How Much Can You Afford to Spend in Retirement?
A blog post dedicated to showing you the tools Swell Financial uses to help ensure that you don’t run out of money, and more importantly, get the opportunity to enjoy every single dollar in retirement.
What if I told you that you could comfortably afford to spend more money in retirement?
Would you believe me?
More importantly, would you do it?
I once attended a conference where a well-respected industry expert paneled a room full of financial advisors and asked, “Who here has ever had one of their clients run out of money?”
Two brave hands went up.
You could feel the silence in the room as every advisor was silently judging these two poor souls for allowing such a thing to happen; the ultimate cardinal sin in financial planning.
And then the speaker sternly said, “Shame on every single advisor in this room who did not raise their hand. Your clients either passed away or have lost valuable years of their retirement not knowing that they could have been spending more money, and you withheld that from them by not doing your job.”
Let’s pause here for just a second.
I am in no way advocating for a wreckless spending plan, rather, what occurred to me at that moment was that the traditional framework of which I (and the entire industry) have approached spending in retirement was flawed.
The decision to know how much to spend from your portfolio each year is one of (if not the most) critical questions in retirement.
And what I hope to accomplish through this blog post is to showcase all the various methods experts have used to calculate retirement spending and show you what I believe is a better method and one that allows for much more flexibility and superior outcomes.
Method #1: The 4% Rule
A Traditional Approach to Retirement Spending
Last year, I wrote about how to solve for your retirement spending needs using the traditional 4% rule as well as some other popular textbook methods. I walked readers through how to calculate their annual spending needs to help solve their portfolio withdrawal rate.
As a refresher, your withdrawal rate is the amount you can withdraw from your accounts each year without running out of money before reaching the end of your life.
According to Financial Planner William Bengen, the 4% approach suggests that by having a portfolio of 50% stock and 50% bonds, retirees can safely withdraw an amount equal to 4% of their savings during the year they retire and then adjust for inflation each subsequent year for approximately 30 years.
The 4% rule is a simple rule of thumb as opposed to a hard and fast rule for retirement income and aims to provide a rough estimate of the amount of steady income a retiree can receive without depleting their retirement account.
💡Important: It should be noted that academic research has shown the 4% rule to have approximately an 85% success rate. This means in 10,000 simulations, there were 1,500 scenarios where the retiree ran out of money - Dr. Wade Pfau.
As widely accepted as the 4% rule is, it is merely a rule of thumb and should not be considered bulletproof advice.
Critique: Continuing to withdraw the exact same amount each year, while market conditions change, such as a Bear Market or heightened inflation, could be costly, especially early on in your retirement.
“A retiree following the 4% rule to the letter who does not monitor their portfolio annually or work with an advisor to help, may spend considerably less than they could, in an average or better market, while also failing to adjust spending if they experience a down market.” Source: Charles Schwab Wealth Management Insights
Method #2: Reality
Retirement Planning Method
In direct contrast with the 4% rule is Financial Planner Ty Bernicke who published his white paper in the Journal of Financial Planning suggesting that retirement spending actually decreases on average by about 15% every 5 years.
And that by the time a retiree reaches their late 70s, their spending drops to less than half of what they were spending in their late 50s.
Bernicke states that traditional financial planning widely assumes that retirement spending will stay the same throughout one’s entire lifetime, with the only adjustment needing to be inflation.
This approach, Bernicke says, requires one to adjust their income upward every year throughout retirement to account for a rise in inflation. Furthermore, this method requires a retiree to save more money than they’ll actually really need, while spending less, and potentially retiring later.
To counter this, Bernicke’s approach believes that the 4% rule is too rigid and that since retirees wind up spending much less in later years as they age, they could safely afford to retire earlier or spend more in the earlier years of retirement. This static rule dictates that the retiree does not change spending, up or down, no matter how the market performs. As a result, the retiree may run out of money.
Method #3: Keep It Simple
25x Rule
A more simplistic retirement planning method includes multiplying your annual spending needs by 25 to help you estimate the total amount of money you need to save for retirement.
For example, let’s assume you’ve determined that you’ll need $75,000/year in retirement. Taking into consideration your other sources of income that we can count on, Social Security, pensions, or a part-time job to cover $25,000 of this amount. This means you must cover the remaining $50,000 from your investments.
According to the 25x Rule, you would need to save at least $1.25 million to safely retire and be able to withdraw $50,000 of income in your first year of retirement.
Note: Keep in mind that depending on the type of account the money is withdrawn from, you may owe income or capital gains taxes.
Critique: Much like the 4% Rule, it is important to remember that the 25x Rule is merely a rule of thumb and may not be a high enough estimate for your specific retirement plan. Additionally, this 25x figure does not account for inflation or changing market conditions
Method #4: Retirement Spending Smile
Certified Financial Planner, David Blanchett set out to bust the retirement myth that retirees will spend the same amount of money year after year through their retirement.
Blanchett believes that many retirement planning software models may be overestimating the cost of retirement and that retiree consumption does not increase annually by inflation.
In his model, he illustrates that traditional retirement spending mirrors the shape of a “SMILE”, where retirees are likely to spend more both early and late retirement.
Image Credit: David BlanchettIn support of the SMILE approach was Researcher and Advisor, Wade Pfau stating:
Many people want to take advantage of their early retirement while they are still spry and energetic enough to travel, or just make up for lost time on their (expensive) hobbies that they put to the side before retirement. As we get older, we tend to slow down and get more sedentary. This often translates to a decreased desire to spend. And then towards the end of our live there are a number of medical expenses that we will likely need to contend with. Source: Retirement Researcher - Wade Pfau, Ph.D, CFA
Method # 5: Monte Carlo Simulations
Many retirement planning softwares such as eMoney use Monte Carlo to test if one will have enough income throughout retirement. This approach runs a retirement scenario modeling 1,000 random scenarios to see what the likelihood of success will be.
According to eMoney, “Monte Carlo simulations model the probability of different outcomes in a process that can’t be easily predicted due to the intervention of random variables.”
With the unpredictability of the stock market, Monte Carlo simulations can help financial planners model how a particular portfolio (and plan) will perform under various market conditions, thus helping them make more informed investment decisions.
“This approach is especially useful in retirement planning, in which investors try to figure out which savings rates, allocations, market returns, and spending patterns will allow them to make their nest eggs last a lifetime,” Morningstar.
Critique of Monte Carlo: Planning tools do not “recognize that portfolio performance depends at least as much on the sequence of future investment returns as it does on the average of those returns. Moreover, the thousands of iterations Monte Carlo simulators produce can lull clients into believing they've considered all the possible financial outcomes they could experience, when in fact the numbers generated may have little relevance to their particular financial situation. Further, Monte Carlo doesn't measure bear markets well. Finally, this kind of simulation is not capable of connecting projected investment returns with realistic cash flows.” Source: Wealth Management Magazine
Finding the Signal In the Noise
A More Realistic (and Accurate)
Approach to Retirement Spending
With all of the proposed theories on retirement spending, which one are we to trust?
I knew there had to be a better way to predict retirement spending and help clients enjoy more of their money in retirement, instead of providing “estimates” or looking at spending one year behind.
As a Certified Financial Planner with more than a decade of experience, I was finding that many of these software programs we not able to fully:
Give specific spending amounts (based on market volatility) rather than providing an estimate based on an assumed growth rate
More importantly, these softwares weren’t able to inform me (or the client) when it was time to increase or decrease spending … due to market volatility
Rather, spending was only decreased when the client began to run out of money
The models never adjusted based on the performance of the stock market
Even if the client had no intentions of spending more, just the peace of mind of knowing how much more they could comfortably afford to spend was what I was after.
I thought to myself, there has to be software out there that adjusts for real-time market changes, a program that updates spending amounts and has robust data to back up historical claims and spending limits.
The reason this is so important is that having software and a model that provides real-time spending and adjustments, shifts the conversation away from worrying about an arbitrary account value on a statement due to poor market performance and instead hones in on lifestyle and spending.
Introducing the Retirement Guardrails Approach
Developed by Financial Planner Jonathan Guyton and business professor William Klinger, the Guardrails Approach offers a far better, more dynamic method for deciding how much you can spend each year in retirement.
In this (Guardrail) approach, when your investments do very well, you increase your draw, but when your portfolio value drops a lot, you cut your spending.
Opher Ganel of Wealth Tender
These early warning signs can then be used to establish guardrails that modify a retirement strategy by providing corrective action to avoid failure.
The goal was to identify events leading to failure early enough to rescue the portfolio. A proactive approach to try and get ahead of any threats early enough.
Guardrails are an easy-to-follow system to avoid portfolio failures. A guardrail can be applied to a retirement strategy specifying a reduction in the withdrawal rate to be taken when an early warning sign reaches a particular value.
The high level of the plan's success (shown below when compared to the 4% rule) came as the result of knowing when to take cuts in retirement spending.
Source: SCFF via Charles SchwabWhy we like The Guardrails Approach:
It allows for higher spending earlier on in retirement compared to the 4% rule
It thrives on the flexibility of being able to increase or decrease withdrawals based on market performance
It allows for increased spending later in retirement or more flexibility to leave a legacy
Example of the Guardrails Approach
To get started, we want to first identify an initial withdrawal rate. Somewhere in the 4-6% is a great starting point.
💡Important: The higher you set your rate initially, the more likely you are to adjust it and decrease your spending later in life.
In our example, our sample clients wanted to retire and live comfortably on $75,000/year and had a starting portfolio value of $1.5 million. Together, we identified a safe withdrawal rate of 5% to get them $75,000/year.
Next, we’ll set our top and bottom guardrails to determine when to adjust your withdrawal rate.
Guardrails Approach Key Terms
Desired Monthly Income is $6,250, or $75,000/year (5%)
The top guardrail will be called Proposed Income (6%)
The bottom guardrail will be called Essential Monthly Income (4%)
Using the guardrails approach, we will set a range for our guardrails to be 20% above and below our starting withdrawal rate of 5%.
Our lower guardrail would be 4% (0.80 x 5%)
Our upper guardrail would be 6% (1.2 x 5%)
If our withdrawal rate begins to drift outside of the guardrails we set, we would then need to course correct and either increase or decrease our withdrawal amount to get back on track and into the 4-6% we originally set.
Using Guardrails in a Bear Market
Using a starting portfolio value of $1,500,000 - 5% Withdrawal = $75,000/year or $6,250/mo
The lower guardrail of a 10% decrease is would be adjusted to $5,625/mo
Knowing that these clients will soon have Social Security and other income sources kicking in, their upper boundary was set at $8,300/mo (approx. $100,000 per year)
Market drops by 20%
Assuming a market drop of 20%, our client’s starting portfolio of $1,500,000 would now be worth $1,200,000
To figure out our new guardrails and how much our clients could afford to withdraw, we first adjust annual spending to account for inflation at 3%
The inflation-adjusted withdrawal amount is $77,250 ($75,000 x 1.03).
By doing this, we can now see that our current withdrawal rate is out of bounds!
If we were to divide $77,250 by $1,200,000, we would get 6.4% and this number is NOT sustainable since is higher than the 6% upper guardrail we originally set.
To correct this, we would have to cut spending by 10% down to $69,525 ($75,000x 0.9)
When we do this math, we can see that $69,525 / $1,200,000 is 5.8% and safely back inside our guardrail.
Using our guardrails approach software, we can help you better measure:
How often you will need to make significant income/spending adjustments
And how big those adjustments need to be
Additionally, you’ll be able to learn how large of an annual pay raise or pay cut you’ll need to make to stay in bounds and how frequently those larger adjustments (throughout history) occur and last.
💡Remember: Retirement plans don’t fail, they adjust
Using Guardrails where assets rise by 30% in a Bull Market
Assuming the market roars up 30%, our client’s starting portfolio of $1,500,000 portfolio would now be worth $1,950,000
To figure out our new guardrails and how much our clients could afford to withdraw, we first adjust annual spending to account for inflation at 3%
The inflation-adjusted withdrawal amount is $77,250 ($75,000 x 1.03) or $6,431/mo.
By doing this, we can now see that our current withdrawal rate is out of bounds!
But this time, instead of cutting spending, you would actually be able to increase spending and give yourself a raise!
If we were to divide $77,250 by $1,950,000, we would get 3.9% which is lower than the initial bottom guardrail of 4% that we set.
You would now have permission to increase your spending by 10% and safely spend $7,081/mo or about 4.3%
💡Important: It’s worth noting that you’ll want to make sure and run these numbers annually to see where you fall or hire a financial planner with capable software to adjust and provide you with new annual spending amounts.
Closing Thoughts
Your retirement will be filled with all kinds of changes from potentially relocating to possibly welcoming in grandkids. Additionally, it’s common for you to experience both up and down markets as well as periods of high and low inflation. So if markets and economic conditions are changing, then why wouldn’t your spending change as well?
Whether you prefer to manage your own money or work with an Advisor, I encourage you to stay flexible, remember to monitor your portfolio and spending annually, and keep your spending within your guardrails to ensure balance and portfolio longevity.
To a happy and successful retirement.