5 Minute Retirement Planning Drill

What to do with a million dollars in your retirement account?

In the first 5 Minute Retirement Planning Drill, we explored a simple compound interest calculator. Messing around with this calculator allows you appreciate the importance of investing early and often. It shows that waiting to invest will take more work to get to a larger account size by retirement time. The real question is what do you do with that hopefully large number in your retirement account when it’s time to hang up your gear? Take a lump sum? Divide it equally for each year you expect to be on this earth? Conventional tactics involve keeping the funds invested and withdrawing a little each year. In this article we are going to explore how you would go about withdrawing those funds that preserves your wealth until the end. Armed with this information, you can begin planning your retirement with the end in mind and a better framework for getting where you need to be.

The 4 Trinity Study

The 4 Trinity Study, published in 1998 sought to answer the question of how to safely withdraw your retirement portfolio in a way that you wouldn’t run out of money at the end of your retirement. Researchers took various stock and bond portfolios, tested various yearly withdrawal rates and back tested them against the stock and bond markets from 1925 to 1995. They tried a variety of stock and bond portfolios, and ultimately arrived at a 4% withdrawal rate. In this study, withdrawing 4% of your portfolio each year allowed you to continue collecting a reliable retirement check from your retirement accounts 98% of all years tested. It’s not a perfect process, and despite some faults (which will be the subject of future posts), the 4% rule has stuck as a widely accepted guideline for how to withdraw from your retirement account.

4% Withdrawal Rate?

If you had a million dollars by retirement and continued to invest your money in the stock and bond markets, you would be able to withdraw $40,000 from your account the first year. This would leave the remaining $960,000 to grow in your account. The next year, you withdraw 4% of that. So on an so forth. Say your portfolio grows 10% the first year you would have $960,000 x 1.1= $1,056,000 to take 4% from in year two. That would be $42,240 to withdraw in year two. You have essentially created a self sustaining retirement fund that grows each year. You get a cost of living adjustment that better keeps pace with inflation. This has a 98% success rate.

Retirement Planning In Conjunction With A Define Benefit Pension?

A lot of our department have a defined benefit pension and wonder how they should factor in their 401(k) plans with a pension. Although there are many other variables that we will build on in future posts, we will keep it simple. For a rough estimate of my yearly income in retirement, I pretend that my yearly benefit from my pension is 4% of a larger lump sum. By simply multiplying that benefit by 25, I can use that number in combination with my 401(k) and other investments to get a rough idea of what my yearly payout will be. For instance, if I received $70,000 a year from my pension, I would multiply that by 25 to get $1,750,000. Add that to your hypothetical $1,000,000 and you are left with $2,750,000. 4% of that would be a nice $110,000 for your fist year of retirement. While the $70,000 stays fixed plus whatever negotiated cost of living adjustment happens, your 401(k) ought to grow in subsequent years with market forces.

In Summary

There are many forces that will ultimately affect your retirement accounts. Market downturns. Boom and bust cycles in the economy and other factors may change this paradigm. With such a long time until retirement, we can only go off the conventional wisdom at hand, but the 4% rule is a great rough estimate of what to expect and what to plan for.