[Editor's Note: Today's guest post was submitted by regular reader, Dr. Dave Gorson. Dr. Gorson recently retired after 34 years in private practice as an Endocrinologist. We have no financial relationship.]
By Dr. Dave Gorson
Most of us want to eventually reduce the pace at which we work now. We may want to slow down, or stop entirely. If so, you will need your savings and investments to maintain your desired lifestyle. So how much will you need?
A few caveats before we start: taxes may be the highest expense in retirement, so it is crucially important to develop a retirement plan which takes this into account. While deferring taxes into a 401(k), 403(b), or IRA is useful to reduce current taxes, it may be more useful to pay some taxes now in order to fund a Roth IRA, which will be tax-free later. Keep in mind that assets need to be kept in a Roth IRA for five years to avoid early withdrawal penalties. When in doubt, discuss your personal tax situation with a certified public accountant and/or a certified financial advisor (CFP).
The most widely known plans for spending your assets in retirement are reviewed below. There are others, and a discussion of your own situation with a CFP or registered investment advisor (RIA) may also be beneficial. Be sure you understand the risks of your investments and any potential conflicts of interest with any advisor you pick. Make sure your advisor is a fiduciary, and know if they will financially benefit from any of their recommendations.
How Much Will You Need in Retirement?
So, how much will you need? Everyone’s individual circumstances are different. For example, will you have a pension or rental real estate income? When will you draw social security (for most people waiting until age 70 is considered best)? How do you plan to fund anticipated or unanticipated large expenses such as new vehicle purchases or home repair? Therefore, use the following as a guideline.
You could use a rule of thumb such as “you will need 70-80% (or even 100%) of your preretirement income” once you retire. I don’t recommend this and refer to WCI's good explanation as to why it is not a good idea.
The 4% Rule
A better approach begins by first getting an accurate idea of how much you spend now. I suggest tracking all of your spending for one year while you are still working. It will become immediately obvious which expenses will go away, such as saving for retirement or possibly private school costs or funding a college education for children.
Then you will have a general idea of what you will spend in retirement. For a 30 year retirement, a common rule of thumb is to simply multiply that annual number by 25. So, if annual spending is expected to be $100,000, then 25 times that is $2.5 million, and this is the amount you would need in your nest egg.
This derives from the groundbreaking work of William Bengen, CFP, who in 1994 developed the “4% rule”. This was developed as a worst-case scenario such that, based on historical inflation and stock and bond returns data going back to 1926, one may annually withdraw an inflation-adjusted 4% of a 50/50 portfolio (S&P 500 and intermediate-term US treasuries) without running out of money over a 30-year retirement. Not only that, using this approach, his analysis showed that there was a 67% chance that the ending principal would be nearly double the initial portfolio size. Several years later, after incorporation of small-cap stocks into the portfolio (but still with a 50/50 stock/bond split), he modified the safe withdrawal rate to 4.5%.
This sounds straightforward enough, so what’s the problem? One issue is that retirement spending is likely to be dynamic and not static. That is, when the stock market is going gangbusters, we feel rich and may want to spend more. The opposite is also true. This brings us to the seminal work of Jonathan Guyton, CFP, and William Klinger. Their research utilized market returns and inflation data from 1928 through 2004. Using “portfolio rules” (see below), they found a portfolio with a 50/40/10 split (S&P 500/total bond market/cash) had a 100% “success rate” (not running out of money) over a 30-year retirement with a 4.6% initial withdrawal rate. In addition, their data showed a 99% likelihood of maintenance of purchasing power with 99% confidence
This is very close to the Bengen data above, so what’s the difference? Here is where it gets more complicated, as this approach requires “rules” or “guardrails” to be followed over time to ensure success. First the good news: when the stock market does well, the “prosperity rule” says that if the portfolio growth is such that the annual withdrawal is less than 3.7% of the portfolio value (that is, 20% below the initial withdrawal rate), then you get a 10% spending raise for that year. For example, if the starting nest egg is $1,000,000, the first year withdrawal would be $46,000 (4.6%). If at the end of the year the portfolio has gone up to $2,000,000 (highly unlikely), the initial withdrawal amount of $46,000 (if taken out in year two) represents only 2.3% of the portfolio value. So in this case the withdrawal for year two is increased 10%, from $46,000 up to $50,600 (plus inflation). These are generally lower numbers than what a high income professional may expect, but you get the idea.
-Capital Preservation Rule
Now the bad news: the “capital preservation rule” states that if the anticipated annual withdrawal is more than the upper guardrail (which is 20% over the initial 4.6%, or 5.5%), then the annual withdrawal is reduced by 10%. For example, if the initial $1,000,000 has dropped to $700,000 in year two, then the initial withdrawal amount of $46,000 represents 6.6% of the portfolio value. This is above the upper guardrail of 5.5%, and in that case, the annual withdrawal is reduced by 10%, which in this example would be $41,400. Since this represents 5.9% of the portfolio value, and since this exceeds the initial withdrawal rate of 4.6%, there is no inflation adjustment that year.
This is the “inflation rule”. The silver lining in this bad news is that since less money is taken out that year, there will be less tax owed. Furthermore, if there are other sources of income (e.g. rental real estate or social security) then total spending for that year will be reduced by less than 10%.
-Portfolio Management Rule
Finally, there is the “portfolio management rule”. This rule is predicated on rebalancing the portfolio at the end of the year towards the initial allocations (50/40/10), and that spending is taken from (in order): overweight equities, overweight fixed income, cash from money market funds, withdrawals from the remaining fixed-income assets, and finally withdrawals from remaining equity assets in order of the prior year’s performance. Importantly, no withdrawal is taken from equities with a negative return that year if there is sufficient cash and fixed income to cover that year’s withdrawal.
Retirement Spending Smile
Next, we come to the work of David Blanchett, Ph.D., CFP. His research, sponsored by the National Institute on Aging and based on data from nearly 600 households collected over 10 years, revealed that spending early in retirement tends to be higher because of travel, or large purchases such as an RV or boat. Later retirement spending typically decreases, until late in life when spending increases again in part due to increasing medical bills. He calls this the “retirement spending smile”. His work demonstrated that at age 65, and initially spending $100,000, the inflation-adjusted average annual spending at age 85 was just 75% of what might have been predicted based on year one retirement spending.
Safe Withdrawal Rate
Given today’s low-interest rates, in How Much Can I Spend in Retirement Wade Pfau, Ph.D., CFA, using Bengen’s data as above, calculated that a lower initial withdrawal rate of 3% may be more appropriate for a 30-year retirement. However, using Blanchette’s spending smile data as above, he also found 4.7% to be a safe inflation-adjusted withdrawal rate for a 30-year horizon (using 50/50 S&P/ intermediate-term Government bonds). It is important to note that a safe initial withdrawal rate depends in large part on how much time is required for the portfolio to last. Pfau has calculated that a safe withdrawal rate would be 3.7% for 40 years and as high as 15% over five years.
Finally, all of the above are based on withdrawals from savings and investments and are calculated on historical data which may not be applicable in the future. For that reason, some people choose to buy an annuity which guarantees income for life. In a nutshell, you give a lump sum of money to an insurance company which then promises to give you a monthly check for life. These can provide immediate or deferred income, and may be inflation-adjusted or not. A discussion of these is beyond the scope of this article and I refer you to Safety First Retirement Planning, an excellent resource on this subject by Wade Pfau.
[Editor's Note: While it is useful to know what is out there in the academic literature about safe withdrawal rates, I think a practical position is far less complicated. The 4% rule is most useful as an estimator of necessary nest egg size, not an actual withdrawal strategy. The vast majority of retirees are simply following an “adjust as you go” strategy without any specific rules associated with it. They start by withdrawing around 4% of their portfolio. When economic times are good and the portfolio is doing well, they take out and spend a little more. When times are poor and portfolio returns have fallen, they take out less and spend a little less, just like they did their entire life. A recent interview by Bengen is enlightening. He suggests the rule is really the 4.5% rule and that on average, 7% does just fine. Personally, he withdraws 5%. He also notes that failure of that rule is actually more likely to be due to high inflation than poor returns. The more flexible you can be with your spending in retirement, the more likely you are to succeed at buying everything that will make you happier without running out of money. If you cannot make your spending very flexible, consider buying a SPIA or two with some of your nest egg to cover your fixed spending. Frankly, most of my readers who worry a lot about SWRs are going to make their heirs very, very wealthy someday. Remember three things have to happen for you to run out of money–you have to have a “too high” withdrawal rate, you have to experience poor returns, AND you have to live a long time. Chances are all three aren't going to happen.]
What do you think? What number do you use to determine needed portfolio size? How do you plan to spend your money in retirement? Comment below!