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Will retirement portfolio provide enough income?

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By Doug Awad

Your retirement lifestyle will depend not only on your assets and investment choices but also on how quickly you draw down your retirement portfolio. The annual percentage that you take out of your portfolio, whether from returns or the principal itself, is known as your withdrawal rate. Figuring out an appropriate withdrawal rate is a key issue in retirement planning and pre-sents many challenges.

Why is your withdrawal rate important? Take out too much too soon, and you might run out of money in your later years. Take out too little and you might not enjoy your retirement years as much as you could.

Your withdrawal rate is especially important in the early years of retirement. How your portfolio is structured then and how much you take out can have a significant impact on how long your savings will last.

Gains in life expectancy have been dramatic. According to National Center for Health statistics, people today can expect to live more than 30 years longer than they did a century ago.

Individuals who reached 65 in 1950 could anticipate living an average of 14 more years, to age 79. Now a 65-year-old might expect to live for roughly an additional 19 years.

Assuming rising inflation, your projected annual income in retirement will need to factor in those cost of living increases. That means you’ll need to think carefully about how to structure your portfolio to provide an appropriate withdrawal rate, especially in the early years of retirement.

Conventional wisdom: A seminal study on withdrawal rates for tax-deferred accounts (Bengen, ”Determining Withdrawal rates Using Historical Data,” Journal of Financial Planning Oct.1994) looked at the annual performance of hypothetical portfolios that are continually rebalanced to achieve a 50-50 mix of large cap common stocks and intermediate term treasuries.

He took into account the early Depression years and recession years of 1937 to 1941 and 1973 and ‘74. It found that a withdrawal rate of 4 percent would have provided inflation-adjusted income for at least 30 years.

An updated study by Bengen showed that a withdrawal rate of closer to 5 percent might be possible during the early years if withdrawals in late years grew more slowly than inflation.

More recent studies have shown that broader portfolio diversification and rebalancing strategies also can have a significant impact on initial withdrawal rates. In an October 2004 study (Decision Rules and Portfolio Management for Retirees), Jonathon Guyton found that adding asset classes, such as international stocks and real estate helped increase portfolio longevity.

By applying so-called decision rules (like withdrawing less during poor portfolio performance years), Guyton found it possible to have “safe” withdrawal rates above 5 percent.

Inflation is a major consideration: For many people, even a 5 percent withdrawal rate seems low. To better understand why suggested initial withdrawal rates aren’t higher, it’s essential to think about how inflation can affect your investment income.

Here’s a hypothetical illustration. To keep it simple, it does not account for the impact of any taxes.

If a $100,000 portfolio is invested in an account yielding 5 percent, it provides $5,000 of annual income. But if annual inflation pushes prices up by 3 percent, more income – $5250 – would be needed next year to preserve purchasing power.

Since the account provides only $5,000, an additional $150 would have to be withdrawn from principal to meet expenses. That withdrawal reduces the portfolio’s ability to produce income next year.

Market volatility and portfolio longevity: When setting an initial withdrawal rate it’s important to take a portfolio’s ups and downs into account. According to several studies in the late 1990s by P. Cooley, C. Hubbard, and D. Walz, the more dramatic a portfolio’s fluctuations the greater the odds that the portfolio might not last as long as needed.

If it becomes necessary to sell securities during market downturns to continue to meet a fixed withdrawal rate, it could affect the portfolio’s ability to generate future income. Making your portfolio either more aggressive or more conservative will affect its lifespan.

Every individual has unique retirement goals, means, and circumstances. Visit your financial advisor on a regular basis to make sure your portfolio is properly asset allocated.

If you have questions, call Doug Awad at 854-6866, or e-mail Doug.Awad@raymondjeames.com. He is a resident on the 200 Corridor and his office is on 31st Road, adjacent to Paddock Mall.

This information was partially prepared by Forefield Inc., an independent third party. It is general in nature, is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security.

Investments and strategies mentioned may not be suitable for all investors. Past performance may not be indicative of future results. Raymond James & Associates Inc. does not provide advice on tax, legal, or mortgage issues. These matters should be discussed with an appropriate professional.