Rethinking retirement: Why the 4% isn't enough
Picture this: You've been socking away a portion of your earnings into investment accounts year after year in the hopes of a comfortable (and enjoyable!) retirement. Spending time with your family, travel, and a life of leisure is in your future. But the truth is, while saving for retirement is undeniably crucial, what you end up having to spend might not align with the retirement of your dreams.
I know what you might be thinking: "But I've planned for this. I've worked hard, saved my money, built a nest egg, and the consensus financial advice – specifically, the 4% rule - has assured me that I'll have enough retirement income."
Unfortunately, there's no strict rule of thumb, guideline, or "retirement calculator" that can help you determine how much money you'll need for your planned retirement. As retirees look forward to their life of leisure, a crucial question is: how much do we need to be able to maintain our lifestyle? And how sensitive are your retirement savings to factors like inflation and taxes?
We decided to find out.
A recent study found that Americans, on average, believe they will need approximately $1.27 million to retire comfortably.¹ Naturally, the numbers vary with age. The study also found that many believe it's likely that they will live to be 100 years old, with 40% of Gen Z and Millennials expecting to hit triple digits.
Using a Monte Carlo simulation engine that captures many realistic behaviors of asset prices and taxes, we find that the safe spend supported by the $1.27 million estimate varies significantly by account type and inflation rate. For this analysis, we assume that the retiree holds a typical "60/40" portfolio with typical adviser fees.² We also assume the retiree is 60 years old and plans for a 40-year retirement.
Starting with $1.27 million and assuming no inflation, a retiree can expect a safe spend rate of approximately $3,100/month for 40 years from a taxable account. But, adding 2% annual inflation and spending instead out of a Traditional IRA (Individual Retirement Account) in New York, the estimated safe spend drops over 40% to approximately $1,800/month. And that's just the beginning.
Our results, shown below, are discussed throughout the rest of this blog post. We compare them to each other to quantify the impact of inflation and account type on safe spend. We also compare our results to a benchmark of the popular 4% rule, which suggests investors can safely withdraw 4% of their savings per year in retirement. This rule would indicate a spend rate of approximately $4,263 per month, more than twice what some of our examples suggest.
Personal situations matter greatly in retirement planning. In this blog post, we'll also explore some examples of how account type, tax residency, and inflation assumptions can drastically impact safe spend.
Baseline safe spend
To get a baseline understanding on safe spend, let's use the simplest case as an example. Distributions from Roth IRA accounts are not subject to taxes – and gains in the account are untaxed – so the Roth IRA provides a straightforward example of how portfolios support safe spend. We find that a Roth IRA supports approximately $3,250 in monthly safe spend.
The assumed portfolio – 60% equities and 40% bonds – has a median net-of-fee annualized return of 4.6% and an annualized volatility of 9.7%. Using an annuity formula based on the net-of-fee return of 4.6%, the $1.27 million initial investment would lead to an annuity of approximately $5,832 per month – but that's without any volatility.
Of course, volatility matters as returns can vary significantly over time, and the potential for poor market outcomes at the beginning of retirement can drive sequence of return risk. This outcome can drive lower end wealth even for a given distribution of potential returns.³ With 9.7% annualized portfolio volatility, the "safe spend" amount – the amount that results in approximately 90% success rate is approximately $3,250 per month.⁴
Inflation
It's not surprising that in the same survey, inflation was the top financial concern coming in at 51%. But what is surprising, is that many of the general rules that we turn to for help in determining the right amount to save for retirement, don't take inflation into account. It turns out, our analysis shows that inflation impacts safe spend significantly. We assume that inflation only affects the cost of spend and does not impact portfolio returns. Safe spend throughout this piece is defined in today's dollars. So, a $3,000 per month spend at 2% annualized inflation would map to needing $3,060 per month in one year and over $6,600 per month by the end of the 40-year horizon.
Using the same Roth IRA example as before, the safe spend rate with 2% inflation is $2,200 – much lower than the $3,250 assuming no inflation. In other words, a 2% inflation rate – in-line with what the Federal Reserve has set as their target inflation number – wipes out approximately one-third of spend relative to a no-inflation benchmark. 2% can make a huge difference in what you're able to spend in retirement when compounded over time.
A 2% inflation rate wipes out approximately one-third of spend relative to a no-inflation benchmark.
Account types and taxes
Our previous examples assumed a Roth IRA. Roth IRAs are straightforward because there are no taxes owed on distributions. However, most individuals have other account types, and tax implications that must be considered. For instance, taxes owed on capital gains and interest imply that a retiree must assume lower net-of-tax portfolio returns for taxable accounts. For Traditional IRAs, distributions are subject to income taxes, which means the Traditional IRA will have a lower net-of-tax wealth than the same account value for a Roth IRA.
But how much do these tax considerations matter? For taxable accounts, compared to Roth IRAs, there's a small but meaningful haircut to safe spend rates, since capital gains and interest income are subject to taxes. The real impact is felt in Traditional IRAs, where the income tax on distributions significantly impacts spending power.
In addition to the 12% marginal federal income tax rate (we assume Married Filing Jointly and $50k of annual baseline income), distributions are subject to state income tax rates, outlined below.
The marginal income tax rate on the first dollar of distributions in New York is 17.85%, meaning that a dollar in the account is only able to support approximately 82 cents of spend. You can see this reflected in the safe spend rate: compared to the Roth IRA safe spend of $3,250, the Traditional IRA safe spend for a New York resident is approximately $2,650 (approximately 82% of Roth).
In California, where the combined state and federal marginal tax rate would be 16%, the Traditional IRA safe spend is $2,750 (approximately 85% of Roth). In Florida, where only the 12% federal rate is relevant, the Traditional IRA safe spend is approximately $2,850 (approximately 88% of Roth5).
Does the 4% rule get it wrong?
The popular 4% rule suggests that a retiree can spend 4% per year of their initial investment throughout a 30-year retirement.⁶ Using the assumptions we laid out earlier, this would amount to approximately $4,263 monthly. The 4% rule has a number of premises that could bias its result higher or lower than our exercise:
4% could result in over-spending because...
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4% could result in under-spending because...
To give even more context, safe spend rates are impacted meaningfully by portfolio return assumptions. The 4% rule was designed around historical data with equity total returns averaging 10.3% and intermediate-term Treasuries averaging 5.1%. The 60/40 portfolio was assumed to generate 8.2% total investment return. Our analysis takes a more conservative approach, with similar total Treasury returns but moderated equity returns (7.1% total annualized).⁷ This is more in line with recent industry outlooks, and aligns with the view that, especially when planning for retirement, it's best not to count on equity returns being particularly high.⁸
Effectively, the 4% rule doesn't consider the different types of tax-advantaged accounts, doesn't consider advisor fees, and doesn't consider how your state of residence might affect your safe spend. But as shown by our analysis, these factors are very important when calculating how much you can actually spend in retirement – and by not taking them into consideration, investors can risk over-spending.
What does this mean for investors planning for retirement?
While we appreciate the simplicity of a golden number that reflects what individuals believe they'll need for retirement, we also highlight that there is no single number that can reflect every individual's unique situation. In our small experiment alone, where we test different inflation rates, account types, and tax situations, we find that:
With every experiment, it's important for investors planning for retirement to consider the potential impacts of inflation, account type, and tax situation on their ability to spend. For example, inflation could be worse than 2%, and due to other income, the impact of taxes could be even greater than our examples here.
What can investors start doing today?
Planning for retirement can seem simple. Put aside your money, don't touch it, and you'll probably have enough when the time comes.
But as our experiment shows, there are many individual circumstances, factors, and requirements that can significantly affect your safe spend when it comes to retirement. And unfortunately, no simple "rule" will give you an accurate representation of what you'll need to have a comfortable retirement.
Financial advisors can help – they're here to help you explore your options in terms of the different accounts you have and help you understand your personal tax profile. And at NDVR, our advisors are equipped with proprietary technology (Our NDVR Portfolio Lab) to help you build a custom portfolio, completely integrated into your financial plan.
Try our technology for free, today, or meet with an advisor to explore what NDVR could do for you and your retirement planning.
Why wait to optimize your wealth? Connect with a financial advisor today.
Appendix
We use our NDVR Portfolio Lab to study the simulated effects of tax residency and inflation on safe spend rate. We assume a 60-year-old (birth year 1963). We use a 40-year horizon and assume monthly spending needs. Inflation adjustments, if relevant, occur monthly. Our engine runs 1000 scenarios based on historically-calibrated models of asset return behavior.
Taxes. We assume a base income of $50,000 per year (adjusted by 2% inflation) to reflect potential Social Security income. The 2023 federal and state tax brackets are assumed, assuming a Married Filing Jointly status, and are adjusted at a 2% inflation rate; the associated tax rates are assumed to remain constant. State-specific tax information is used in the simulation, such as state-specific treatment of capital gains and dividends. Taxes are assumed to be paid once per year and are designed to mimic actual tax return logic.
Investment. The portfolio is assumed to be a Traditional 60/40 portfolio with 132 basis points of annualized fees. 60% of the portfolio is assumed to be in global equities, split into 60% US, 30% Developed Ex-US, and 10% Emerging equities. 40% of the portfolio is allocated to a 7-year Treasury bond ladder. The portfolio is rebalanced monthly.
Asset Returns. For this analysis, the global equity portfolio is assumed to have a total return of 7.1% annualized (5.2% excess returns) with a volatility of 17.8%. The 7-year bond ladder is assumed to have total returns of 5.0% annualized (3.0% excess returns) with a volatility of 5.2%. The 60/40 portfolio therefore has an assumed total return of 6.3%. Our asset class assumptions vary over time and are responsive to initial conditions such as the shape of the yield curve and recent market volatility. The assumptions used for this piece were reflective of our assumptions as of August 15, 2023.
Defining Safe Spend. We define safe spend to be the highest spend rate (in today's dollars) that has at least a 90 Plan Security Score (PSS) in our engine. The PSS reflects the root mean squared shortfall of the plan, and is scaled from 0 to 100 such that 100 PSS reflects fulfilling all planned withdrawals in their entirety. The root-mean-squared nature of the metric reflects that larger shortfalls are penalized more heavily than small shortfalls.
Account Type. We use Roth IRA, Traditional IRA, and Taxable accounts in our study. The taxes on retirement distributions are assumed to be paid as part of the study. All spend rates are net-of-tax.
Footnotes
Disclosure
This material is published for informational purposes only.
The views expressed and other information included are as of the date indicated and based on the data available at that time. They may change based on changes in markets, general economic conditions, rules and regulations, and other factors. NDVR does not assume any duty to update any of the views and information herein. Unless otherwise noted, views and opinions expressed are those of the authors and not necessarily those of NDVR or its affiliates.
NDVR is an investment advisor that may or may not apply the views and other information described herein when providing services to its clients. The views and information herein are not and may not be relied on in any manner as, investment, legal, tax, accounting or other advice provided by NDVR to any individual or entity or as an offer to sell or a solicitation of an offer to buy any security.