Withdrawal Rate Rule #4: You must take retirement income withdrawals in a particular, prescribed order.
When you take withdrawals, your retirement income must come from each category in a particular order. For the new investor, these rules can be complex. To simplify the idea, picture three buckets.
Retirement Income Bucket #1
Bucket number one is filled with cash; enough to cover one year’s worth of living expenses.
Retirement Income Bucket #2
Inside bucket number two you stack your fixed income investments(sometimes called a bond ladder). Each layer represents one year’s living expenses. Every year, one year’s worth of spending money “matures”, and moves from the “fixed income” bucket to the “cash” bucket. This assures you always have enough cash on hand to cover your upcoming expenses.
Retirement Income Bucket #3
The third bucket is filled to the rim with equities. You may only take money from the equity bucket when it overflows. An overflow year is any year when equities have above average returns; roughly an annual return in excess of 12- 15%. At the end of an overflow year, you sell excess equities, and use the proceeds to refill the fixed income and cash buckets.
There will be many years where the equity bucket does not overflow. It will take discipline to realize it is okay to let the fixed income and cash buckets get to a low level during these years. Eventually, an overflow year will come along and all buckets will be refilled.
Following this rule will prevent you from becoming a victim of your own emotions, and selling investments at an unfavorable time.
Many of these rules were developed through research conducted by Jonathon Guyton. You can find additional details on his prescribed order of which assets to use first, in the article titled Decision Rules and Maximum Initial Withdrawal Rates on his website. (The article was first published in the March 2006 issue of the Journal of Financial Planning.)
Next: Withdrawal Rate Rule #5: You Must Take Retirement Income Pay Cuts During Bear Markets
