Many people spend too much, too fast after they retire. Others are excessively constrained by fear. Both are big mistakes.
Spending rates are a subject of much debate in the financial world. Spending in retirement is typically the sum of income (including Social Security) plus account withdrawals.
From an asset management perspective, the question is usually framed around how much of your investment portfolio can be withdrawn each year, or “withdrawal rate.”
The reason so many people make bad decisions is because our brains are poorly equipped to deal with volatility. After a few years of high investment returns, many people get comfortable spending at a high rate because they are still seeing their balances go up. Humans are wired to extrapolate trends and we begin to think that our investments will constantly provide income to spend. It takes a lot of discipline to avoid this trap.
The reality is that for people with meaningful stock allocations, if the market does well (especially in the first years) everything will probably be fine, even with high withdrawal rates. If not, there can be problems.
Despite the role of luck and timing, it is still important to have a more detailed understanding of how your withdrawal rate will likely impact your retirement and the tradeoff between extra spending and maintaining wealth.
First, let’s look at some generic odds of investment portfolio survival with some basic assumptions.
Assumptions used are an 8 percent annualized return for stocks (20 percent annual standard deviation), 4.5 percent for bonds, and 3 percent inflation. Withdrawals stay constant, but are adjusted for inflation. No fees or transaction costs were included and the assumption was that all money is taxable, and that the tax rate on gains is 15 percent. In real life, expect higher fees and taxes. Remember taxes may still be due on deferred accounts such as IRAs, so you may have less money than you think.
These assumptions may prove wrong, but they are a good starting point for analysis.
This table shows the chances of a portfolio running out of money at some point before the given time horizon expires. It is segmented by each annual withdrawal rate, starting at 2 percent, and shows results for several different stock/bond allocation mixes.
At first, these look pretty scary for most people.
One positive is that we have is that we can adapt over time. These scenarios assume the universe shifts on the date you retire and all plans ever after are set in stone. This is not the case. I highly recommend you change your target asset allocation only rarely and at not based on short-term market predictions. Otherwise you run a very high risk of succumbing to fear or greed and ruining your plan. However, it is good to be more flexible with spending and we can take more risk early with the knowledge that we can cut back later if necessary.
What About Actual History?
Looking at historical returns, survival rates are much higher. This makes sense because equities have generally done very well in the last century, better than my forward looking assumptions.
Using a 5 percent withdrawal rate, in retirement years from 1926 until 1990, the 35-year portfolio exhaustion rate was only 20 percent for accounts in 100 percent equities. This means in 80 percent of years, if one started with a withdrawal rate of 5 percent of the value of the portfolio and adjusted the withdrawal amount annually by inflation, there would still be money left after 35 years. The worst year to start was 1928, when the portfolio only would have lasted 16 years.
Even more exciting, of the 80 percent of retirement years that did not lead to portfolio exhaustion, all but two grew to new highs and showed no signs of looking back.
This shows that in real life really good outcomes are common. We just need to be prepared for bad ones when we plan.
It is quite common to see financial planning articles suggest 4 percent as the maximum safe withdrawal rate. From the tables above, it is easy to see why. It is a good rule. History suggests 5 percent is also a relatively safe for people with a 35-year time horizon, as long as they own a majority in equities. With my assumptions, this withdrawal rate is pretty risky, but not unreasonable.
Those with shorter time horizons can safely increase their withdrawal rate above 5 percent.
If things go well initially, the withdrawal amount can often be increased over time.
For people who can live comfortably and pursue their retirement dreams with a 4 percent withdrawal or less, this is a good rule to stick by. Those who need more can gamble and be a bit more aggressive.
For example, with a 35-year time horizon, using a 75/25 stock/bond allocation, a 5 percent withdrawal rate has a 60 percent chance of expiring before the time horizon ends. Remember, these are rough estimates. What this really means is that if stocks do well in the first decade or so, everything will likely be fine. If they do not, it is a big problem. The timing of returns is nearly as important as the actual returns. If one is flexible, they can play a bit with these odds. Historically, stocks have gone up about 2/3 of years. Only 11 out of 82 three-year periods have been down more than 10 percent.
So if one starts with a 5 percent withdrawal rate, they should still be on track after the first three years. If so, they can continue with it. But if the first three years are bad, the rate must be adjusted down to about 3 percent, so a person who pursues this strategy must be willing to really cut back if they are unlucky. Only play this game if it is possible to cut back to 3 percent if necessary. It is simply up to each person if they want to take this risk. Eventually, with the 5 percent withdrawal rate, spending will likely have to be reduced, but there is a very good chance this may not happen for 15 years or so, and there is about a one-third chance it will never happen.
What to Think About
There are no absolute rules, only information that can help one better understand the odds. Here are some considerations for those with long time horizons:
- Spending and post-retirement income can be hard to plan for. It is worthwhile to try and understand what your average withdrawal rate will be. The easiest way is to make a year-by-year cash flow table.
- If you can be comfortable and accomplish what you would like with 3 percent withdrawals, use 3 percent to start.
- If 3 percent or less impacts your lifestyle, 4 percent is a good rule.
- If 4 percent feels restrictive, 5 percent can be used but be prepared to reduce spending if returns are bad in initial years.
- Portfolio withdrawals above 6 percent annually should be considered a depletion strategy, though there is about a 50 percent chance to get lucky and sustain them for a long time.
- You can’t gamble with aggressive withdrawal rates if you are unwilling to gamble with a relatively high equity allocation. High withdrawal rates and high bond allocations are disastrous.
- Before taking aggressive withdrawals, consider your fate if your retirement account is exhausted.
- Is there real estate or other assets that can be sold if necessary?
- How well can you live on Social Security and other income such as pensions or annuity payments?
- Will your children support you if necessary?
- Does your spouse place a higher priority on current expenditure or safety later? (Uncomfortable as it may be, this should be discussed if it is a question.)
- Remember that unexpected medical expenses are common.