Q: What's a good way to withdraw annual retirement income from an investment portfolio? --DA, via email
A: I like the two-bucket method. It has the virtue of simplicity, and it makes sense both emotionally and fiancially.
But the caveat I cited in my last post applies here, too: It won't work well if you don't have enough money.
Here's the idea:
When you retire, you divide your nest egg into a Cash Flow Bucket and an Investment Bucket.
Fill the Cash Flow Bucket with enough money to cover your living expenses for two years. Keep it in a money market fund.
Fill the Investment Bucket with a mix of stock and bond funds. The most appropriate mix depends on factors like the size of your portfolio, your other sources of income, your life expectancy, your assumptions about future market returns and inflation rates, and your appetite for risk. My own best guess is that a healthy 65 year-old shouldn’t have a stock/bond mix more aggressive than 65/35 or more conservative than 50/50.
Clear so far?
Okay, let's look at an example.
Let's give you a $1 million nest egg, and say you want to withdraw a constant $45,000 a year (i.e., $45,000 after inflation) to cover your living expenses. In other words, your annual spending rate will be 4.5% plus inflation. In effect, you've turned your portfolio into an inflation-adjusted annuity. These $45,000 withdrawals will supplement your monthly Social Security benefit and any other income you may have, such as a pension or earnings from a part-time job.
You'll put $90,000 into your Cash Flow Bucket. Every month, you'll write yourself a money market fund check for about $3,800.
Think of this as your paycheck.
The remaining $910,000 goes into the Investment Bucket's mix of stock and bond funds. Once or a year you'll rebalance this portfolio back to your original allocation. When you rebalance, you'll also transfer enough money out of Investment Bucket into the Cash Flow Bucket to bring its balance back up to $90,000.
What if you don't need to rebalance the Investment Bucket that often because your allocation hasn't changed?
In that case, when there's less than a year’s worth of expenses remaining in the Cash Flow Bucket, you'll examine the contents of the Investment Bucket to identify what to sell to replenish your Cash Bucket. Remember, you want to sell shares of funds that are doing well. You should avoid selling an investment that is experiencing significant losses; you want to give it the time to recover.
Sell enough of an investment that is doing well to provide the money to bring the Cash Flow Bucket balance back to $90,000. Don't forget to rebalance the Investment Bucket after you've done this.
Okay -- but what if nothing is doing well in the Investment Bucket? What if all your investments are losing value? A bear market in both stocks and bonds lasting longer than a year is unlikely, but not impossible. In that case, you replenish your Cash Flow Bucket by liquidating some of your most conservative bond holdings, says Harold Evensky, the fee-only financial adviser who pioneered the two-bucket method. He recommends that your Investment Bucket contain about three years worth of living expenses in short-term, high quality bonds.
In other words, this approach gives you liquidity enough to cover up to five years' worth of withdrawals: two years in the Cash Flow Bucket, plus three years in the Investment Bucket.
The beauty of this system is that it’s relatively simple. It's comfortingly familiar because it preserves the psychological distinction between your checking account and your investment portfolio. It offers some protection against having to sell stocks at the worst possible moment. And it helps provide emotional stability: you're less likely to agonize over market volatility if you know you have enough cash on hand to cover a couple of years’ worth of living expenses.
But it’s no coincidence that financial planners and columnists so often use a $1 million portfolio to illustrate such strategies: You need that big a nest egg if you want to withdraw $45,000 a year, adjusted for inflation, for up to three decades of retirement. In fact, if your annual, inflation-adjusted withdrawals exceed 5% of your initial portfolio, you run a serious risk of outliving your savings.
In my next post, I’ll explain why that is.
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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