How Much To Spend Safely in Retirement
The greatest fear of most retirees is outliving their money. A fair amount of research has been devoted to developing spending rules retirees can follow to avoid doing that. This month I want to show you a new way to determine how much to spend safely.
Most retirement plans begin with an estimate of both necessary and desired spending. The plans then try to match that spending with investment returns and other expected sources of income. That process is a lot of work and involves many estimates. If reality doesn’t match a couple of estimates, the entire plan needs to be revised.
A way to check the results of the traditional approach, or even to replace it, is to develop a spending rule. The spending rule is the answer to the question: How much of the portfolio can be spent safely each year without prematurely depleting the fund? It is an estimate of the maximum percentage of a retirement fund that can be spent each year.
The weak link in most plans and spending rules is the assumption that the investment portfolio will earn a fixed minimum return each year. That is not going to happen, as anyone who has followed the markets even the last few years knows. The real danger for most retirees is that a few years of returns below the minimum estimated return occur early in retirement. If those below average years occur later, the portfolio likely will have built up a few years of excess returns as a cushion. But the fund will disappear quickly if a deep bear market occurs in the early years of retirement and spending is not changed. An even bigger problem can be an extended period of low returns, such as began in the late 1960s.
If either of these events occurs early in retirement, you can estimate the average investment return for your retirement years exactly right and still run out of money half way through.
Many financial planners now use a statistical method known as the Monte Carlo simulation. This is a better technique and produces a probability that a plan will be successful.
That still doesn’t get the job done. A retiree doesn’t want to know that he has a 90% probability of not running out of money. He wants to know what is the most he can spend each year if he experiences the worst investment markets on record, especially at the start of retirement.
Fortunately, studies have been done to answer exactly that question. The studies use the 1970s bear market and the following years.
Assuming the worst case of very bad historic returns at the start of retirement, the researchers agree that to ensure a portfolio lasts 30 years the first-year withdrawal rate should be 4% to 5% of the portfolio’s value. The most conservative study puts the first-year spending at no higher than 4.1% of the portfolio’s value. After the first year the withdrawals increase by 3% annually to maintain the purchasing power of the distributions. The withdrawals are before any taxes, so the spending actually will be less than 4.1% of the portfolio’s original value.
Those who want to estimate how much to save for retirement, can turn the calculation around. First, decide how much will be spent in the first year of retirement and subtract the amount that will be paid by other sources of income, such as Social Security. Let’s say the result is $40,000. Divide that by 4.1%, and the result is $975,610. That is the portfolio that has to be accumulated to safely withdraw $40,000 annually in today’s dollars and have the portfolio last through a 30-year retirement.
Notice that these numbers show the wealth will last for 30 years. If your retirement might last longer, you have to make adjustments. If you want to leave something for heirs or charity, you also have to make adjustments.
While useful, this method focuses on the worst case situation. It doesn’t tell you what to do if the worst case doesn’t happen early in retirement. If you plan for the worst case and it doesn’t happen, your retirement standard of living will be lower than it needed to be. That could be good for your heirs or charity, but it gives you only peace of mind. You also will underestimate spending if your inflation rate is less than 3% annually.
Perhaps the best way to plan retirement spending is to adopt the strategy used by Yale University for spending its endowment fund. A group of Yale’s best economic professors and its endowment officials developed the rule years ago. The rule allows spending to increase over time if the markets allow. It also avoids overspending in good years and excessive spending reductions in bad years. It keeps market performances from dictating year to year spending. Yet, it also ensures that the endowment will last as long as the university needs it to. Spending adjustments are made automatically, but gradually.
Here’s how to adopt the Yale rule to taking distributions from your own retirement fund.
First, decide the target spending percentage of your portfolio. The studies mentioned above say that target should be 4% to 5% of the beginning value the first year. Let’s say you pick 5%.
Then, divide your annual spending into two portions. The first portion is last year’s spending plus whatever inflation was for the last year. Multiply this by 70%. The other portion is your target distribution rate from the fund. Multiply this by 30%. Add the two numbers, and that is your distribution for the year.
Example: Suppose you have a $500,000 retirement fund, set a 5% spending rule, your spending was $25,000 last year, and inflation was 2%. Here’s how you do the calculations.
Last year’s spending plus inflation is $25,500. Multiplied by 70%, that is $17,850. Five percent of your fund is $25,000. Take 30% of that to get $7,500. Add the two results, and you will take $25,350 from the fund this year.
Suppose the portfolio declines to $480,000 next year and inflation is 2%. One bucket of your spending will be $25,350 increased by 2%, or $25,857. Take 70% of that to get $18,100. The other bucket is 5% of the fund, or $24,000. Take 30% of that, or $7,200. Add the two and your spending is $25,300. You will have a small spending reduction to recognize the reduced value of your portfolio.
Under a fixed 5% plus inflation rule, you would have spent $25,500 the first year and $26,010 the second year.
This rule is designed to make your fund last longer than the strict percentage rule, since an endowment fund is supposed to last forever. If your portfolio experiences a period of poor investment returns, your distributions will be less under the Yale method, because only 70% of distributions are based on last year’s spending.
You also are less likely to deprive yourself in good times, because if market returns exceed expectations your distributions will rise with the returns.
A benefit of this approach is that about 30% of a person’s budget tends to be flexible. You can defer purchases of new cars, clothing, and other things. Travel, recreation, and entertainment spending can be reduced. The exact amount of flexibility and which items are flexible depends on each retiree’s budget.
Since your fund doesn’t have to last forever, you get additional flexibility. If bad markets cause spending to decline for a few years, you can suspend the spending rule and dip into principal for necessary spending. The next year’s spending would incorporate this, because 30% of the spending will be based on the fund’s value.
No spending formula or plan is perfect. You want to develop a plan that is flexible, recognizes changed circumstances, takes emotions out of the process, and makes gradual changes. The Yale rule meets these goals. It also gives you an edge by adding flexibility and increasing the likelihood that your fund will outlast the worst markets.
