Imagine yourself on the first day of the retirement you’ve been looking forward to for years. You’re in good health; and between your pension, Social Security, and IRA, you have more than enough to fund your lifestyle.
Now, imagine it’s 10 years later: you’re still in good health, but to maintain your lifestyle, you’ve had to dip deeper and deeper into your IRA each year. You’ve realized that at the rate you’re going, your IRA will be depleted in a couple of years. You’re 75 years old and your alternatives are grim: you either make drastic cuts in your expenses or go back to work, where you’ll struggle to replace what you’re going to lose.
Sound like a nightmare? It’s been a reality for many retirees who after years of living comfortably, suddenly face the prospect of severely tightening their belts to continue to make ends meet. If you don’t want that to you, you need to know what to do to make your retirement money last your entire lifetime. The sooner you learn how, the easier it’s going to be.
The secret is to withdraw less from your nest egg than it earns, so that each year it will grow. While that sounds simple, it’s not quite so easy. It involves keeping your expenses, inflation, withdrawal rate, and investment returns I dynamic balance. Let’s take a closer look at each component of the equation.
Your Expenses Always Grow
Even if you watch your pennies, the fact is that every year it becomes more expensive to buy exactly what you bought the previous year. That’s because of inflation, which over the last 80 years has averaged about 3% a year.
Of course, the inflation rate has fluctuated from year to year, sometimes going negative (called deflation, which has happened 18 times since 1900) and sometimes going into positive double digits (as in 1975 and 1981, at 11% both years). But at an average rate of 3% a year, a basket of goods and services becomes 25% more expensive in just eight to nine years.
While Social Security has a built-in cost –of-living adjustment, the amounts in pension and annuity checks generally never change from day one. That means that just to keep your lifestyle from degrading, you must take out more from your retirement savings to cover the income/expense gap.
Keep Returns Equal to Withdrawals Plus Inflation
The problem with increasing withdrawals is that as your account balances decline, the same rate of return puts fewer dollars back into that balance. To solve that problem, your investments have to earn enough to do two things: earn back the purchasing power you’ve lost to inflation and earn enough to replace what you’ve withdrawn.
For example, let’s say you have a $100,000 portfolio and withdraw $4,000 at the beginning of the year to cover your expenses – a 4% rate of withdrawal. That brings your portfolio balance down to $96,000. If your portfolio earns only 4%, you’re going to get progressively poorer, because to maintain your lifestyle your withdrawals must increase.
The rate of return that keeps your original $100,000 worth the same amount in future dollars in this scenario is 7%, which is your withdrawal rate plus the rate of inflation. That preserves the value of your nest egg for as long as you live.
Fine-Tuning the Approach
In reality, people don’t withdraw everything they’re going to need to pay their bills at the start of the year. Neither does inflation hold steady at 3% a year. So the key to keeping your finances in balance is to make adjustments. When prices go up faster than 3% or your returns are less than projected, you either spend less or shift to investments with a higher rate of return, or some combination of the two.
Making all these calculations and financially agile. It’s well worth your while to have another look at your retirement plan. Please call if you’d like to discuss this in more detail.