Reviewing the Safe Spending Formula

You can spend a maximum of 4% of your retirement fund the first year and increase the distribution for inflation each year after.

That’s standard spending advice for retirees and has been since the mid-1990s, when studies of past investment returns indicated 4% plus inflation was the maximum “safe spending rate.” Yet, surveys still show many people believe they can withdraw a much higher rate of 8% or more.

Don’t be despondent when you realize how little 4% of your retirement fund amounts to. You aren’t locked in to the 4% withdrawal rate. You can modify it for today’s markets and your circumstances when you fully understand it.

The 4% rate assumes you increase spending at the rate of inflation each year and that inflation is 3%. The studies supporting the 4% rate also took a standard asset allocation of stocks, bonds, and cash and looked at how long the portfolio lasted in different investment markets. The portfolio would need to last for at least 30 years in the worst environment for the withdrawal rate to be considered safe.

You can modify the withdrawal rate – safely – by recognizing changes in the markets, your portfolio, or your behavior that are different from the assumptions.

The most difficult period for the portfolio in the studies, and the one that contributed the most to bringing the maximum safe distribution rate down to 4%, began in 1966. The stock market was at a peak it did not see again until 1982. Inflation was about to soar, causing losses in bonds. Anyone who retired at the start of such a treacherous period had to spend very conservatively or invest very well.

When you retire during a different environment, a higher spending rate may be justified. When retirement coincides with a major bull market, a 4% spending rate is much too low. Adjusting your spending based on this factor requires some fortune-telling and you when to be cautious. But when the market just experienced its first negative-return calendar decade, you may be comfortable assuming returns will be better than those that followed 1966.

You still want to be conservative. Interest rates are historically low, so you can’t count on the kind of returns that followed 1982.

A higher withdrawal rate also can be justified when asset allocations are relatively low. This isn’t such a time. But those who begin retirement at such a time could be comfortable with a greater-than-4% rate.

Another reason you may be able to spend more than 4% is that you have a better asset allocation than in the studies. A basic portfolio of stocks, bonds, and cash does not give true diversification, as we discussed in the past. Adding other asset classes or using our hedge fund portfolio gives you better returns and less downside risk than the traditional portfolio.

Probably the key unrealistic factor in the 4% rate studies is the assumption the asset allocation does not change. If you change your asset allocation periodically to manage and reduce risk, you probably can afford a higher spending rate.

The studies assume your distributions increase steadily each year with inflation. Most retirees don’t follow that pattern.

We said in past visits that retirement spending tends to have three stages. The initial active retirement years tend to have the highest spending. In the second stage, retirees slow down a bit and spend less. The third stage involves even less activity, though it could have higher medical expenses. The length of each stage depends on your health and interests.

You also can adjust your spending based on the portfolio’s performance, instead of inflation. You could decide spending won’t increase for any year when the portfolio’s value at the start of the year is not higher than it was at the start of the previous year. You also could decide not to increase spending when the portfolio’s investment return was negative for the previous year. Finally, you could decide in high inflation years that you won’t increase spending by the full inflation rate. Many pension plans limit inflation increases to 3% or 4%.

When you make the adjustments and assumptions we’ve discussed, studies show the first year’s spending can be up to 6% of the portfolio’s value.

We always have recommended more flexible approaches than withdrawing 4% of the portfolio the first year and increasing it for inflation each year. Our recommendations are:

? Use a modified version of the Yale University Endowment spending formula. First, decide on a spending target of from 4% to 6% of the portfolio. Each year 70% of the distribution is last year’s spending plus inflation. To get this amount, multiply last year’s total distributions by the inflation rate, and multiply that by 70%. The other portion of the spending is based on the portfolio’s value. Take the value at the end of last year and multiply it by your target spending rate. Multiply this by 30%. Add the two results to determine your spending for the year. More details are in my book, The New Rules of Retirement.

This way your spending rises and falls with both inflation and your investment returns, but the changes are more gradual than under other approaches.

? Be flexible. Part of your budget is fixed but much of it is variable. When markets are in the tank, reduce your spending for at least a year or two. Eat fewer restaurant meals. Travel less. Defer major purchases such as a new car.

? Diversify your portfolio. True diversification in a portfolio smoothes investment returns and prevents large losses in most economic environments. True diversification is when portions of the portfolio have little or no correlation with each other. Investments should benefit from different economic environments, and they shouldn’t all be tied to the stock market.

? Expect change. Too many people develop a plan at the start of retirement and expect it to last for the next 30 years, or however long retirement lasts. You need to revisit the plan every year or two and compare expectations to reality. The need to make changes is not a sign of failure. Retirement plans are based on numerous assumptions about the future. You can’t be 100% accurate in the assumptions. You should expect to make adjustments in your plan on a regular basis. Sometimes reality will be better than assumed. Other times it won’t be as favorable.

 In the first years of retirement, review the plan regularly, at least every year. After a few years, reviews probably can be less frequent.

February 2010 RW.