As you approach retirement, are you aware of the silent killer lurking on the horizon? Let’s call our silent killer “W.D.” When you enter the retirement zone, W.D. will be right behind you, looking over your shoulder, waiting to spring into action. When you dare to take your first withdrawal from your portfolio, W.D. will pounce – only you won’t know it. You will continue on, as if nothing happened, innocently taking your withdrawals each month. As each deposit hits your checking account, W.D. will extract a toll on your portfolio, one that will increase in size with each transaction. And guess what? You will never know what hit you. You see, W.D., or “Withdrawal Drag,” is the ultimate portfolio silent killer.
Before we expose the secrets of “withdrawal drag,” first some background. When you’re saving for retirement, or you’re in the “accumulation stage,” as we retirement income planners like to refer to it, assuming that you take no withdrawals from your portfolio, you realize the beauty and grace of compounding rates of return. To appreciate compounding, let’s start with simple interest.
With simple interest, you earn interest on your principal. Let’s say you have a portfolio that’s worth $500,000 and it earns simple interest of 7%. In year 1, you will earn $500,000 x 7%, or $35,000. Your portfolio will be worth $535,000 ($500,000 + $35,000) at the end of year 1. In year 2, you will earn $500,000 x 7%, or $35,000. At the end of year 2, your portfolio will be worth $570,000 ($535,000 + $35,000). And so on. That’s OK, however, there’s a better way to go – compounding.
Through compounding, in addition to earning interest on your principal, you also earn interest on your interest. Using the previous example, after year 1 when your portfolio is worth $535,000, in year 2 you earn interest on $535,000, not just $500,000. You earn $535,000 x 7%, or $37,450 vs. $35,000 and your portfolio is worth $572,450 vs. $570,000 at the end of year 2 using simple interest. The benefit to you of earning compound vs. simple rates of return increases each year. For a simple example of the magic of compounding, please see Exhibit 1 – $500,000 Growing At 7% Compound Interest. Per Exhibit 1, over 26 years, you have earned $2,403,676 and your portfolio has grown from $500,000 to $2,903,676. Although it isn’t illustrated, this is an increase of $1,493,676, or more than double, over the value of your portfolio of $1,410,000 using simple interest.
Enter Mr. W.D., or “Withdrawal Drag.” Continuing on with our example, let’s take a look at Exhibit 2 – $500,000 Growing at 7% Compound Interest With Annual Withdrawals. Now you’re 65 and you’ve entered the retirement zone. You’re still earning a compound rate of return of 7% on your portfolio, however, you’re taking withdrawals from your portfolio each year. Let’s assume that your withdrawals at age 65 total 5% of the value of your portfolio, or 5% of $500,000, or $25,000, and they increase by 3% each year. Per Exhibit 2, after starting with $500,000 at age 65, after 26 years, or at age 90, (1) your withdrawals total $964,000, (2) you earned $926,000, and (3) your portfolio is worth $462,000, or $38,000 less than what you started with. Not a bad result, right? Well, yes and no.
To answer the question, let’s step back and look at what your $500,000 portfolio would have been worth if you never took any withdrawals and you subtract your total withdrawals and ending balance of your portfolio at age 90 after taking withdrawals:
$500,000 growing at 7% compound interest for 26 years per Exhibit 1: $ 2,903,676
Less: Total withdrawals at age 90 per Exhibit 2 ( 963,826)
Less: Ending balance of portfolio at age 90 per Exhibit 2 ( 462,230)
Withdrawal Drag $ 1,477,620
What happened to almost $1.5 million? Ah, hah – mystery solved! The culprit is, guess who? Mr. W.D. Sure enough, per Exhibit 3 – Withdrawal Drag, the difference between your total earnings of $2,403,676, assuming no withdrawals per Exhibit 1, and your total earnings of $926,056, assuming withdrawals of 5% of your starting principal increasing by 3% per year per Exhibit 2, is exactly $1,477,620. At first, seemingly innocent, extracting a mere $1,750 from your portfolio at age 65 per Exhibit 3, Mr. W.D. doesn’t seem like such a bad guy. With each, passing year, however, Mr. W.D. gets greedier and greedier, taking almost $20,000 at age 72, $59,000 at age 80, and helping himself to $160,000 at age 90.
And so ladies and gentleman, as you enter the retirement zone, keep a close eye out for Mr. W.D. each and every time that you take a withdrawal from your portfolio. He’ll be watching you!