Exploring Retirement Spending: Going Beyond the 4% Rule

You’ve diligently contributed to your retirement plan each month. You’ve got a good understanding of your monthly expenses. Now you’re ready to retire. Determining how much you can afford to withdraw from your retirement savings each year while ensuring it lasts throughout your retirement is a critical aspect of retirement planning.

The 4% rule has long been the go-to retirement spending calculation for the past 30 years. This is a guideline to determine a sustainable withdrawal rate from a retirement portfolio. It aims to balance the need for retirees to have enough income to support their lifestyle throughout retirement while also ensuring that they don't deplete their savings prematurely.

Here's a breakdown of how the 4% rule works:

1. Determine the total value of your retirement portfolio at the time of retirement.
2. Withdraw 4% of that total in the first year of retirement.
3. Adjust the dollar amount of subsequent withdrawals each year to account for inflation.

For example, with a $1,000,000 portfolio, applying the 4% rule would entail withdrawing 4% of that amount in the first year of retirement. 4% of $1,000,000 is $40,000. In subsequent years, the dollar amount you withdraw would be adjusted for inflation. Let's say inflation is 2% in the first year, so for the second year, you would increase your withdrawal by 2%. Thus, in the second year, your withdrawal would be $40,000 * 1.02 = $40,800. You would continue this pattern for the next 30 years, adjusting the withdrawal amount each year based on the previous year's withdrawal amount and the inflation rate for that year.

The 4% rule assumes you withdraw the same amount from your portfolio every year, adjusted for inflation

By following this formula, the idea is that you can withdraw a relatively stable income from your retirement savings while also allowing your portfolio to grow enough to sustain you throughout a typical retirement period, often assumed to be around 30 years.

However, it's important to note that the 4% rule is not a guarantee and should be considered as a rough guideline rather than a strict rule. Factors such as investment returns or sequence-of-returns (see below), inflation rates, and individual spending habits can all impact the sustainability of withdrawals over time. Additionally, unforeseen expenses or changes in market conditions may require adjustments to withdrawal strategies.

Sequence-of-returns risk

This refers to the danger that a retiree faces when experiencing negative investment returns early in their retirement, potentially leading to a significantly diminished portfolio over time. This risk arises from the fact that retirees typically withdraw funds from their investment portfolios to cover living expenses during retirement. If the investment returns are negative in the initial years of retirement, coupled with ongoing withdrawals, the portfolio may be depleted faster than anticipated.

This risk is particularly concerning because the impact of negative returns is more pronounced when the portfolio is larger, such as at the beginning of retirement when the portfolio balance is typically at its highest. A substantial loss early in retirement may leave the portfolio with fewer assets to benefit from potential market recoveries in later years, increasing the likelihood of running out of money later in retirement. You can see how this can affect the 4% withdrawal rate.

So Is the 4% rule still relevant?

Now when the 4% rule was first developed, in the early 1990s, it was determined to be the safe withdrawal rate that would stand up to the worst 30-year markets in history. The supporting research considered market environments like the high-inflationary 1970s, and Great Depression of the 1930s. Yes, even through those environments, so the back-testing went, the 4% rule worked.

Fast-forward to today. Post-2008-09 Great Recession. On the downside of the post-pandemic inflationary period that began in 2020. And the research today suggests that there may be a better approach: utilizing spending “guardrails” can provide the same downside protection while actually increasing what retirees can spend in retirement.

Spending guardrails

With the guardrails approach, retirees adjust their spending based on economic conditions: increasing spending when the portfolio rate-of-return is up, but decreasing spending when the portfolio is down.

Specifically, it looks like this: if the market is trending upward and all criteria are met, the retiree would get a 10% increase on top of the inflation-adjusted prior-year withdrawal. But if the market is dropping and the reverse happens, the retiree would cut the annual withdrawal by 10%.

This obviously this takes a more flexible and responsive approach. Control what you can control, at least to a certain extent (spending), while trying your best to compartmentalize what is out of your control (market performance).

Ultimately, spending less in down markets helps with mitigating some of the sequence-of-returns risk, and smooths out the glide path of spending. Additionally, more recent research shows this approach results in higher lifetime withdrawal rates, and may still leave some assets to pass on to beneficiaries.

Determine your personalized withdrawal rate

OK – so back to the original question from the first paragraph. How much can you afford to withdrawal from your retirement savings each year while ensuring it lasts throughout your retirement?

Here are initial questions to ask yourself to help you head down the path of determining your own personalized withdrawal rate:

• Life expectancy: Estimate how long you expect to live in retirement. While its impossible to predict precisely, considering your family history, health status, and lifestyle choices can help provide a rough estimate.
• Expected investment asset allocation and returns: Consider the potential returns on your investment portfolio. Historically, stocks have provided higher returns than bonds or cash over the long term, but they also come with higher volatility and risk. And speaking of risk….what is your tolerance for it? What can you stomach to lose – or, more precisely, what can your financial plan endure – in terms of a market downturn?
• Flexibility: Are you prepared to adjust your withdrawal strategy as needed based on changes in your financial situation, investment performance, or unexpected expenses.
• Inflation: Account for the impact of inflation on your purchasing power over time. Inflation erodes the value of money, meaning that the same amount of money will buy less in the future.
• Other sources of income: Consider any other sources of retirement income you may have, such as Social Security benefits, pensions, rental income, or part-time work. These income streams can supplement your withdrawals from savings and reduce the amount you need to withdraw.
• Healthcare costs: Factor in potential healthcare expenses, including premiums, deductibles, and out-of-pocket costs for medical care and prescription drugs.
• Legacy goals: Consider any desires to leave a financial legacy for heirs or charitable causes and how this may affect your withdrawal strategy.

Keep in mind that the 4% rule is based upon a linear approach to financial planning: the same rate-of-return for your portfolio and the same spending (adjusted for inflation) each year.

We know that life is not linear. Stuff happens. Markets go up. Markets go down.

Instead, consider making changes during a down market, like cutting expenses that are not absolutely essential and lowering your discretionary spending on a vacation or a new car. This way, you can increase your financial plan’s probability of success and the likelihood that your money will last through your retirement.

Consider staying flexible, and revisit and review your financial plan on a regular basis, especially when a significant life event happens. (You do have a financial plan, right?)

If the market takes a downturn, you might not feel comfortable upping your spending at all. And, on the flip side, if the market skyrockets, you may feel better spending some of that gain on a vacation or a new car.

Bottom line: the 4% rule is a great place to start, but the better approach is to fine-tune and figure out your own personalized withdrawal rate to ensure the best retirement outcome possible.

#retirementplanning #financialplanning #feeonlyadvisor #CFP #4%rule

Bill Davis is a CERTIFIED FINANCIAL PLANNER™ and Managing Partner with Vericrest Private Wealth LLC, a financial advisory firm in Newtown, Pennsylvania.

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