needs.

Indeed, 10 years later, in 1989, you took $160,012 from a portfolio that started the year worth $844,772. That withdrawal rate was unsustainable, and in fact that portfolio ran completely out of money sometime in 1994.

With the flexible 5% distributions, your portfolio was healthy. But you paid a high price in the 1970s, failing to keep up with inflation.

In fact, that flexible distribution didn’t catch up to be worth its inflation-adjusted 1970 value until 1997. In other words, for the first 26 years of retirement, flexible distributions forced you to adapt to a lower standard of living than you had in your first year of retirement.

Neither of these outcomes is good. But there is a third path that will let you keep your portfolio healthy and have enough to live on. If that sounds too good to be true, I will tell you that there is a catch: Before you retire, you will need to have more money saved up.

You can do that by working longer (postponing retirement). You might be able to do that by taking a second (part-time) job and saving all the income from it. However you accomplish this, the rewards can be great from saving more before retirement.

In table 3, I assume you retired in 1970 with $1.5 million instead of $1 million, and you could meet your essential cost of living with $50,000.

This scenario presents the best of all worlds. Your portfolio is ample. Your spending is well above your rock-bottom needs. And you have enough cushion to take money out for extras once in a while.

If you’re retired already or just about to retire and thus don’t have time to add significantly to your savings, your best bet may be to find ways to keep your spending under control.

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