This is among the most common questions we receive from clients, many of whom are either already retired or nearing retirement. It is an important issue and one that often prompts investors to seek out professional help from an advisor.
But first, let’s lay out some basic terminology:
What is the ‘net spending rate’?
This number is defined in relation to your assets. First, add up all your annual expenses from last year. Make any needed adjustment(s) to get a more realistic amount if you feel some items were overstated or understated. If you were still working, adjust for that as well. Subtract from these expenses any income you receive from sources other than your portfolio: social security benefits, annuities, pension, rents, alimony, etc. The difference between the two is your net spending, i.e., the amount you'll need to draw from your portfolio. The net spending rate is simply this number expressed as a percentage of your portfolio's value.
What is a sustainable spending rate?
The notion of a safe or sustainable rate is the next important concept: what is the percentage that will almost guarantee that you don't outlive your assets? Most of you have heard of the 4% rule which is based initially on an academic study from William Bengen over two decades ago. The study assumed that the retiree would spend 4% in year 1 (age 65) and increase that amount in the future by the amount of inflation. So, for instance, if one has a $1,000,000 portfolio, the maximum annual withdrawal in year 1 would be $40,000. If inflation equals 2%, it will increase to $40,800 in year 2, and so forth. Additionally, the research assumed a 30-year time horizon and a 60% stocks/40% bonds allocation. The result: a 4% initial withdrawal rate delivers a 90% success rate.
Because the number was so simple, the media and the financial planning community ran with it. We also use this study when people ask us in general terms what a sustainable spending rate is. However, only some people meet the study's assumptions, and consequently, everyone should carefully review their situation before deciding on a strategy.
What parameters should be considered?
Generally, these are the primary factors to consider:
Factor #1: How much of your non-discretionary spending is covered by non-portfolio income?
Suppose you split your expenses between needs (food, housing, health insurance, etc.) and wants (vacations, luxury items, gifts, etc.). How much of the needs are covered by social security, pensions, and other guaranteed sources of income? The higher the percentage, the more you can take from your portfolio in any year without long-term consequences since it is mainly used for non-vital expenses that can be adjusted down easily. On the other end, if you depend on your portfolio for most of your needed living expenses, it is better to err on the conservative side.
Factor #2: What is your time horizon?
Nobody knows for sure how long he or she will live, but it is nonetheless helpful to look at the numbers. Check mortality tables. Adjust for your health and family history if needed, and if you're married, consider your spouse's situation as well (meaning plan for a horizon that covers your joint life expectancy). Then, give yourself a significant margin of safety! Studies have shown that the life expectancy tables provided by the IRS (to calculate required minimum distributions) offer a good guide for a sustainable spending rate that adjusts with age. For example, if you retire before age 65, the sustainable percentage can be substantially below 4% (depending on how early you stop working) because you're not collecting any outside retirement benefits. However, once you reach your late seventies or eighties, your safe withdrawal rate will progressively increase well above 4%.
Interestingly, more recent research looked at actual spending in retirement and discovered that, after an initial surge in the early years, spending declines as people age. This would argue for a safe higher initial withdrawal rate.
Factor #3: What is your portfolio’s asset allocation?
As we mentioned, the studies assumed a 60/40 balanced portfolio. Yields on cash and bonds during retirement matter: the long-term historical average for the overall US bond market is about 6.5%, versus slightly over 5% today and 1.5% just three years ago. Current interest rates make it more likely that a 4% spending rate will be sustainable for investors retiring today. A higher proportion of stocks generally permits a higher spending rate since stock returns have exceeded bonds—and inflation—over longer periods. However, stocks expose your portfolio spending to a different kind of risk:
Factor #4: What is sequence risk?
It is essential to remember that you will very likely experience more than one bear market during your retirement. The timing of these bear markets can dramatically impact the portfolio's sustainability. Bear markets in the early years have a disproportionate impact and might require spending lower than 4%, while a bull market would allow for a higher rate.
The result is that longer time horizons only justify increasing the proportion of stocks to a point, and the odds of running out of money increase once you go past the 50% to 70% equity allocation.
Other secondary factors to consider include the timing of claiming social security benefits, which type of accounts (individual/joint/trust, IRA, Roth…, etc.) to draw from first—or last—to manage the tax impact, whether to purchase an income annuity to reduce longevity risk, etc.
Bottom Line: 'Safe' Withdrawal Rates
The bottom line is that there is no one 100%-safe number that works for everyone. The appropriate withdrawal rate is different for every investor and is a moving target. The 4% rule as a guideline could be a reasonable starting point for most people. It also helps pre-retirees estimate whether they have enough assets: if one's projected spending rate exceeds 4%, it might be necessary to work longer or plan on a reduced lifestyle at retirement.
Our recommendation is to be flexible: consider safe spending as a moving target within a narrow range with a floor and a ceiling. Incorporating the factors we just discussed, we can help you estimate what's within range and what's not, and set up a plan. We will then review progress during our regular meetings and make minor necessary adjustments long enough in advance to avoid jeopardizing your long-term financial security. Better safe than sorry.
This article was previously published in June 2018.
Your Financial Situation is Unique
Accordingly, your portfolio should meet your individual needs, not those of your neighbor or in-laws. At Bristlecone Value Partners, we build a plan around you. That way, you can enjoy other priorities: family, business, travel, volunteering.
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