4-Minute Read
Imagine driving along a winding scenic road beside an ocean cliff. While you want to enjoy the ride, you must ensure you don’t veer off the road. It would be reassuring to know guardrails are in place to nudge you back on track if you drift too far.
This analogy can be extended to how you spend money in retirement. By setting up a financial equivalent of guardrails, you can establish a clear plan for how you will respond to market changes in advance.
Using guardrails assumes you’re willing to adopt a flexible approach to retirement spending. Depending on your life stage, such a willingness presents some intriguing opportunities:
- If you’re still working, you may be able to retire sooner than you think.
- If you’re already retired, you may be able to spend more money now than you thought you could.
In last month’s blog, I discussed The Real Reasons Why You Should Save Money. There were two big reasons emphasized: freedom and flexibility. Build enough of those elements in your life, and you’ll be able to retire on your own terms.
Let’s switch gears, talk about retirement spending, and expand on this concept of guardrails.
As a financial planner, I’ve had access to various tools to help my clients assess their retirement readiness. However, tools have limitations, and they are important to recognize when it comes to spending money in retirement. As a retiree, you face two significant unknowns: your life expectancy and how markets will perform during your lifetime.
The guardrail approach is appealing because, if used correctly, it can help you find a balance between spending too much or too little during retirement.
Looking back at my financial planner training, I’ve realized the approach was skewed toward preventing people from spending too much. After all, fully depleting your portfolio while alive is an unacceptable option—it’s a non-starter.
It may be harder to grasp the risk of spending too little. But there are people who craft their whole life philosophy around that risk. One salient example is Bill Perkins, author of Die with Zero.
Much of the risk-averse framework comes from the original research on retirement spending. It focused on your so-called withdrawal rate. That was simply how much you could withdraw from your first year of retirement, expressed as a percentage of your total portfolio.
What made your withdrawal rate “safe” was that you could withdraw that amount each year of your retirement with inflation adjustments. You could continue those withdrawals for thirty years and never run out of money.
Born out of all this was the four percent rule. It was the safe withdrawal rate that could have gotten you through the worst period historically. For example, using this rule, you could withdraw $40,000 annually from a starting $1 Million portfolio.
While this was a great starting point for retirement research, it had several flaws. One question you might immediately raise is: Who do you know who spends the same amount of money every year of retirement?
But I think there’s a bigger limitation. If you strictly adhere to a safe withdrawal rate approach, you are overwhelmingly likely to leave a disproportionately large sum of money to your heirs at death. Is this a problem?
Well, that approach is fine if your main goal is to leave a legacy. But even that goal could be scrutinized for one implicit tradeoff you’re making. Are you giving up the satisfaction of giving money away while alive?
Aside from that, not everyone wants to optimize for legacy. You may want to optimize for income or some better balance between the two. Put another way, you may want to get the maximum enjoyment from your money while you’re alive and care somewhat less about what is left behind after death for children, charities, etc.
Thoughtful planners and researchers recognized limitations like the ones I’ve described. This opened the door to dynamic withdrawal strategies. These allow you to have a higher withdrawal rate at the beginning of retirement. But the catch was that you would need to be willing to adjust your spending if conditions required it.
Over the past twenty years, several proposals have been made for implementing a dynamic withdrawal strategy. The early approaches looked good on paper. As a former engineer, I was initially thrilled there were some simple formulas I could apply and communicate with clients.
However, implementing this in the real world was difficult. There was too much potential for variability (or noise) in the financial advice. Research and tools from the last several years have shown more promise. I’ll spare the technical details, but the newer approaches have addressed many critical limitations.
This is a long way to explain how we arrived at guardrails today. Guardrails are ultimately just another type of dynamic withdrawal strategy, but I think they have incredible potential to improve your retirement experience.
Think about it this way: How much more comfortable would you be, assuming you’re retired, if you knew what value your portfolio would have to reach before you would be required to make a spending cut? You would have a clear plan during market uncertainty, and you wouldn’t have to second-guess your plan every time the market takes a dip.
Furthermore, you would know exactly what spending cut you’d need to make. Remember that portfolio spending is not necessarily the same as your total spending. You may have other sources of income in retirement, such as Social Security, pensions, or part-time wages.
But what if you’re fortunate enough to grow your portfolio in retirement? Wouldn’t you like to know what level it would need to rise to before you can comfortably increase your spending? Can you imagine truly giving yourself permission to spend more or give more?
This balance is one of the ideals I believe the planning profession is moving towards. How do we, as advisors, make better judgment calls for our retired clients while dealing with so many variables and uncertainty?
I’ve spent much time, particularly in the past year, figuring out how to implement guardrail strategies for my retired clients. I’m excited that I have a much more robust solution available now than when I started my practice.
Of course, this is all a process, and I haven’t reached perfection. But the advice I can give today is better suited to dealing with the complex nature of cash flows, inflation, and aging in retirement.
If you would like to learn more, many online resources regarding dynamic withdrawal strategies and guardrails are available. You might start with one recent piece by Derek Tharp summarizing the potential for risk-based guardrails.
As this is still an evolving area, I suggest you discuss the strategy with a financial planner competent in retirement income planning. But I hope you have a better idea of why guardrails may be something you may want to implement in your own retirement plan.
If you have comments or questions on this piece, please drop me a line at: [email protected]
References
- https://krishnawealth.com/the-real-reasons-why-you-should-save-money/
- https://www.diewithzerobook.com/welcome
- https://www.kitces.com/wp-content/uploads/2014/11/Kitces-Report-March-2012-20-Years-Of-Safe-Withdrawal-Rate-Research.pdf
- https://www.kitces.com/blog/guyton-klinger-guardrails-retirement-income-rules-risk-based/
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