The spending strategy is one of the most import and yet overlooked parts of a retirement plan.
The spending strategy — also called a distribution, drawdown, or withdrawal strategy — reduces the risk of running out of money during retirement by setting the maximum amount you should spend from the nest egg each year.
I’ve seen surveys of preretirees that indicate most Americans believe they can spend 7% or more of their nest eggs each year with no risk of running out of money. Financial planners and economists disagree.
The classic 4% Rule, backed by years of studies, concludes there’s a high probability your nest egg will last 30 years or longer when the most you spend the first year of retirement is a little over 4% of your portfolio, and each year after that your spending is limited to the previous year’s dollar amount increased by last year’s rate of inflation.
Long-time readers know I’ve had problems with the 4% rule from its beginnings, which I detailed in the newsletter over the years and in the revised version of my book, “The New Rules of Retirement.”
The bottom line is that the 4% Rule should be a starting point, not a plan to be strictly followed.
Most importantly, the 4% Rule is an unnatural spending pattern. As I’ve mentioned in the past, U.S. Department of Labor studies show that most people increase spending during the first few years of retirement. In their 70s, spending adjusted for inflation declines for many people. Later in life, spending might increase because of higher medical or long-term-care expenses, or it might level out.
It is better to have a dynamic, flexible spending strategy. Spending should change with markets and inflation. It also should change to reflect your stage of life.
That’s why I’ve long recommended a variation of the Yale University Endowment distribution strategy as a good strategy for setting your maximum amount of spending each year.
Under this strategy, the first year you select a percentage of the portfolio to spend. In following years, the maximum spending amount is determined by dividing the withdrawal into two parts. The first part is the amount withdrawn the previous year increased by the inflation rate for the year. This is 70% of the distribution. The second part is the portfolio value at the end of the previous year multiplied by the first year spending rate. This is 30% of the distribution.
Example: You have a $500,000 nest egg and decide on a 5% first year spending rate. The first year you withdraw $25,000. Inflation was 2% during the first year, and after investment results and distributions, the nest egg’s value at the end of the first year was $480,000.
To compute the second year’s maximum spending, you add 2% inflation to the first year’s spending and get $25,500. Multiply that by 70% to get the first component of the second year’s spending limit, or $17,850. Then, multiply the end-of-year nest egg value by 5%, and you get $24,000. Multiply this by 30% to arrive at $7,200 for the second component of the second year’s spending. Add the two components together for a second year spending limit of $25,050 ($17,850 plus $7,200).
With this approach, the spending limit increases and decreases with market returns and inflation. You’re less likely to overspend and run out of money if there’s an extended period of poor investment returns. It also keeps you from artificially restraining spending when investment returns are better than expected.
But the spending fluctuations are gradual. They won’t vary as much as the annual fluctuations of the markets, but long-term return patterns will be reflected.
It is important to stress test any strategy. See what the results would have been in the past using real investment returns and inflation rates. I’ve done that in two accompanying charts. One chart shows how the value of the nest egg changes year to year. The other shows how the maximum distributions change each year.
In these scenarios, I used an initial nest egg value of $500,000 and first year distribution rate of 4%. I also compared two simple investment strategies. In one strategy, the entire nest egg was invested in the Vanguard Balanced Index Investors fund. This fund generally is 60% stocks and 40% bonds. In the other strategy, the nest egg is invested in Vanguard Wellesley Income, which is 40% stocks and 60% bonds. I used the real returns of these funds for the last 10 years and repeated them again to have results for 20 years. That gives us a 20-year period with two bear markets and two extended recoveries. I also used real inflation for the last 10 years and repeated it to have 20 years of data.
You can see the portfolio balances were slightly higher after the first year but declined sharply the second year. The values declined to $380,433 with the Vanguard Balanced Index fund and $438,577 with the Vanguard Wellesley Income fund. Then, the values began to grow.
After the second bear market, the Balanced Index nest egg again declined below the initial value to $471,216, but the Wellesley Income nest egg declined
only to $558,410.
As expected, the changes in maximum spending were not as great as the nest egg fluctuations. The Wellesley Income strategy increased the distribution the second year. Then, it had three years of distributions below that level before climbing above it with the sixth year distribution. The Balanced Index nest egg took until the eighth year to exceed the year 2 distribution.
There are a few important conclusions to draw from the data:
Avoiding large losses is important.
This is especially true when you’re in or near retirement. The Balanced
Index’s bear market percentage losses were more than twice those of Wellesley Income. Though Balanced Index had higher returns during most of
the bull years, they weren’t enough to overcome the bear market declines.
Be slow to change a plan. Many investors would be tempted to change to a more conservative investment strategy after experiencing losses in the early years of retirement. That would have compounded the problems and made it harder to maintain spending during retirement because they would have missed the rebound. A better strategy would be to have a conservative investment strategy at the start of retirement and perhaps take more risk after a few years.
Likewise, there would be a temptation to increase spending or charitable giving dramatically after several years of strong returns. As you can see, a new bear market could wipe out most or all of those gains. When the initial spending plan was carefully developed, significant increases in spending and giving shouldn’t be considered for at least the first 10 years unless a more conservative investment strategy is adopted.
Stress test your strategy. You should test more scenarios than I’ve presented here. Experiment with investment returns, inflation rates and beginning spending rates. See what happens to your distributions and nest egg under the different results.
Develop additional limits. If there’s a bad market in the early years of retirement, your nest egg is likely to decline below its initial value and the maximum spending amount also will decline.
Most advisors recommend placing a firm floor on spending to ensure you can meet required expenses. Decide in advance that the maximum spending won’t fall below a certain dollar amount regardless of what the formula indicates.
Have flexibility in your spending. For a dynamic spending strategy to work, there must be expenses you can eliminate or delay. If most of your spending is fixed, required expenses, it is hard to adjust spending.
Adjust the spending rules during retirement. You might want to spend more early in retirement, and then decrease it later. That would mean increasing the initial year’s spending above the 4% in this example, and then resetting the spending strategy five to 10 years into retirement.
Minimize unexpected expenses. Many retirement plans are disrupted by large, unplanned expenses, such as medical and long-term-care expenses. You can minimize this problem with insurance. You’ll have higher fixed annual expenses, but the coverage reduces the potential for large, unplanned expenses.