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At what rate should I withdraw from my savings once I have retired?

23 July 2017 by National Bank
At what rate should I withdraw from my savings once I have retired?

Vous avez fait des sacrifices pour épargner afin qu’une fois arrivé à la retraite vous puissiez puiser dans cette cagnotte pour compléter les revenus tirés de votre régime de retraite (si vous en avez un) et des prestations gouvernementales (le RRQ et le PSV, par exemple).

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You made sacrifices in order to build a nest egg you can dip into during retirement and supplement income from your pension plan (if you have one) and government benefits (e.g., QPP and OAS).

But at what rate should you withdraw from your savings? This is an important question as it will determine your lifestyle during retirement and is influenced by your longevity risk (with life expectancies on the rise, retirements are lasting longer and are becoming more costly to finance).

There are a number of ways to withdraw from your savings. Some opt to take it "one month at a time," but it's more advisable to adopt a systematic approach, as it gives you a better idea of the long-term impact of your withdrawal rate. Below are the three main systematic withdrawal approaches:

  • Withdraw an initial annual amount that is later indexed for inflation (IIA). Example: Withdraw $1,000 per month and increase that amount every 12 months based on inflation.
  • Withdraw a fixed annual amount throughout retirement (FAA). Example: Withdraw $1,300 per month and never adjust that amount.
  • Withdraw a certain percentage of your total savings throughout retirement (PCT). This percentage can remain fixed or can vary based on a simple formula. A popular method entails starting with a small percentage (when the portfolio is still worth a lot) and increasing that percentage along the way.

 

The table below compares the main characteristics of the three approaches:

Let's look at an example.[1] Let's assume that you've saved $560,000 by the time you retire. You want to use that amount over the next 25 years to supplement your private retirement benefits (if you have an employer pension plan) and government benefits. For approaches 1 (IAA) and 2 (FAA), if the markets behave on average as forecasted, we can calculate that the following withdrawal amounts will bring your savings down to approximately $0 in 25 years:

  • Initial annual amount fully indexed for inflation: $23,244 (net of taxes)
  • Fixed annual annuity amount: $28,442 (net of taxes)

The third approach (PCT) is more difficult to assess as there is no rule for determining the changes to annual percentages. Some recommend the following formula: Withdraw each year a percentage equal to 1 / remaining years. For example, at the start of your first year of retirement, you withdraw 4% of your total savings (i.e., 1/25, as 25 years remain in your retirement plan), plus the interest and dividends that will be earned over the course of the year. As with the two approaches above, this formula implies that you will withdraw 100% of your remaining savings in the last year of your retirement.

Figure 1 shows the changes (in current dollars on the left and in inflation-adjusted dollars on the right) to average annual withdrawals (i.e., if the portfolio achieves it’s expected average return every year) for the three approaches being analyzed. Approaches 1 (IAA) and 3 (increasing percentage) suggest similar average annual withdrawals, which are lower in the beginning (approximately $23,000) but increase in the second half of retirement (to approximately $35,000), as compared to approach 2, which is fixed at $28,442. Approach 2 therefore allows for a better lifestyle in the beginning, but inflation will erode your purchasing power in the long term. Lastly, the annual annuity withdrawn as part of the increasing percentage approach (PCT) relies on the value of investments at the start of the year. As portfolio returns vary from one year to another, this approach will generally result in more variable annual annuities from year to year, which can make it difficult to establish a stable lifestyle.

Figure 1: Changes to average annual withdrawals based on the three approaches analyzed

 

Legend: Blue: Indexed initial amount / Orange: Fixed amount / Grey: Increasing percentage

What is the best alternative? It all depends on the lifestyle changes you foresee in your retirement. The fixed annual amount approach allows for a more expensive lifestyle in the beginning, when some would like to spend more (e.g., on travel) in order to take advantage of the fact that they are usually still fairly healthy. However, this approach decreases your purchasing power in the second half of your retirement, which means that if you need additional healthcare during that time, your safety net will be reduced.

In the end, you should carefully consider your objectives, discuss them with your spouse, if applicable, and stick to the approach with which you are most comfortable. Of course, a fair amount of discipline will help prevent unpleasant financial surprises, but you should remain flexible: Too much discipline can lead to rigidity, which you want to avoid as you will need to be able to adapt should an unexpected event occur.

 

[1] Note: This is a fictional example and is a simplification of reality. However, it is a sufficiently accurate representation of reality to help explain the challenges discussed. A detailed version of our calculation assumptions is available upon request from laurent.blanchard@nbc.ca.

 

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