For years, people planning for retirement have used the 4 percent rule of thumb to determine if there is enough money saved to retire. To use the rule, you take the total value of your retirement accounts and calculate 4 percent of it. That amount is how much you can withdraw the first year and increase it yearly with inflation. In other words, as long as you have 25 times the amount you need for your first year in retirement, there is a high probability that your portfolio will last the rest of your life.
However, in today’s market conditions with low interest rates, the recent market volatility and the impact of inflation, the rule may not be safe to use. In a recent study by Morningstar, under ordinary circumstances the 4 percent rule historically led to a success rate of 94 percent. The rule assumes that your retirement portfolio is split between stocks and bonds. The stock portion will help with inflation in the future, and the bond portion will provide current income. But recently the bond portion has returned on average only 2.5 percent, less than the 4 percent needed. The study concluded that if today’s low rates continue, the chance of failure using the 4 percent rule rises from 6 percent to 57 percent! Even if the market returns to ordinary conditions five to 10 years later, failure rates will be substantially higher.
Here are some tips for determining the right withdrawal rate for retirement given today’s market returns. Since every person has different circumstances, it is important to cater your withdrawal rate to your personal situation. See a financial planner to plan through this process.
* Work longer if you can. With people living longer today, working an extra year or two can make a big difference financially while not decreasing your retirement years too much. Working longer also will help you save more to build up your portfolio.
* Start at 3 percent. The Morningstar study recommends planning at a 3 percent withdrawal rate for greater sustainability. Look to cut expenses in retirement and simplify your life! Spending less money in retirement will not only significantly increase your success rate, but also help you deal with financial crises in the future.
* Improve yield. Investing in higher-risk assets such as high-yield bonds will give you more interest than a regular bond. It also has a greater risk of default, so consult a financial planner to see which risk profile and portfolio is right for you. Consider using dividend paying stocks or alternative investments such as senior secured loan funds that can provide a safer investment with higher yield in exchange for liquidity. Visit artofthinkingsmart.com for more information.
* Lower your investment portfolio fees. Reducing fees will automatically boost returns of your portfolio. Commissions, high expense ratios and other hidden fees can eat into your overall return. Lowering an investment portfolio’s fee by 1 percent on $100,000 held over 25 years with an annual return of 8 percent will save you more than $127,000!
It is important to constantly review your financial situation and adjust if needed.