Q: You recently wrote that retirees should withdraw only 4% a year of their nest egg. I've read this before. But no one addresses the fact that if the assets produce 4% per year -- and all records show that the stock market has returned more than that over the last umpteen years -- the principal would barely be touched.
I'm retired, and most of my assets are in stock and bond mutual funds. My income consists of Social Security and dividends and interest from my investments. If I need more income, I take some principal. Hopefully, my investments' growth will maintain enough of my principal to last for the next 30 years. My point is that retirees seem to have problems with taking a little principal for a little enjoyment. No one ever mentions that there's nothing wrong with taking some principal if you need it for something special. --JC via email
A: You're right that too few retirees understand that it's okay to spend principal in retirement. In fact, for all but the richest retirees, it's more than okay. It's both sensible and necessary.
The 4% formula I described in my earlier post assumes that you’ll be withdrawing investment principal as well as earnings. In fact, it’s a plan that essentially turns your portfolio into a 4% inflation-adjusted immediate annuity. An immediate annuity pays you income for life – and each annuity payment includes some of your principal along with earnings.
Many people point out, as you have, that stocks historically have returned more than 4% a year – and they conclude that a 4% withdrawal rate must leave your principal untouched.
Unfortunately, this isn’t true, for two reasons:
The first is that the 4% withdrawal plan includes an annual inflation adjustment. If you retire with a $1 million nest egg, for example, your first annual withdrawal is $40,000 – 4% of your balance. If the annual inflation rate is 3%, the following year you withdraw $41,200 -- $40,000 plus 3% ($1,200) for inflation. If the inflation rate is 2% the year after that, the next year you withdraw $42,024 -- $41,200 plus 2% ($824) for inflation. And so on.
In other words, a more accurate name for this strategy would be ‘the 4% plus-annual-inflation-rate withdrawal plan.’
The second reason is that there's a huge difference between the market's average return over umpteen years and its return in any single year.
You're right about the long-term numbers. From 1980 through 2010, for example, the Standard & Poor’s 500 Index delivered a handsome 11.44% average annualized return. During the same period, the Barclay’s Aggregate Bond Index (which used to be called the Lehman Brothers Aggregate Bond Index) had an 8.71% average annualized return.
But that doesn't mean that every year during that three decade period stocks grew 11.44% and bonds grew 8.71%! Or even that they delivered those returns in typical year. An average is just that -- an average. The good years were much better; in 1997, for example, stocks gained 33%. And the bad years were much, much worse. In 2008, stocks lost 37%. Bond swings were less violent, but bond returns fluctuated dramatically too. In 1991, bonds gained 16%. In 1994, they lost almost 3%.
It's natural to focus on long-term average rates of return when you’re saving for retirement: If you won’t spend your money for 30 years, the 30-year average annual return is more relevant than this year’s return. It's a different story when you’re living on your savings! Sure, in the long run, stocks have outpaced inflation. But you have to eat in the short run, too -- and in the short run, the stock market often has lower-than-average and/or negative returns.
The result: when you withdraw 4% a year plus inflation from your portfolio every year for two or three decades, by definition you’re withdrawing principal.
I should add that the 4% formula assumes that you’re invested in a mix of stocks and bonds. You need the stocks so your principal has a shot at outpacing inflation. And you need the bonds to cushion your losses, calm your nerves, and help you avoid selling stocks at a loss in bad years.
Most retirees would love to live on investment income, preserving their principal for emergencies and/or their children’s inheritance. Unfortunately, this plan only works if you're fabulously wealthy or have such a short life expectancy that you don't need to worry about inflation.
Please send your questions to Lynn@LynnBrennersFamilyFinance.com. I'm sorry I can't respond personally to every email. Questions are only addressed online.
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