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The basic question everyone facing retirement asks is: How
much can I withdraw safely and not run out of money before I
die? Of course, this question would be a lot easier to answer if
we knew how long we were going to live and how much our living
costs would be.
Thirty years ago, when retirement planning was in
its infancy, financial planners would just assume
that your assets would grow at 8 percent indef -
initely and that if you were withdrawing 5 percent, you’d
be OK. But as we’ve seen over the years, most dramatically
in the 2008 to 2009 market, making projections like this
is unrealistic. What if you had retired in fall 2008 relying on
these simplistic projections? You’d have had a rude awakening
as your principal declined.
Various approaches have been developed to better
simulate real life. The most common approach used today
is one using a fixed rate of return, a constant level of ex -
penses only changing with inflation and a constant inflation
rate. This is often referred to as “deterministic” and
doesn’t take any changes into account for the variables of
returns, expenses and inflation.
This more simple projection doesn’t address the pos -
sible varia bility in any of the assumptions. Also, be aware
that the longer-term financial projections are the more
likely errors will be present. This is why financial plans
need to be updated regularly.
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Financial Planner | PERSONAL FINANCE
Will Your Money Last as Long as You Do?
Projecting Retirement Income
by Alexandra Armstrong, CFP, and Kelly Wright, CFP
Withdrawal Rate of Assets
Another tool used is examining forecasted withdrawal rates
of assets. Cash flow is the most critical financial measurement
since you need sufficient cash flow to meet ongoing
expenses. Often in retirement, cash flow from earnings
must be replaced with cash flow from other sources.
These other sources for cash flow may include pensions
and Social Security income. Usually these sources of re tire -
ment income are insufficient to meet expenses, so in come
from investments must also be used to meet ongoing
expenses.
The income from investments is often not just dividend
and interest income, but gradual withdrawals from prin -
cipal as well. The dollar amount needed to be re moved
from invested assets divided by the original principal
amount is the withdrawal rate.
Many studies suggest a withdrawal rate of 4 percent
will allow a portfolio to survive intact even with the ups
and downs of the market. Other studies suggest the em pir -
ical safe zone is in the 4 percent to 6 percent withdrawal
range.
If a financial projection shows you need to withdraw
6 percent or more, a prudent financial planner will rec om -
mend you reduce your expenses, often easier said than
done, so that the assets will not be depleted too quickly.
We find that the biggest expense in later years is health
care costs. This added to the fact that many people are
living longer than they ever have makes retirement planning
more difficult.
The Monte Carlo Simulation
Another tool commonly used today is the Monte Carlo sim -
u lation (see the graphic below). It takes into account
varying inputs and is used to actually illustrate uncertainty.
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March 2013 | BetterInvesting | 11