The missing link in many retirement plans is the withdraw-al, distribution, or spending strategy. Accumulating for retirement is the easy part, and many people enter retirement with what seem to be adequate resources. Yet, a high percentage of Americans die owning their home equity and little more. Most rely heavily on Social Security to fund spending in their later years.
Some of this shortfall is due to unexpected spending, especially medical and long-term care expenses. But most of the shortfall is due to people entering retirement with no spending plan or a poorly-conceived plan. Even after the financial crisis and years of very low interest rates, surveys show many Americans enter retirement with no idea how much they can safely spend each year or who believe they can spend annually 7% to 10% of their nest eggs.
We’re going to discuss how you can develop the right spending plan for you.
Most of you are familiar with the maximum safe withdrawal rate, or the 4% rule. Developed in the 1990s, the rule states that to have a high probability a nest egg will last at least 30 years you can withdraw a maximum of just over 4% of the portfolio the first year. Each year after that you withdraw the previous year’s dollar amount increased by the previous year’s inflation rate.
I’ve been among the critics of the 4% rule from the start, and many others have joined. Key shortcomings are that the rule doesn’t guarantee your money will last at least 30 years in all scenarios. It only has a high probability of doing so using historic data. The rule also doesn’t help the growing group who are retired more than 30 years. More recent studies argue that the 4% rule was developed in a period of high returns that aren’t likely to be matched in the next 30 years. They assert that for today’s retiree a maximum spending rate of 3% or less is the safe spending rate.
Perhaps most important is that very few people actually spend money as described under the 4% rule. Few retirees plan their annual spending by totaling last year’s spending and increasing it by last year’s Consumer Price Index increase. In fact, following the 4% rule or something similar is likely to cause people to either save too much for retirement or not spend as much as they could in the early years of retirement.
For most people, spending doesn’t steadily increase in retirement. Lifetime retirement spending is more likely to resemble a smile than a steadily upward-sloping line, according to studies by the Department of Labor and some private researchers.
People tend to spend at a fairly high level in the first years of retirement (though they usually spend less than they did in their 40s and early 50s). Until about age 70 most people still are relatively young, healthy, and active. Also, they often enter retirement with a list of activities they want to do.
Don’t get caught up in a rule of thumb, such as that people spend 80% of their pre-retirement income in the first year of retirement. The fact is, some people spend as much or more in the first years of retirement as they did before retiring. Others spend less, and sometimes much less. It depends on your interests, health, and other factors.
After the first few years of retirement, spending often declines for a few years and then levels out. Spending declines partly because some of those pent-up desires have been fulfilled and partly because people are less active as they age.
In the later years, spending might continue to decline because of the reduction in activity. But later years spending also could increase because of medical expenses, the need to have others help with daily activities, or long-term care expenses. There’s a lot of uncertainty about these expenses, and purchasing insurance can reduce that uncertainty.
So, most people shouldn’t plan on spending to steadily increase each year in retirement.
In addition, most people have some flexibility in their spending each year. Of course, they have fixed expenses for housing, food, medical care, insurance, and other needs. But they also can make adjustments to entertainment, dining out, travel, gift giving, home furnishings, and other spending. This flexibility allows a retiree to reduce spending in years when a portfolio is losing value, instead of selling depressed investments.
There’s really no maximum safe spending rate that will work in all scenarios if you plan to invest for a decent return that subjects you to market risk, interest rate risk, and other risks. Instead of searching for a safe spending rate, you need to either invest for safety and keep your spending within the cash generated or have a flexible spending plan under which your spending increases or decreases with both your goals and market changes. Here are the key strategies to consider, other than the 4% rule.
? Buy immediate annuities with all or most of your nest egg. This generates fixed annual income that is guaranteed for life. You can buy inflation-indexed annuities that pay less initially but increase with inflation. This strategy has the disadvantages of locking in today’s low yields and limiting flexibility, but it does guarantee you won’t run out of money.
? Buy a ladder of TIPS or other bonds. Buy equal amounts of Treasury Inflation-Protected Securities (TIPS) that mature in different years over the next 30. Each maturing bond funds your spending until the next bond matures, and the inflation-indexing feature of TIPS should preserve your purchasing power. Again, you lock in today’s low yields and give up flexibility and the potential for higher returns. You also run out of money after 30 years when all the bonds have matured. Unlike the immediate annuities, this approach does leave something for your heirs if you pass away before 30 years.
? Spend what a fixed-term annuity would pay you. You recalculate the spending amount each year based on what an insurance company would pay. The first year you have a 30-year time horizon. (You can increase or decrease it if you want.) Check the first year payment an insurance company would pay if you invested your entire nest egg in a 30-year fixed annuity. You don’t buy the annuity. But that amount is the maximum you spend the first year. You can use a calculator, spreadsheet, or a price check with insurers to determine the amount.
The next year you do the same thing, except you determine what a 29-year annuity would pay, using current interest rates and the current balance of your nest egg. You do that each year. The annual spending adjusts automatically for change in interest rates and the value of your portfolio.
? Use the 20-10 strategy. Under this strategy, split the portfolio in two portions. One portion is to fund the first 20 years of retirement. You can use any of the strategies mentioned here. A conservative investor would use laddered TIPS maturing over 20 years or buy a 20-year annuity. An aggressive investor would invest the nest egg and adopt a spending plan designed to last at least 20 years. Other investors could adopt still other strategies.
To cover spending for any years you live beyond 20, purchase longevity annuities, also known as deferred income annuities, with the rest of your nest egg. These annuities won’t pay income until you live 20 years in retirement, but then they’ll pay fixed income for the rest of your life. Under this strategy there is nothing for your heirs, unless your investment returns exceed your spending during the first 20 years.
? Spend a fixed percentage of the portfolio each year. This is the 4% rule but without the annual inflation adjustments. Spending automatically rises and falls with market changes, but the changes from year to year can be extreme. If the portfolio goes into an extended bear market, spending might be less than the first year’s spending for years.
? Add a floor and ceiling. You spend a fixed percentage of the nest egg each year, but you smooth out fluctuations by placing a floor and ceiling on the amount by which the spending can change in any year. For example, you might say in any year spending can’t rise or fall more than 10% from the previous year. You could also say spending can’t fall more than a fixed percentage below the first year’s spending. The wider the floor and ceiling, the less likely you are to run out of money. There are many variations of floor and ceiling strategies.
? Secure fixed expenses with guaranteed income. Determine your fixed annual expenses. To the extent that they exceed what you receive from Social Security, buy immediate annuities to cover them. The rest of your portfolio is invested to fund your other spending. This approach gives you flexibility to adapt to the markets and your desired spending levels.
You can use any investment strategy that works for you. The big advantage of this approach is that you are less tempted to panic and sell investments during bad markets, because you know your essential spending is covered indefinitely.
? Adjust spending to the markets and inflation. There are many possible ways to do this. You should choose one that uses a formula that automatically makes gradual adjustments. I favor a modification of the formula the Yale University Endowment uses to determine its annual distributions to the university. Here’s how it can work.
Your first year spending limit is a percentage of the nest egg. You withdraw that amount of the nest egg the first year. Each year’s subsequent spending limit is divided in two parts. Last year’s spending amount plus inflation is 70% of the distribution. The other 30% is the first year withdrawal percentage applied to the nest egg value at the end of the previous year.
Here’s an example. Suppose the nest egg at the start of retirement is $500,000, and the selected spending rate is 5%. In the first year, $25,000 is the spending limit ($500,000 times 5%). Let’s say inflation was 2% for the first year, and at the end of the first year after spending and investment results, the portfolio value is $480,000.
The first part of the second year spending limit is determined by taking the first year’s limit of $25,000 and adding inflation to it. The result is multiplied by 70%, giving a result of $17,850. The second part of the spending limit is the new fund value of $480,000 multiplied by the spending rate of 5%. That result is multiplied by 30% to arrive at $7,200. Add the two results together, and the second year spending limit is $25,050, a slight increase over the first year.
I think for most people a combination of the last two spending policies will work well. Use Social Security and immediate annuities to generate enough guaranteed lifetime income to cover your fixed, required annual expenses. Invest the rest of your nest egg and establish a flexible spending policy, such as one similar to the Yale Endowment policy. The combination gives you lifetime income to cover your essential expenses. It also gives you the potential to increase your net worth and enhance your standard of living through a combination of good investments and prudent spending. You also have the potential of leaving something for your heirs.
Whichever strategy or combination you lean toward, remember that your investment strategies and their success are the major influences on the amount that safely can be withdrawn. The studies leading to the 4% rules generally used fixed portfolios of either 60% stocks and 40% bonds or 60% stocks, 30% bonds, and 10% cash. A more conservative portfolio likely would generate a lower long-term return and require a distribution rate lower than 4%. But a more diversified portfolio that avoids the worst of stock bear markets or a successful tactical asset allocation strategy would allow a higher distribution rate.
RW July 2015.