One might think that they are no tricks to retirement spending or spending your financial independence dough (aka your FIDough). Surely you can just kick back, enjoy your early retirement or financial freedom, and not give one lick about how to spend your nest egg, right? Nope. Without some planning, you will almost certainly hit some rough (ruff?) spots. You could even face every retiree’s nightmare – running out of FIDough too soon – yelp!
To avoid that, you need a plan. The following is aimed to help you with that by providing an overview of some strategies you can use along with references to some more sources.
A simple static model that works as a good starting point for most people – the 4% rule
Like investing, there is no one absolute best strategy on how much you can spend in retirement (although some answers are better than others). In sum, most experts agree that with a balanced portfolio, initially withdrawing up to 4% of your portfolio is a good place to start. Under the simple version of the 4% rule, this initial annual budget amount is then adjusted annually for inflation. So, for example, with a portfolio of $500,000, you would initially budget $20,000. If inflation were 2.5% in the first year of retirement, you would then increase the budget to $20,500 the next year (and so on). Annual inflation rate data is available from a variety of sources, including here.
This 4% number comes from research initially conducted by William Bengen in 1994. Bengen’s research showed that using a balanced portfolio (50% stock/50% bonds), retirees could start with a 4% withdrawal rate and increase that amount annually by the amount of inflation and not run out of money for 30 years across a wide range of market conditions. In other words, start at 4%, and give yourself a cost-of-living adjustment (COLA) each year based on inflation.
This is now commonly referred to as the “safe withdrawal rate” or “SAFEMAX.” Note too that the 4% rule is the foundation for the “25 times” rule of thumb; if 4% is going to cover your expenses, you must save 25 times your expense for the math to work (i.e., 100 ÷ 4 = 25). So although there are always nuances and complexities, it is a good starting point for planning purposes.
There has, of course, been a lot more research on the so-called SAFEMAX since 1994. Some research has suggested that if you diversify more broadly (by, for example, including small cap stocks, etc., in your portfolio), the safe withdrawal rate increases to 4.5% (over 30 years). Others have noted that the actual safe withdrawal rate depends on valuations when you retire. Because equity valuations are currently considered high (by some metrics), and interest rates remain low, some believe starting at 4% (and then automatically adjusting that amount for inflation each year) may currently be too aggressive and that current retirees-especially early retirees-should start with something closer to a 3% withdrawal rate.
But this criticism, and many others, focus on the fact that the 4% rule is a so-called “static” spending model. That is, it assumes that one will increase the withdrawal rate each year (by the inflation amount) regardless of what is happening to one’s portfolio or the stock market. So if one blindly follows the rule, and it does not work going forward, that could turn out badly.
With such assumptions, these criticisms make sense. But as Mr. Money Mustache has elegantly explained here, real people don’t blindly follow the 4% rule even if they start spending 4% initially and plan to generally follow the rule. In the real world, retirees—especially early retirees—can’t help but trim spending when the market tanks. (Take away here: if you have no cushion built into your spending plan, you need to rethink your plan!)
What this means for the real world is that the 4% rule still works as a good starting point for most people. And one of my other favorite resources on the 4% rule that breaks it down in a sensible manner is Chapter 8 of Jane Bryant Quinn’s excellent book How to Make Your Money Last. Wade Pfau’s collection of articles on the 4% rule is also worth exploring.
Dynamic spending models
Because of the theoretical problem that results from blindly following a static spending model in retirement, many folks have developed so-called “dynamic” spending models. These models automatically adjust with one’s portfolio thereby eliminating the theoretical problems with models like the simple 4% rule. Such models also typically permit one to start out initially spending more than 4% – a big plus for those planning to travel or otherwise spend more while they are younger.
Although dynamic spending models come in a variety of flavors, the most popular (and user friendly) models involve using a fixed percentage or they combine a fixed percentage with adjustments based on what happened to the portfolio during the prior year. Other dynamic models use life expectancy tables adjusted annually. Here are two popular dynamic spending models.
Withdrawing a fixed percentage each year.
Perhaps the simplest dynamic spending model involves withdrawing a fixed percentage each year. FIDough Favorite Paul Merriman has put together tables showing what such spending would like for a robust $1 million portfolio from 1970 to 2015. With this strategy, a 5% withdrawal rate is considered moderate. The downside of this strategy is, of course, that it requires trimming spending when the market declines.
Merriman’s Table 7 – which assumes a $1million portfolio consisting of 60% global stocks and 40% bonds – elegantly illustrates the pros and cons of this strategy. In 1970, for example, the initial withdrawal would have been $50,000 (5% of $1 million). By 2007 the portfolio would have grown to $7,458,910 permitting a withdrawal of $372,945 for the following year’s spending. At the end of 2008, the portfolio would have declined to $5,338,737, meaning spending would need to be cut to $266,937 the next year.
According to the CPI Inflation Calculator, the $50,000 you started out with in 1970 has the same purchasing power as $305,434.28 in 2015 dollars. Or to flip the math, $266,937 in 2015 is equivalent to slightly more than $43,600 in 1970 dollars – a significant 12.8% cut from one’s initial budget. Although one would have taken a real pay cut in 2009, in most years one could nevertheless spend more than with the simple 4% rule. This makes the strategy attractive for some.
Due to the variability that comes with such a strategy, however, it is best suited for individuals with a lot of discretionary spending. If you have lots of cushion, you can trim without too much pain and enjoy being able to spend more in good years.
The Floor and Ceiling Guardrail Strategy
Another popular strategy that has gained traction in recent years is the Floor and Ceiling Strategy aka “Guardrails.” A floor and ceiling strategy likewise starts with a fixed percentage (e.g., 5%), but then adds so-called “guardrails” to the spending increases and decreases (e.g., +5% to -5%) to make yearly budgeting more manageable. This strategy thus also allows you to start with a slightly higher initial spending rate, but then dynamically adjusts in the event the market has series of bad years while also avoiding wild budget swings.
Using the above 5% assumptions (although there are other reasonable ones), a $1,000,000 portfolio would start with a $50,000 spending budget in year 1 of retirement. It the portfolio increased only slightly (something less than 5%), the 5% spend of the portfolio would remain in place up to the ceiling of a 5% increase over the prior year. In other words, if the portfolio gained more than 5% (e.g., 10% and thus becoming worth $1,10,000), you would cap your budget increase at 5% (so your budget would be limited to 52,500 rather than $55,000.) Similarly, if the market declined, the 5% floor would remain in place down to the floor of a -5% decrease over the prior year. Given the general predictability that provide for budgeting along with their flexibility, there is much to be said about these strategies.
One twist on this model would be to make the guardrails themselves dynamically adjust based on inflation. After all, it is real inflation adjusted dollars not nominal dollars that matter for budgeting. So, for example, one could start with a 4-6% initial portfolio spend rate, and then set the floor and ceiling amounts as a variable percentage that uses last year’s inflation rate and perhaps adds to this rate a small fixed amount (somewhere between 0% and 1%, for example). Such a strategy would take into account what retirees are really aiming for, i.e., keeping up with inflation during retirement. But this model does not seem to have been back tested, and there does not seem to be much (if anything) written about it.
There has, of course, been a fair amount written on this topic. Here are some other resources worth exploring:
- What goes into “expenses” when planning for retirement – Determining Your Financial Independence Income Number. By understanding exactly what your FIDough Income must cover, you will be better equipped to implement a spending strategy..
- How to create your own paycheck in retirement – This Consuelo Mack WealthTrack interview with Professor Jamie Hopkins and Financial Advisor Steven Earhart discusses building a personal retirement paycheck and other issues that arise after you have moved from the accumulation phase to living off of your nest egg.
- Which Retirement Spending Strategy Is Right For You? by Wade Pfau – Article by the Retirement Researcher discussing how different retirement spending strategies have different patterns, which may help you identify the best strategy for your particular situation.
- How Much Should Your Spend in Retirement, podcast by J.D. Stein.
Summing it up – Mind the gap.
For many, 4% is a perfectly fine starting point, and if one is willing to adjust along the way, the current criticisms of this model miss the mark. If one is willing to ensure even more volatility, then explore some of the dynamic spending strategies. They offer some real benefits for those looking to start at a higher rate, and for those with large cushions built into their portfolios.
Ultimately, like investing, there are many sound approaches to managing your spending in retirement to ensure your money lasts and no one strategy is best suited for everyone. So, explore the above strategies and find one that suits you. Then, be sure to track your spending and portfolio gains over time, and “mind the gap.”