Today I’m discussing a new retirement withdrawal strategy.
The strategy is simple + allows retirees to (safely) spend more money than the 4% rule.
It also protects against one of the biggest threats to retirement — Sequence Risk.
If you want to avoid leaving behind a mattress full of money and learn about a simpler approach to boosting retirement income, you’ll enjoy today’s episode.
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- Stay Wealthy Episodes Mentioned:
- Retirement Income Part 1: Why Most Retirees Will Never Draw Down Their Savings
- Retirement Income Part 2: The 4% Rule and Why the Creator Doesn’t Follow It
- Retirement Income Part 3: Immediate Annuities and Dividend Stocks + Their Pros & Cons
- Retirement Income Part 4: Using Dynamic Withdrawal Strategies to Maximize Income
- How to Invest During a Lost Decade
- Research Papers Referenced:
- How to Spend More in Retirement [Nick Maggiulli]
- Why Are Retirees Not Spending More? [Investments & Wealth Monitor]
- Life Cycle Theory of Consumption [Franco Modigliani]
- Guyton-Klinger Paper on Guardrails [FPA]
- Why Most Retirees Will Never Draw Down Their Retirement Portfolio [Kitces]
A New (and Simple!) Strategy to Boost Retirement Income
Taylor Schulte: The reason we save money for retirement during our working years is so we can spend it in the future when earned income shuts off.
In fact, one popular study on this topic concludes that the ideal outcome for most retirees is one where they spend their very last dollar on the last day of their life.
But actual spending behavior in retirement – specifically, the spending behavior of affluent retirees – tells a different story.
Affluent retirees are defined as individuals with non-housing assets of at least $200,000. And according to a recent study by Greenwald & Associates, only 14% of affluent retirees are drawing down principal to fund retirement expenses.
In other words, 86% of people with more than $200k in savings and investments are not withdrawing more than their portfolio earns each year. Said another way, 6 out of every 7 affluent retirees die with more money than when they entered retirement.
Surprisingly, this spending behavior doesn’t seem to change when retirement expenses increase unexpectedly either. Instead of dipping into principal, retirees are twice as likely to reduce other spending to absorb the unforeseen larger expenses.
Based on research, the majority of people with at least a couple hundred thousand dollars of retirement savings will underspend and leave more money behind than intended.
While there’s no shortage of withdrawal strategies to help retirees maximize their income and safely spend down their savings while mitigating the chances of running out of money, their emotions often prevent them from doing so.
They’re used to seeing their balance grow in the accumulation phase of life and struggle to watch it go the other way. Or, they aren’t naturally great spenders, hence why they’ve done such a great job accumulating a healthy nest egg.
It could also be that they just don’t know how to create a safe withdrawal plan in retirement and/or they aren’t sure how to accurately interpret the health of their plan through different market environments and different life events as they begin spending.
And I don’t necessarily blame them. Evaluating all of the different retirement withdrawal strategies out there, finding one that fits your unique needs, following every little rule outlined in a nerdy research paper, and implementing it properly year over year for 30-40 years can be a daunting task.
Which leads many retirement savers to gravitate to something simple and conservative like the 4% rule. While there are far worse approaches, a study done by Michael Kitces revealed that a retiree with a 30-year time horizon using the 4% rule is more likely to end up with 4x their starting balance than below it.
How about something in between the advanced withdrawal strategies implemented by financial professionals and something simple and perhaps too conservative like the 4% rule? Something that encourages retirees to safely spend and enjoy more of their hard-earned money?
Welcome to the Stay Wealthy podcast, I’m your host, Taylor Schulte, and today I’m sharing the details of new withdrawal strategy I recently came across.
It’s simple to implement, it’s dynamic, and it can help retirees spend more money in retirement while protecting them from running out before end of life.
For all of the links and resources mentioned in today's episode, just head over to youstaywealthy.com/192.
Two years ago, I published a 4-part series on creating income in retirement. If you missed it or want to listen again, I’ll link to the episodes in today's show notes.
In the final episode of that series, I talked about dynamic withdrawal strategies such as Guyton’s Guardrails (sometimes referred to as the Guyton-Klinger Rule). Unlike the 4% rule, which would be considered static, dynamic withdrawal strategies adjust the amount a retiree can withdraw each year based on the performance of the market and underlying investments.
In short, dynamic strategies permit higher spending during good years and require reductions during bad ones. The dynamic nature and unique rules allow retirees to have a much higher starting withdrawal amount than the 4% rule -- something closer to 5-6%, depending on a few variables. A dynamic withdrawal strategy also allows retirees to maximize their spending and avoid leaving a mattress full of money behind at end of life.
While we systematically implement the Guardrails strategy at my firm to create a healthy, reliable income stream for our clients – and I think it’s the superior approach -- I realize it’s not easy for people navigating retirement without a financial professional to implement it on their own. Which is why a recent article written by a friend of the show, Nick Maguilli, caught my attention.
He refers to this new, proposed approach as a “Flexible Spending Strategy.” It’s more complex than the static 4% rule but simpler than the popular dynamic withdrawal strategies implemented by professionals. Given the additional complexity, a retiree adopting this strategy could potentially begin withdrawing at a rate much higher than 4%. In some very extreme cases, he argues the starting withdrawal rate could be as high as 7%. But more on that later. Let’s cover the basics first.
The Flexible Spending Strategy starts by asking retirees to separate their fixed expenses from their discretionary.
Fixed expenses are the things that you NEED to spend money on in retirement. Things like food, housing, groceries, gas, insurance premiums, etc. While you have some control over how much you spend on these items, they are must-haves and things you can’t just eliminate from your budget entirely.
Discretionary expenses, on the other hand, are expenses that you have full control over. These are the things you would like to spend money on if your plan allows for it, but they aren’t necessary. Travel, eating out, country club or gym membership, and charitable giving are some examples. You can be flexible with discretionary expenses – you can reduce them or cut them out entirely if you had to.
So step one is to add up all of your expenses and then determine what percentage of your total living expenses in retirement are discretionary. This percentage will help drive what your starting withdrawal rate is based on the rules of this strategy.
More specifically, the starting withdrawal rate assumes an investor has an 80% stock/20% bond portfolio and adjusts up or down depending on two things:
1. The percentage of your total expenses that are discretionary. In short, the higher the percentage, the higher your starting withdrawal rate can be.
2. The probability of success you’re willing to accept. If you want a 0% chance of outliving your money, your starting withdrawal rate will be lower than if you were willing to take a little risk and accept a 5% chance of outliving your money.
Let’s go through an example. Let’s say your total living expenses are estimated to be $55,000 per year and you’ve determined that half of them are discretionary. If your discretionary expenses represent 50% of your spending and you wanted a 100% chance of not running out of money over a 30-year retirement, your starting withdrawal rate according to the Flexible Spending Strategy would be 5.5%.
Once you determine your starting withdrawal rate, you can apply it to your retirement nest egg and begin following the dynamic rules to adjust portfolio withdrawals as required each year.
As mentioned, this strategy is intentionally simple. So simple that it only has three potential outcomes each year and the only variable impacting these outcomes is the performance of the U.S. stock market as represented by the S&P 500.
Here’s how it works.
On December 31st of each year, you would check to see how far the S&P 500 is from its all-time highs. Based on that number, you would fall into one of three possible scenarios:
1. The first is what’s considered a “Normal Market.” In this scenario, if the S&P 500 is less than 10% away from its all-time highs on December 31st, then you are permitted to spend all of your discretionary spending in the next year.
2. The second possible scenario is a “Correction.” And the rule states that if the S&P 500 is MORE than 10% away from its highs on 12/31 but less than 20%, you are only permitted to spend half of your discretionary spending in the next year.
3. The last possible scenario is a “Beat Market” and this is where you’re really forced to cut back. In this scenario, if the S&P 500 is more than 20% away from its highs, you don’t get to spend any money on discretionary expenses in the next year.
Let’s put some dollar figures to this. Let’s say we have a $1mil portfolio, 50% of our expenses are discretionary, and we want a 0% chance of running out of money over a 30-year retirement. In that case, as previously mentioned, our starting withdrawal rate based on the table provided in the article would be 5.5%.
Since half of our expenses are fixed, we would cut that 5.5% in half and 2.75% or $27,500 would be earmarked for those fixed expenses. Here’s the interesting part that speaks to the simplicity of this approach. That $27,500 annual withdrawal earmarked for fixed expenses is now set in stone and never changes for the rest of your retirement except for adjusting it for inflation each year. The performance of the portfolio or the U.S. stock market does not change this withdrawal amount.
The only dynamic changes that are made for the next 30 years are to the withdrawal amount earmarked for discretionary expenses – the other half of that 5.5% or the other $27,500. The changes to this withdrawal are directly influenced by the performance of the S&P 500 each year as explained in the three scenarios a minute ago.
And, according to the rules, your discretionary expenses are never adjusted for inflation. This is because research suggests that discretionary spending in retirement decreases over time and this natural decrease helps to offset the impact of inflation over a three-decade retirement.
So, theoretically, if you projected your fixed expenses correctly, you can now sleep at night knowing that these expenses will be safely covered for the rest of your 30-year retirement. We could go through 08/09 round two, the stock market could be cut in half, but you would still be withdrawing your $27,500 adjusted for inflation each year.
It’s your discretionary expenses that will be impacted by the different market environments – the three scenarios we discussed. If we’re in a “normal market” on 12/31 of this year, you would be permitted to withdraw $27,500 next year to pay for your discretionary expenses. If we’re in a correction based on the definition previously shared, you would only be permitted to withdraw and spend half that amount – or $13,750 on discretionary expenses.
And if it’s a bear market, you would not be permitted to withdraw anything next year for discretionary expenses. You would only be permitted to withdraw the $27,500 adjusted for inflation to pay for your fixed expenses.
To summarize why this approach could be appealing, in two out the three scenarios (the normal market and correction scenario), you get to spend more than you otherwise would if you used the 4% rule. But, as Nick notes, this comes at a cost – you have to completely cut your discretionary spending during all years following a bear market.
He further states that,
“bear markets only happen about 20% of the time or 1 out of every 5 years, but they tend to cluster together.”
His extreme example was if someone retired in 1930 using this Flexible Spending Strategy, they would have had to cut all discretionary spending for 14 years. While that may never happen again, one would need to expect that it’s very possible to have a series of years where they will be required to eliminate all discretionary spending.
In addition to offering up a simple approach to dynamic spending in retirement and allowing retirees to spend more money, the Flexible Spending Strategy helps protect against one of the biggest retirement threats - sequence of returns risk. The rules we discussed prevent retirees from over withdrawing from their portfolio during the bad years and getting into a position where it may be impossible to recover and get through retirement safely without making some major life changes.
Just like there’s no free lunch with investing, there is no free lunch with retirement withdrawal strategies. If we want to spend more in retirement, we can either work longer and build up a larger nest egg, take more risk with ouR plan, or accept that we will need to make some adjustments to our spending from time to time (i.e., you have to be flexible).
Now, while I love the simplicity and cleverness of the Flexible Spending Strategy, and I think it’s an improvement over the 4% rule, there are few things that immediately jump out to me that one should take into consideration.
1. First, as previously mentioned, the research was based on an 80% stock, 20% bond portfolio. It’s possible that a retiree – especially a retiree attempting to implement this on their own – is not able to stomach that aggressive of an allocation for 30 years. For reference, the original 4% rule was based on a 50% stock/50% bond allocation and the Guyton-Klinger Rule or Guardrails Strategy is based on a 65% stock / 25% bond / 10% cash allocation.
In addition, the Guardrails strategy allows investors to adjust their starting withdrawal rate up or down based on their desired allocation. So, if you prefer to take less risk and reduce exposure to the stock market, you can do that, with the caveat that you will have to accept a lower starting withdrawal rate.
2. Second, the Flexible Spending Strategy is based on a 30-year time horizon, while other dynamic withdrawal strategies like the Guardrails are based on a 40-year. To be fair, the Guyton paper was eventually updated to include rules and withdrawal rates for a 30-year time horizon as well, but I typically lean on the 40-year rules.
And that’s because there are a lot of future unknowns in retirement. If we can develop a 40-year plan that gets someone safely to age 100, then we know we have some extra buffer if something catches us off guard. It’s a way to help stress the plan and potentially give clients more confidence to spend.
Just know that if you retire earlier than the traditional retirement age or like the idea of having a plan that stretches out 40 years to create some extra buffer, you will need to make some adjustments to the proposed rules or adopt a different withdrawal strategy.
3. Third, the Flexible Spending Strategy rules are based on the performance of one single asset class, the S&P 500. The argument is that if the S&P 500 is in bear market territory, it’s likely that the rest of the world is, too. And therefore, to keep the strategy as simple as possible, they concluded that basing the spending changes on that one index was sufficient.
While I understand the rationale and appreciate them staying true to keeping it simple, it is possible for a retiree's properly diversified portfolio to behave very differently than the S&P 500 for extended periods of time (for example, the lost decade in the early 2000s). And it sure wouldn’t make for a fulfilling retirement to be forced to cut discretionary spending just because of the performance of a single index that may not match the individual's portfolio performance.
The Guardrails rules, on the other hand, are based on the performance of the individual's portfolio and not on any single index.
4. Lastly, the Flexible Spending Strategy assumes that retirees want to spend money on their discretionary expenses equally each year. But it’s quite common for people in the first 10 years of retirement to want to spend a lot more than in the remaining 20 years. It’s also common for retirees to want to spend more in those early years ahead of Social Security and pensions kicking in later on that will take pressure off the portfolio.
To create a withdrawal strategy that allows extra spending in the first 10 years while mitigating sequence of returns risk and not putting the back half of retirement in jeopardy requires some advanced planning. Again, the simplicity of the Flexible Spending Strategy is very much appreciated, but it can still leave retirees wanting something that aligns more closely with their spending goals and unique needs, especially in those go-go years. In that case, a more advanced and customized withdrawal strategy will likely be required.
There is no one size fits all retirement income strategy. It’s important to adopt one that works for you and allows you to achieve your unique needs and goals. And, just like investing, the best withdrawal strategy is ultimately the one that you understand and you can stick with for the long term. If you jump from a dividend spending strategy to buying an annuity to trying out the 4% rule, you’re likely going to introduce more stress than needed – both on you and your investment portfolio.
Once again, to grab the links and resources mentioned in today’s episode, including links to the research papers referenced today, just head over to youstaywealthy.com/192.
Thank you, as always, for listening and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.