One of the most nerve-wracking aspects of nearing retirement is the prospect of possibly running out of money in your golden years.
Even if you have been the most diligent of savers, mismanaging your withdrawal of retirement income could have disastrous consequences.
There are two main strategies for retirement income withdrawal: systematic withdrawal and bucket withdrawal. It pays to understand the pros and cons of each of these strategies long before you need to use them, especially since the state of the economy when you retire may affect your strategy.
Here is a basic breakdown of these two withdrawal strategies:
Systemic Withdrawal, aka The 4% Safe Withdrawal Rate Rule
The thinking behind this strategy is that by withdrawing a modest amount of your retirement money each year, you would deplete the principal slowly enough to make your funds last for 25 (or more) years of retirement living.
The rule of thumb amount for this strategy is 4%. According to dailyfinance.com,
“Bill Bengen, a financial adviser in Southern California, created the 4% rule in 1994, demonstrating in a study that if retirees followed the plan, and increased their withdrawals over the years to adjust for inflation, their savings would last them for 30 years.”
For example, if you take 4% of your portfolio your first year of retirement—let’s say that’s $40,000—you would then plan to take an additional 3% of that $40,000 (or $1200) the second year to cover inflation. Even doing that each year would still theoretically allow you to live comfortably throughout 30 years of retirement.
The 4% rule is a popular strategy, partially because it is simple and easy to understand. Also, it can serve retirees well—in good economic times. The downside to systemic withdrawal is the possibility of market volatility.
When you are investing in your portfolio, you can take advantage of dollar-cost-averaging. That means that if you regularly invest equal amounts in a portfolio, you will sometimes buy more shares at a low price, or fewer shares at a high price, depending on how much your regular investment can buy.
That means you maximize your profits because you have more low price shares that can go up, and fewer high price shares that can go down.
Unfortunately, using the systematic approach to retirement withdrawal means you have the same situation, but in reverse. For example, when you sell shares of something during retirement, you might end up selling more of them if their value is lower—giving you fewer shares to hold onto and benefit from when/if the price goes up again later.
The “Bucket Method” Withdrawal
This strategy is gaining popularity, especially since the economic downturn. This approach, more technically known as asset allocation, assumes that retirees need to plan for market volatility. To do so, investors split their portfolios into separate income “buckets,” which will each take care of a different portion of retirement.
For example, planning for a 30 year retirement means you would want at least three “buckets”:
- The first would take care of your financial needs for your first five to ten years of retirement, and would consist of very stable and conservative investments. You would know that you can count on that amount of money staying relatively stable, even if you retire in the midst of a recession.
- The second bucket would consist of a mix of conservative and riskier investments, so that retirees would have the first decade or so to capitalize on the higher potential income from those less secure stocks.
- Finally, the last bucket would have the greatest number of high-risk/high-return investments in your portfolio. You can afford to put money in these riskier investments since you do not plan to dip into this bucket until 15-20 years after retirement. By placing the majority of these in the third bucket, you have the time to wait out market swings.
The benefit to this strategy is that it gives retirees more control over where their money is coming from in any given year, and it allows for them to make adjustments should their needs change. This also gives investors a psychological boost, since they can make structured plans and goals for the use of their money.
The Bottom Line
No matter what strategy you use for your retirement income, make sure you sit down with a financial adviser to discuss your options.