4/23/2011
Retirement Investing: Withdrawal Strategy
Retirees depend on the investment income from their portfolio. A good withdrawal strategy for their retirement portfolio can make their life a lot easier and better.
How to withdraw the money from your retirement portfolio to meet your living expense? How to guarantee you would not run out of your fund before your expected date?
There are several withdrawal strategies available today, but most of them can not guarantee you can reach your goal with a 100% rate. The one that guarantees may leave a lot of money on the table, it’s safe but too conservative. People can google for “safe withdrawal rates” and “withdrawal methods” for related information.
Here we introduce a simple method that shows how we can better utilize the money in our fund and can have a confident withdrawal approach to meet our expected date.
Let’s start with an example. We want to make a 30 year withdrawal plan for a portfolio. So let’s divide the portfolio into 30 lots first.
If the annualized return of the portfolio is 0%, we can set each lot as 1/30th of the portfolio. So for each year we get 1/30th from the fund, and we withdraw all the money after 30 years.
* * * Fixed Annual Return * * *
What if the return is fixed at 5% each year and we want to get a fixed amount every year? The ratio of the 30 lots would be like 1: 1/1.05: 1/1.05^2: 1/1.05^3: …: 1/1.05^29. Because the total should be adjusted to 1, after a little calculation, it would be like 0.061954: 0.059004: 0.056194: …: 0.015051.
So the first year we get 0.061954, it’s about 6.2%. The second year we can 0.059004*1.05 = 0.061954, the same as the first year. The third year and the following years we can all get the same amount, 0.061954. It’s like an annuity.
* * * Variable Annual Return * * *
For a fund with variable annual returns, we use the same approach. The major issue is how to determine the ratio of the lots by the annualized return of the fund.
As we look into the results, we would know that the amount withdrawn each year is the ratio of the lot multiplied by the total return of the fund in that period. For example, if we divide the portfolio with the factor 1.05 and the return of the portfolio for the first two years are 0.04 and 0.06.
The first year, we will withdraw 0.061954 * 1.04 = 0.06443216. It’s about 6.44% of the equivalent value of the original portfolio.
The second year, we will withdraw 0.059004 * 1.04 * 1.06 = 0.06504601. It’s about 6.5% of the equivalent value of the original portfolio.
For each year n, it’s like we withdraw a certain ratio X(n), such that
X(n) = ( (calculated total return of the portfolio for year n since inception)/1.05^n) * f, f is a constant.
We can see that if the annualized return of the portfolio is closer to 1.05, the withdrawal ratio X(n) is smoother. Basically we can use the annualized compound return of the portfolio to determine the ratio that is used to divide the portfolio. We will give some examples in the following paragraphs to show how the different ratios impact the results of the withdrawal rates.
Here we have to notice that we withdraw the percentage of the equivalent value of the “original” portfolio. It’s more like we cut the original portfolio into 30 chunks and invest them separately. Then each year we get one chunk from the portfolio.
* * * Inflation Rate * * *
Basically the money withdrawn from the portfolio should provide retirees almost the same living standards each year, so we have to take the expected inflation rate into account.
With considering the inflation rate, we will use the real return of the portfolio to determine the ratio rather than the nominal return of the portfolio.
How to withdraw the money from your retirement portfolio to meet your living expense? How to guarantee you would not run out of your fund before your expected date?
There are several withdrawal strategies available today, but most of them can not guarantee you can reach your goal with a 100% rate. The one that guarantees may leave a lot of money on the table, it’s safe but too conservative. People can google for “safe withdrawal rates” and “withdrawal methods” for related information.
Here we introduce a simple method that shows how we can better utilize the money in our fund and can have a confident withdrawal approach to meet our expected date.
Let’s start with an example. We want to make a 30 year withdrawal plan for a portfolio. So let’s divide the portfolio into 30 lots first.
If the annualized return of the portfolio is 0%, we can set each lot as 1/30th of the portfolio. So for each year we get 1/30th from the fund, and we withdraw all the money after 30 years.
* * * Fixed Annual Return * * *
What if the return is fixed at 5% each year and we want to get a fixed amount every year? The ratio of the 30 lots would be like 1: 1/1.05: 1/1.05^2: 1/1.05^3: …: 1/1.05^29. Because the total should be adjusted to 1, after a little calculation, it would be like 0.061954: 0.059004: 0.056194: …: 0.015051.
So the first year we get 0.061954, it’s about 6.2%. The second year we can 0.059004*1.05 = 0.061954, the same as the first year. The third year and the following years we can all get the same amount, 0.061954. It’s like an annuity.
* * * Variable Annual Return * * *
For a fund with variable annual returns, we use the same approach. The major issue is how to determine the ratio of the lots by the annualized return of the fund.
As we look into the results, we would know that the amount withdrawn each year is the ratio of the lot multiplied by the total return of the fund in that period. For example, if we divide the portfolio with the factor 1.05 and the return of the portfolio for the first two years are 0.04 and 0.06.
The first year, we will withdraw 0.061954 * 1.04 = 0.06443216. It’s about 6.44% of the equivalent value of the original portfolio.
The second year, we will withdraw 0.059004 * 1.04 * 1.06 = 0.06504601. It’s about 6.5% of the equivalent value of the original portfolio.
For each year n, it’s like we withdraw a certain ratio X(n), such that
X(n) = ( (calculated total return of the portfolio for year n since inception)/1.05^n) * f, f is a constant.
We can see that if the annualized return of the portfolio is closer to 1.05, the withdrawal ratio X(n) is smoother. Basically we can use the annualized compound return of the portfolio to determine the ratio that is used to divide the portfolio. We will give some examples in the following paragraphs to show how the different ratios impact the results of the withdrawal rates.
Here we have to notice that we withdraw the percentage of the equivalent value of the “original” portfolio. It’s more like we cut the original portfolio into 30 chunks and invest them separately. Then each year we get one chunk from the portfolio.
* * * Inflation Rate * * *
Basically the money withdrawn from the portfolio should provide retirees almost the same living standards each year, so we have to take the expected inflation rate into account.
With considering the inflation rate, we will use the real return of the portfolio to determine the ratio rather than the nominal return of the portfolio.
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