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 that some items were over or understated. If you were still working, adjust for that as well. Subtract from these expenses any income that 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 originally based on an academic study from William Bengen more than two decades ago. The study assumed that the retiree would spend 4% in year 1 (age 65) and increase that amount going forward 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 would 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.
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, not everyone meets the assumptions of the study and consequently, everyone should carefully review their own 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?
If 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 mostly 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 is going to live but it is nonetheless useful 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 which covers your joint life expectancy). Then, give yourself a big margin of safety! Some recent studies have shown that the life expectancy tables provided by the IRS (to calculate required minimum distribution) provide a good guide for a sustainable spending rate which adjusts with age. For example, if you retire before age 65, the percentage that is sustainable is significantly below 4% (depending 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%.
Factor #3: What is your portfolio’s asset allocation?
As we mentioned, the studies assumed a 60/40 balanced portfolio. A higher proportion of stocks generally permits a higher spending rate, since stock returns have exceeded bonds over longer periods of time. However, stocks expose your spending to a different kind of risk:
Factor #4: What is sequence risk?
This is an issue we’ve discussed before in a recent blog post "Just Keep Swimming", but it is important to remember that you will very likely experience more than one bear market during your retirement. The timing of these bear markets has an impact on the portfolio’s sustainability. Bear markets in the early years have a disproportionate impact and might require a lower than 4% spending, while a bull market would allow for a higher rate.
There are other secondary factors to consider such as the timing of claiming social security benefits, which accounts to draw from first or last to manage the tax impact (individual/joint/trust, IRA, Roth…), purchasing an income annuity to reduce longevity risk, etc.
Bottom Line: 'Safe' Withdrawal Rates
The bottom line is that there is not a 100% safe withdrawal rate that works for everyone no matter what happens. The appropriate number is different for every investor and is a moving target. The 4% rule could be a reasonable starting point for most people, if their circumstances match those of the studies. It also helps pre-retirees estimate if they have enough assets: if one’s projected spending rate is well in excess of 4%, it might be necessary to work longer or plan on a reduced lifestyle at retirement.
Our recommendation is to be flexible: think about the safe spending as a moving target within a narrow range with a floor and a ceiling. Considering the factors we just discussed, we can help estimate what’s within range and what’s not, and set up a plan. We will then review during our regular meetings with the goal of making small necessary adjustments long enough in advance to avoid jeopardizing your long-term financial security. Better safe than sorry.
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.