By Professor Rick Ulivi, Ph.D.
professor@ulivi.com
Website: www.ulivi.com
How much income can you afford to take out each year from your investments? This is a tough question for retiree’s because withdrawing too quickly leads to overspending and desperation, but not withdrawing enough at the appropriate time will not allow a retiree to enjoy all his/her savings thru retirement.
The right balance requires taking into account many variables, including a portfolio’s size, its expected rate of return, its volatility, inflation, longevity, income needs, and the withdrawal rate. Researchers estimate that, if you have a portfolio invested with a mix of stocks and bonds, you should be able to withdraw annually about 5%. This withdrawal rate should allow your income to keep up with inflation.
However, how do you monitor your “nest egg’s” ability to generate the income you will need thru retirement? Rather than just focusing on a percent withdrawal rate, I recommend using an additional approach: the funding ratio. Your funding ratio should always be at least 100%. Less than that is a very strong warning signal that you are on your way to depleting your savings. The lower your funding ratio, the sooner you will run out of money. A ratio higher than 100% indicates that your “nest egg” is larger than it needs to be or that it has a cushion; better yet, that you can increase your spending without worrying about running out of money.
I recommend that retirees calculate their funding ratio at least annually. The ratio is calculated by dividing the value of a portfolio by the present value of a retiree’s future income needs. For example, let’s assume that your “nest egg” currently has a value of $500,000 and that you will invest it at 5% per year. To make matters easy, let’s assume inflation will be 0% and that you will need an income of $25,000 per year, for 30 years. Doing a bit of math, this means that the present value of your future retirement income needs is $397,000. Using these numbers we can determine that your funding ratio is 125% (that’s $397,000 divided by $500,000). These numbers mean that you have nothing to worry about. Your “nest egg” will provide the income you’ll need thru retirement.
However, let’s assume that you want to withdraw an annual income of $35,000 instead of the original $25,000. What’s your funding ratio now? It is 88%; that’s because the present value of your future income is now $556,000. Your funding ratio is indicating that you are in a danger zone. This means that, if you keep drawing annually $35,000, you will run out of money. In fact, you will run out of money in the 21st. year of your retirement.
In sum, calculating your funding ratio is an easy and excellent way to monitor the sustainability of your “nest egg” during retirement. I strongly recommend that you calculate and monitor your funding ratio to make sure you can retire smart and live well.