Outside the Box: How do you know how much you can afford to withdraw from your retirement accounts?

The specific question before us seems simple: Should you plan to take out enough money to meet your needs, or should you take out only what your portfolio can “afford” to pay you?

Before I dig in, here’s my summary of three main points.

• If you take out what you need every year and adjust that figure for inflation, you are likely to do fine for a few years no matter what happens. But a string of years with either poor market returns or high inflation could make it impossible to continue this for the long haul.

• If you take out only what your portfolio can “afford” to pay you, your portfolio will be healthy, but you may have to tighten your belt in some years.

• If you start your retirement with savings that are truly ample, you are likely to avoid both these problems.

To see how this works, let’s start with a few assumptions. In the following scenarios, I will assume you retire with $1 million and you’ve determined that you need $50,000 from your portfolio to meet your needs that first year.

In your first blissful year of retirement, things are fine for you financially. You ask yourself: What could go wrong?

Well, how about this: If you increase your withdrawals every year to keep up with inflation, you likely won’t feel any pain if the market goes into a nosedive — at least not right away.

But over time, if the market goes down (or if inflation goes up) those withdrawals can get bigger than your portfolio can handle.

I’ll show you how this would have played out in a few tables that use actual market returns and actual inflation starting in 1970.

I will assume your portfolio was split evenly between a combination of short-term and intermediate-term government bonds and a U.S. stock portfolio made up of four equal parts: the S&P 500 SPX, +0.81% large-cap value stocks, small-cap blend stocks and small-cap value stocks.

Table 1 shows the first 10 years of your retirement if you took out $50,000 in 1970 and adjusted the amount each subsequent year for actual inflation.

Table 1: The first 10 years, fixed withdrawals

Those withdrawals allowed you to go through a pretty challenging decade without the need to tighten your belt.

But notice two things:

• The annual distributions went up dramatically, the result of steep inflation.

• In 1979, you were taking out 8% of your portfolio, a depletion rate that could not be sustained over the long haul.

The next table shows how you would have fared if your annual withdrawals were based strictly on how your investments were doing, and as a result you started each year by withdrawing 5% of your portfolio’s balance.

Table 2: The first 10 years, flexible withdrawals

These annual payments did a fine of meeting your needs for the first few years. But 1974, 1975, and 1976 required some serious belt-tightening. (Your 1976 withdrawal could cover only about 69% of the inflation-adjusted value of your first-year retirement income of $50,000.)

What happened later

Although subsequent years aren’t shown here, fixed distributions (Table 1), gave you plenty to spend, but at the long-term cost of running out of money.

Indeed, this portfolio was flat broke by 2014.

Yes, that’s a long time after you retired. But taking fixed distributions put you on a long-term path from which there was no good ending.

With the flexible 5% distributions, your portfolio remained healthy. But you paid a high price in the 1970s, when your withdrawals failed to keep up with inflation.

In fact, that flexible 5% distribution didn’t catch up to be worth its inflation-adjusted 1970 value until 1989. In other words, for the first 20 years of retirement, flexible distributions forced you into a lower standard of living than you had in your first year of retirement.

Neither of these outcomes is good. But there is a third path that will let you keep your portfolio healthy and have enough to live on.

If that sounds too good to be true, I will tell you that there is a catch: Before you retire, you will need to have more money saved up.

You can do that by working longer (postponing retirement). You might be able to do that by taking a second (part-time) job and saving all the income from it. Or you could supplement your withdrawals by continuing to earn money after you retire (though this solution is far from guaranteed).

However you accomplish this, the rewards can be great.

If your essential cost-of-living needs in 1970 were $50,000, as we assumed above, and you had started with $1.5 million instead of $1 million, a flexible distribution plan would have always provided more than enough money to meet those needs.

Your portfolio would never have been in danger, and you’d always have a cushion so you could take more money for extras.

This is the best combination for retirees, and I call this plan — starting retirement with more than enough to meet your needs — the Ultimate Distribution Strategy.

If you’re retired already or just about to retire and thus don’t have time to add significantly to your savings, your best bet may be to find ways to keep your spending under control.

And by the way, the four-fund equity portfolio I used in these calculations is definitely worth your while. You’ll find more about it here.

For more, check out my podcast: The Ultimate Distribution Strategy.

Richard Buck contributed to this article.