Determine How Confident You Want to Be

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Determine How Confident You Want to Be

Both investors and financial advisors used to calculate withdrawal rates by assuming that a portfolio would earn some average annual rate of return over a period. For example, you might assume that your portfolio would earn 8% per year for 30 years.

The error of that thinking

Recent studies show how wrong that approach can be. The actual returns you experience each year in retirement make a huge difference in how much you can spend each year. Average numbers aren’t enough.

Here’s a historical example, courtesy of a study by T. Rowe Price. Assume you had a $250,000 portfolio in 1969 that was invested 60% in stocks, 30% in bonds, and 10% in cash. That portfolio earned an average of 11.7% per year over a 30-year retirement period from 1969 to 1998.

Let’s say you needed to withdraw 6% of your portfolio each year. Given that 6% is only a bit more than half of your "average" return, you’d have more than enough money to last your retirement, right?

Wrong. Because a bear market occurred early in the cycle (in 1973 and 1974), your nest egg would have been depleted by 1994. Had that bear market come in the 25th and 26th years of your retirement, however, you would have found yourself with a $2,000,000 portfolio at the end of 30 years.

Do not be discouraged

These examples don’t mean that calculating a withdrawal rate is a fruitless activity, though. Computers can run thousands of possible return scenarios, allowing you to use probability testing to make sure your spending rate will hold up when the next bear market comes.

For some of you, certainty is crucial. You want your withdrawal rate to survive most if not all worst-case scenarios 95% to 100% of the time. Other investors may be comfortable with a lower probability of success—maybe you don’t think we’ll hit every economic disaster that these probability tests include. Or perhaps the spending rate at a 95% confidence level is just unacceptably low for you.

On the income worksheet, choose from among three confidence levels. If you choose a 95% confidence level, there would only be a 5% chance that your withdrawal rate wouldn’t last throughout your retirement period. An 85% confidence level means that 15% of the time, your portfolio may expire before you die. And a 50% confidence level means there is a 50% chance you will run out of money too soon.