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Unknowns dictate 4% withdrawals

The Baltimore Sun

I get this question at least once a week. The answer is relevant whether you're retired or just starting out.

You said something I don't understand or am misinterpreting. Your column and others suggest that, as a general rule, if no more than 4 percent of one's assets are spent each year during retirement, our money should last our lifetimes.

But if my assets achieve a rate of return greater than 4 percent, wouldn't not only my money last but my principal also increase? Granted, there could be years where a 4 percent rate of return is not achieved. Is the possible shortfall in some years the reason for the seemingly low recommended withdrawal rate?

That's part of it. But the main reasons are inflation and the dangers of the "sequence of investment returns," a term commonly used in retirement planning.

This latter point is of extreme importance and, judging from my mail, not well (or at all) understood.

The often-quoted and just as often misquoted rule of thumb is that, if you don't want to risk running out of money in retirement, you'd better not withdraw more than 4 percent of your savings annually. But such a simplistic statement is misleading because the 4 percent applies to the first year of retirement only, and with retirement typically assumed to last 30 years. If you have $500,000 saved, for example, you would withdraw no more than $20,000 the first year.

In subsequent years, to keep up with inflation, you would need to withdraw more than $20,000. Assuming inflation runs at 3 percent a year, you would withdraw $20,600 the second year, $21,218 the third, and so on. On year 30 your withdrawal would balloon to $48,545.

Therefore, even if the annual return on your assets matches the initial rate of withdrawal, you could eventually run out of money because you're taking out bigger amounts each year.

Besides inflation, you face the risk of poor investment returns (or investment losses) just as you're starting withdrawals.

"Early positive returns may mean a lifetime of sufficient income, while early losses can mean running out of money in the midst of retirement," explains literature by AXA Equitable Insurance Co.

In one example from AXA, two 65-year-olds retiring with $549,000, making annual withdrawals and achieving an average compounded 8 percent annual rate of return can end up with either $1.8 million at age 90 if above-average gains occur in the early years and losses later on, or less than $1.4 million if the 8 percent return is constant each year. But if losses occur early the money could run out at age 79.

When investing a lump sum without making withdrawals, the math is simpler. If you leave your money alone (say you invest $100,000 and don't touch it for 10 years), the sequence of annual investment returns does not matter.

One example: You'll end up with the same $173,631 whether you make 10 percent a year in years one through eight and lose 10 percent each of the last two years, or whether you lose 10 percent each of the first two years and make 10 percent a year in years three through 10. The math principle applies no matter what the returns are, or the sequence.

But if you're currently adding to your investments - for example, contributing regularly to a 401(k) plan - you actually benefit from early losses because you're "buying low" while prices are down (of course, this assumes prices eventually recover).

Therefore, rather than panic and quit contributing, young workers should step up contributions during market declines.

Humberto Cruz writes for Tribune Media Services.

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