If you’re like most retirees, you’ve spent much of your career accumulating assets to fund your retirement. You’ll likely rely on those assets to generate a portion of your retirement income. While you will probably have Social Security income and possibly even a pension, you may also need income from your savings.
Even if you’ve saved a substantial amount for retirement, it can be difficult to know how much to withdraw each year. If you take too much, you could deplete your savings and put yourself in a challenging financial situation later in life. Take too little, and you may struggle to cover your living expenses.
A popular strategy is to take four percent of your savings balance each year as a retirement distribution. The idea behind this recommendation is that four percent is a modest amount that will allow your savings to continue growing. It’s also a simple approach that makes it easy to plan your distributions.
This approach isn’t right for everyone, though. There are several reasons why the “four percent rule” may not be an effective approach. Below are a few areas in which this method may fall short:
Inflation and Market Volatility
In theory, the four percent withdrawal is supposed to change every year. You look at your account value annually or even more often, and then you adjust your withdrawal to reflect the new balance.
In practice, many retirees fail to make this adjustment, which results in a constant withdrawal amount that stays flat over time. This is problematic because it doesn’t account for inflation. As your cost of living increases, so too should your withdrawals. Otherwise, you may not be able to afford your lifestyle over time.
Another issue with a flat withdrawal is what happens during a market downturn. If you don’t adjust your withdrawal to reflect a lower balance, you could end up withdrawing much more than four percent. If that continues over time, you may deplete your account and limit your opportunities for growth.
Another issue with the four percent approach is that it doesn’t account for your specific asset allocation. A four percent withdrawal may or may not be modest, depending on your investment strategy. If you have a very conservative approach with little upside potential, a four percent annual distribution may deplete your account over time.
It’s impossible to prescribe an optimal withdrawal rate without knowing how the funds are invested. Your withdrawal amount should be based on your specific needs, goals and objectives, and it should be aligned with your allocation and investment strategy.
Finally, one of the biggest issues with the four percent approach is that it isn’t specific to your spending needs. Your plans for retirement are unique to your goals and objectives. Your income strategy should be unique, too.
You may want to spend money in the early years as you travel and pursue favorite hobbies, then cut back on your spending as you get older. Or maybe you want to be conservative early in retirement so you have assets to cover health care or long-term care later in life. Maybe you want to minimize your spending so you can leave a significant legacy for your loved ones.
There could be any number of factors and criteria that influence your income needs. A better approach may be to build a budget that includes your specific spending goals and your projected retirement income. Then you can determine exactly how much income you should take from your savings each year.
Ready to develop your retirement distribution strategy? Contact us at Peak Financial Corp. We can help you analyze your needs and implement a plan. Let’s connect soon and start the conversation.
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