A lower withdrawal rate can help your retirement savings last longer, but it may also limit how much you spend. Moving from 4% to 5% gives you more income upfront while leaving less room for your portfolio to absorb market losses. Your decision will depend on the answer to this question: Is the extra money worth taking on more risk?
What Changes When You Withdraw 5% Instead of 4%
The 4% rule is a common benchmark for estimating sustainable retirement withdrawals. It generally starts with 4% of your portfolio in the first year and adjusts that amount for inflation thereafter. Raising the rate to 5% would increase your income but puts more pressure on your savings. On a $1 million portfolio, the difference could look like this:
| Withdrawal Rate | First-Year Calculation |
|---|---|
| 4% | $1 million × 4% = $40,000 |
| 5% | $1 million × 5% = $50,000 |
| Difference | $50,000 − $40,000 = $10,000 |
Increasing your withdrawal rate to 5% on a $1 million portfolio gives you an additional $10,000 in the first year. Though this could leave less money invested for future growth, which may affect how long your savings last.
Morningstar estimates that a 3.9% starting rate has a 90% probability of supporting fixed, inflation-adjusted withdrawals for 30 years under base-case assumptions. 1 The research also shows that retirees who can vary their expenses may be able to begin with a higher withdrawal rate.
The Chicago-based firm found that flexible strategies supported initial rates ranging from 5.2% to 5.7%. These distributions changed with portfolio performance instead of going up automatically for inflation. That could mean taking more when markets perform well and scaling back when your balance falls.
The catch is that your retirement income becomes less predictable. A larger initial draw can also leave you with a smaller cushion for unexpected costs, longevity or poor investment returns. Your ability to handle those risks should factor into how much you take from your portfolio.
If you want to adjust withdrawals based on portfolio performance instead of inflation, a financial advisor can help you set rates for changing market conditions.
Performance vs. Inflation Adjustments: How Do You Pick?
A performance-based strategy ties your withdrawals to how your investments are doing. As an example, let’s assume that you start with a 5% withdrawal on a $1 million portfolio and adjust future distributions based on investment performance. If your plan calls for a 10% reduction after a market decline and a 5% increase after a recovery, the first three withdrawals could look like this:
| Portfolio Performance | Withdrawal Calculation |
|---|---|
| Starting amount | $1 million × 5% = $50,000 |
| After a decline | $50,000 × 90% = $45,000 |
| Following a recovery | $45,000 × 105% = $47,250 |
The loss would reduce your annual distribution by $5,000. Even after the subsequent increase, you would receive $2,750 less than the original amount. Your budget would need enough flexibility to absorb the difference.
An inflation-based strategy, by comparison, ties future distributions to changes in consumer prices. Starting at 4% with a 3% annual increase would produce the following amounts:
| Inflation Adjustment | Withdrawal Calculation |
|---|---|
| Initial distribution | $1 million × 4% = $40,000 |
| First 3% increase | $40,000 × 1.03 = $41,200 |
| Second 3% increase | $41,200 × 1.03 = $42,436 |
This strategy would provide a steadier spending schedule, but distributions could keep climbing during a downturn. Performance adjustments may work better if you can trim expenses when investments fall, while inflation increases may make more sense if keeping pace with living costs is a priority.
SmartAsset’s retirement calculator can help compare projected retirement income and estimate how long savings may last.
What Could Make a 5% Withdrawal Rate Work?
Other sources of retirement income can make a 5% withdrawal rate easier to manage. If Social Security or a pension covers essential expenses, you may rely less on your portfolio when markets fall. Retirement length also matters because funding 20 years of expenses puts different demands on your savings than planning for 35 or 40.
To assess the risk of taking 5%, estimate how long your portfolio could last if stocks fall early in retirement and compare that result with a 4% withdrawal rate. If the higher rate causes your savings to run out several years sooner, you can weigh that risk against the additional income.
A financial advisor can help you compare both withdrawal rates and determine how each may affect your savings.
Photo credit: ©iStock.com/Jacob Wackerhausen, ©iStock.com/StudioEasy
Read the full article here
