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April 14, 2013

Consider spending strategies in retirement

Retirees face the challenge of converting a nest egg accumulated over a lifetime of work into income that will last for as long as they live in retirement, a period that can last for three decades or more.

One of the most important issues they must address is how and how much to withdraw from their investments each year. The decision involves a trade-off between spending too much and running out of money and being unnecessarily frugal and depriving themselves of a lifestyle they could otherwise afford.

The amount that can reasonably be withdrawn from a portfolio each year depends upon several factors that differ for each person, including assumptions about investment returns, inflation, the length of retirement, and the approach used to draw down the funds. There are two common drawdown methods each with advantages and disadvantages. By understanding both of them, a retiree can craft a “hybrid’ of the two that best fits their specific situation. Let’s take a look at them.

The first involves withdrawing a predetermined percentage of the portfolio for the first year and then adjusting that dollar amount for inflation each subsequent year.

For example, a retiree with $500,000 in retirement savings decides to withdraw $15,000 or 3 percent of the portfolio for the first year. If during that year inflation is 2 percent (i.e. 2 percent of $15,000 is $300), the investor would increase the withdrawal amount to $15,300 for year two.

These inflation adjustments would continue each year, so the retiree could enjoy the same predictable purchasing power throughout retirement.

However, since the withdrawals are increased every year by the amount of inflation regardless of the portfolio’s performance, a prolonged downturn in the financial markets (and therefore the portfolio) could substantially deplete the assets. During these periods, those who use this approach must be prepared to make “as needed” adjustments to spending to avoid exhausting the portfolio prematurely.

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