8-Minute Read
I’m commonly asked as a financial planner: “How Much Money do I Need to Retire?”. I love the question as it can lead to some deep conversations. But I’m also intrigued by one simple way to answer it.
Bill Bengen published a paper in 1994 quantifying how much a retiree could safely withdraw from her portfolio. It turns out using historical market returns and some other assumptions that the “safe withdrawal rate” was around 4 percent. This number has been debated and refined by financial experts for nearly three decades since.
So, is 4 percent a reasonable spending guideline you can use for your own retirement? We’ll explore by covering three areas.
- Is the 4 Percent Rule Realistic?
- Reasons to be Pessimistic of the 4 Percent Rule
- Why I’m Optimistic the 4 Percent Rule Can Work
Is the 4 Percent Rule Realistic?
Back to the question of how much money you need to retire. If you like details, I provided two technical approaches in an earlier blog, Two Ways of Quantifying Your Retirement Analysis. If you prefer a simple rule of thumb, start with the 4 percent rule.
An example may help. Suppose you had a $1 Million portfolio. The rule says you can safely withdraw $40,000 (4 percent of $1 Million) in the first year of your retirement. Then assuming the rule holds true, you can maintain that equivalent purchasing power in every subsequent year for the next 29 years.
You can scale this based on your withdrawal need. A $10 Million portfolio supports a $400,000 annual withdrawal, and so on. Another way to view this: Take how much money you wish to withdraw from your portfolio annually and multiply by 25. The answer may get you surprisingly close to how much you need for a comfortable retirement.
Important Note: Pensions, Social Security, and other non-portfolio income sources are used to supplement this 4 percent withdrawal to determine your overall spending or lifestyle.
You might think that 4 percent is a low number relative to the types of investment returns you expect to get. If you can generate a 6 percent return, shouldn’t 6 percent also be your safe withdrawal rate (hereafter called safe rate)? The answer is probably not. 4 percent arises because of the volatility you’re likely to experience with your investments. It is a concept called “sequence of returns” risk.
Sequence of Returns Risk
Let’s describe this risk through another example. Say your portfolio had a 7 percent expected return for your entire retirement. If there was no risk in obtaining that 7 percent return, your safe rate would be higher. In fact, if there were no risk and no inflation, your safe rate would be around 8 percent!
But say you chose 7 percent as your safe rate in a more realistic return environment. Now fast forward. Suppose it turned out you had a 0 percent average return for the first 15 years of your retirement and then a 14 percent average return for the next 15 years. Sadly, it wouldn’t matter that you averaged a 7 percent return for the full 30 years. You simply wouldn’t have money left after the first 15 years to capture the subsequent positive returns!
Basically, the sequence and volatility in which you obtain your returns matters. Interestingly, the first 15 years (of your supposed 30-year retirement) tend to dominate the safe rate outcomes. The 4 percent rule takes this into account, at least by looking at historical worst-case scenarios. It results in a smaller and likely a more prudent safe rate. But is it safe enough?
Reasons to be Pessimistic of the 4 Percent Rule
There are reasons to be skeptical about the 4 percent rule. Most debates center around expectations for different kinds of investments and long-range economic outlooks. This might sound funny, but I don’t think that matters as much here.
I’ll briefly describe three other reasons that I believe matter more. Your time horizon, taxes, and fees might make you choose a lower safe rate.
One – Time Horizon
The original safe rate research is based off 30-year retirement distribution periods. This seems reasonable based on the ages most people retire and average life expectancies.
But what do you do if you want to retire earlier than most people AND longevity runs in your family. Perhaps that looks like an age 55 retirement with an age 95 life expectancy. This creates a 40-year distribution period.
All else equal, that may be a good problem to have. Financially speaking, you may want to be cautious.
Rule of thumb: if you’re extending your distribution period by 10 years, you may need to cut back your safe rate by roughly half a percent (0.5%).
Two – Taxes
It’s hard to have a financial planning discussion without talking about taxes. The safe rate research is tax agnostic. That means the spending level you choose needs to include taxes.
The amount you pay in taxes in retirement is based on several factors. Unless all your assets are in tax-exempt accounts like Roth IRAs, you will have to account for taxes. Put another way, if all your assets were in tax deferred accounts (e.g., Traditional IRAs, 401ks), then possibly every distribution you make in retirement could come with a tax implication.
So, all this will come down to your tax rate exposure and the types of accounts you have. Your situation will be unique.
Rule of thumb: reduce your safe rate by 0.25% or 0.75% to account for taxes.
Three – Fees
Investing comes with fees, but some fees are more transparent than others.
Here are a few common investment related fees:
- Advisory fees – if you’re using professional help for investing and financial planning. These are fees that could reduce your safe rate but could also increase it if the net effect of the fees is positive, sometimes called advisor “alpha”.
- Product fees – these may come in the form of fund manager expense ratios or sales commissions to enter or exit an investment. These should be reviewed and monitored carefully.
- Transaction fees – To trade or rebalance your portfolio, you may be exposed to fees. Some are explicit like trading fees at the custodian that holds your investments. Some fees are implicit such as “bid/ask spreads” for interacting with the market.
The point here is not to worry about avoiding all fees. Some fees can be very much worthwhile paying. But if you’re like most people, you’re not counting these fees in your lifestyle expenses.
Rule of thumb: For investment expenses equating to 1% of your portfolio, consider reducing your safe rate by around 0.5%.
Why I’m Optimistic the 4 Percent Rule Can Work
The challenges noted in the last section are considerable. They might even suggest your true safe rate is far less than 4 percent! But I’m optimistic the 4 percent rule can work as a foundation if you can build in some flexibility. Here we’ll look at three types of flexibility.
One – Spending Flexibility
The 4 percent rule assumes that once you start making withdrawals in retirement, you will regularly adjust those withdrawals higher each year to account for cost-of-living increases. The 4 percent rule is simple but rigid.
You may be more flexible with your spending decisions in your retirement. During down markets, you may even have a natural tendency to spend less and possibly vice versa during up markets.
Those tendencies can be put into rules that help guide your spending decisions year to year. One example is the so-called guardrail approach. It’s a set of decision rules made up of three components looking something like this:
- When my portfolio return is negative, I will not take an inflation adjustment for retirement expenses. (Withdrawal Rule)
- If my portfolio withdrawal rate exceeds 20% of my initial withdrawal rate, then I will reduce my spending by 10%. (Capital Preservation Rule)
- If my portfolio withdrawal rate falls below 20% below my initial withdrawal rate, then I will increase my spending by 10%. (Prosperity Rule)
The specific thresholds and spending adjustments above can vary based on your circumstances and preferences. Just like physical guardrails can keep your car from veering off the road, financial guardrails can keep your retirement on track.
Remember to Smile
Even if you didn’t have a formal rules-based approach for spending in retirement, it’s possible you may naturally spend less as you age. This was explored in research by David Blanchett2 that retirees spent less (in real, inflation adjusted terms) as they aged. This was true even if they could afford to spend more.
In the groups tested, spending tended to be higher in the early years of retirement. Likely this was due to better health and being able to travel more. Then spending reduced for retirees in their 70s and then peaked back up in the 80s and 90s due to higher health and long-term care costs. If you graphed this out (consumption changes vs age), you would see a curve that looks like a smile.
If true for you, maybe it is a reason to smile. It could mean that typical models (such as those that generate the 4 percent rule) are overestimating the total cost of retirement.
Rule of thumb: If you can be flexible with your spending in retirement, consider increasing your safe rate by 0.5 to 1.0%.
Two – Debt Flexibility
The 4 percent rule assumes that when you need cash to support your lifestyle, you’re always taking it from your available investment portfolio.
There may be circumstances when you would prefer to borrow funds instead of selling assets. One example is when you’re in the middle of a down market. If you have the capacity to borrow during a down market, you might mitigate some of that “sequence of return” risk described earlier.
A common source of borrowing in retirement is from home equity. It’s more common for folks in retirement to have a paid off home or one where most of the debt is paid off. This opens the door to considering a reverse mortgage line of credit.
This strategy won’t resonate with everyone. But I describe it in more depth in The Value of Having Debt Capacity.
Rule of thumb: If you have (and choose to use) debt flexibility, consider increasing your safe rate by 0.5 to 1.0%.
Three – Investment Flexibility
How you invest over a multi-decade period should influence your safe rate, right?
It’s interesting that the safe rate research is based off a two-asset class portfolio. A 50/50 combination of common stocks and intermediate term treasury bonds. Investors have many more asset classes to choose from today. Among others, these include international equities, gold, commodities, inflation protected bonds and so on.
The goal for diversification mathematically is that the asset classes you choose have a low to negative correlation. I won’t get into the details on that here. Just note that in practice, it can be difficult to achieve this consistently. It is, however, reasonable to expect that diversification can provide benefits and help increase your safe rate.
Also, the timing of when you retire will play some part as well. The reason is that investments valuations change throughout time. At some times, it’s a higher valuation. In those cases, you may want to plan for a lower expected return for the first years of your retirement. At other times, it’s a lower valuation and you might have a higher expected return. I’m avoiding the details here, but it’s an area worth discussing with your financial planner.
Admittedly, when you retire may not always be in your complete control. Health or family issues may force an earlier retirement.
Rule of thumb: If you can diversify AND retire in a reasonable valuation environment, consider increasing your safe rate by 0.5% to 1.5%.
Concluding Thoughts
If you follow all my rate adjustments (both negative and positive) throughout this blog, the net average safe rate would be around 4.75%! This is not scientific nor a recommendation. It’s just an observation that 4 percent should be in the reasonable range of safe withdrawal rates. I’m sure there are advisors (and perhaps even my more technical clients) who would challenge me on some of the assumptions I made. That’s fair.
We can’t be sure of what withdrawal rate will work going forward. It can only be known in hindsight, after we’ve lived our lives. To me, it’s an interesting intellectual exercise where getting a precise answer probably shouldn’t be the goal. Try setting a reasonable spending target. Then, if possible, build in some flexibility to make course corrections along the journey of your retirement.
If you have comments or questions on this piece, please drop me a line at: [email protected]
References
- https://krishnawealth.com/two-ways-of-quantifying-your-retirement-readiness/
- Exploring the Retirement Consumption Puzzle, David Blanchett, Journal of Financial Planning, May 2014
- https://www.financialplanningassociation.org/sites/default/files/2020-10/OCT16%20Klinger.pdf
- https://krishnawealth.com/the-value-of-having-debt-capacity/
- https://www.retailinvestor.org/pdf/Bengen1.pdf
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