Do Withdrawal Rates Make Sense for Retirement?
Jason 0 Comments Retire Wealthy Retirement Planning Tips for Retiree's
As you plan your retirement, one of the biggest questions that comes up is how much can I afford to spend each year, and how can I be sure that I won't run out of money if I spend at a certain rate? And a lot of people look to a withdrawal rate to help them figure that out, in other words, they might say, Maybe I can spend 4% or 3%, and that way I would have enough money to last for the rest of my life, but I think there are a lot better ways to go about that, so I wanted to review those with you and point out some of the issues, and hopefully this way you see what you might be missing out on if you use a withdrawal rate and you don't have to waste any time obsessing over what exactly is the perfect rate…
I should mention that when I work with clients, we don't really even look at The withdrawal rate, it's something we can find after the fact, after we've done some more robust planning, but we don't start with a withdraw rate, it's just something we might check out of curiosity. As a quick refresher, a withdrawal rate is a way of looking at how much you're pulling out of your savings and investments that are earmarked for retirement. Perhaps. The most famous and the most notorious is the so called 4% rule, which is really more of a research finding, so it's not a rule that you would necessarily follow, although some people talk about it that way. It's based on some research that was done by Bill Bengen where he looked at how much could you withdraw from a portfolio over a typical 30 year retirement horizon, and let's say you have a 50 50 stock and bond portfolio.
Well, what it turned out was in his research at the time, you could take out 4% of your starting portfolio and adjust it for inflation and not run out of money in any of those worst case scenario historical periods that lasted 30 years. Now, since then, the rule has been debated and criticized and refined, and people talk about things like, what about the current environment? Or what if I diversify more? How might that look? And a lot of people just love or hate the 4% rule. Either way, I don't think it's the best way to go about it, but it's important to understand how it works. So just for simplicity's sake, let's use round numbers that are easy to multiply in our head, and we'll say, let's say you have 100,000, or for each 100,000 of savings that you have at retirement, we would say You can pull 4% of that out per year, and we start with your first year, 4% of 100,000 is 4,000. So that's your Year One withdrawal, now you're going to adjust this for inflation each year, so in the subsequent here, If inflation is anything above zero, you're going to pull out more than that initial 4000 and with each passing here, you're going to adjust your withdrawals, you continue to take those inflation adjusted withdrawals each year, regardless of what happens with the markets or how high inflation is for at least that's how it worked in the original research, so that's a basic overview of a withdrawal strategy like the 4% rule, but just as one example of something that might be missing in that analysis because it's pretty over simplified is taxes.
So for example, are you pulling money out of pre tax accounts that you're going to go income tags on like a traditional IRA, or are you pulling from taxable brokerage account or Roth accounts? They wouldn't necessarily have as much tax, so depending on where the money comes from, that 4000 or 40000, if you have a million dollars is going to offer you more spending money or less…
Now again, at a 40000 income, the taxes might not be too burdensome, but you need to know that there are probably some taxes due, so that's going to affect your budget, another issue with withdrawal rates or the 4% rule, for example, is that you might not spend as much as you could, and that might mean you're missing out on opportunities, making memories or doing things you want to do, or retiring at a later date then you need it to… Historically, there were quite a few runs where you ended up with a lot more money than you started out with, so we assume you started with 1 million dollars, you did a 4% withdrawal rate, and you had more than 2 million at the end of your life, 45% of the time, your money doubled over your retirement years, or in some cases, you might have died with more than 5 million.
That's great if your goal is to give money away at death, but if your goal is to maximize your enjoyment of your assets during life, then a simplified withdraw rate might not let you do that. This would be a perfect time to mention that past performance does not guarantee future results, and this is just a short video, so friendly reminder, please do a lot more research before you make any decisions, decide to take any action or not, because this stuff is really important. So please read that carefully, and by the way, I'm Justin Pritchard and I help people plan for retirement and invest for the future, so in the description below, you're going to find more resources on this topic, some discussions about withdrawal rates and some calculators that help you work with withdrawal rates, if you want to go that route and look at some alternatives, I think you'll find all of that helpful.
When you make a more robust income plan, you might have a withdrawal rate that varies over time, so it might start relatively high, perhaps you're withdrawing at a relatively high rate in the early years of retirement and spending down some assets, and that might be something you do as you wait for Social Security benefits to start, perhaps you're going to delay Social Security, maybe you want that time to make a little bit of room so that you can do Roth conversions or fill up some tax brackets, or maybe you're just trying to maximize what your Social Security benefit is, there's some really good reasons for doing this, for example, maybe there's going to be a survivor involved, and you want to make sure that that benefit is as high as possible because once one spouse dies, for example, the surviving spouse would be left with just one Social Security income, so perhaps it's important to have that be as high as possible, and here's an example of how that could look, so we can just check somebody's withdrawal rate.
And in this case, they aren't going to start Social Security until age 70, so they have started out with a relatively high rate here, then it drops off as other income sources kick in, they're in the low threes here for a while, and then when Long term care expenses come up, you're back to a high withdrawal. We can also see how it looks kind of visually with the asset levels, so again, at retirement here, maybe they're going to wait until 70, they're going to spend down some assets for a while, and then that curve… And by the way, this can be kind of nerve racking to watch your assets decrease over time, but if you have a plan in place and you've got those retirement income sources that can perhaps help you have the confidence they, again, here spending down assets until the Social Security and pension sources kick in, and then the withdrawal rate decreases dramatically, now, not everybody has a pension plus Social Security, that's actually going to help them increase their assets once those income sources kick in, but some people are fortunate, and that's what retirement looks like for them.
One other issue with withdrawal rates is that your spending can change over time, so as just one example, maybe you're going to buy a car periodically, and so that spikes your withdrawal rate every couple of years, so how do you deal with that? Or if we look at research on retiree spending, not everybody spends a flat inflation adjusted amount each year, in fact, for some retirees, you might have them spending at roughly inflation minus 1%, of course, that ignores those healthcare expenses which continue to increase at a pretty fast rate, probably faster than general inflation is a good way to model that, but other expenses might not increase, so if you own your home and you don't drive too much, for example, you might not be experiencing a lot of inflation. In fact, David Blanchett's research called the retirement spending smile actually shows retirees spending at roughly inflation minus 1%.
Or another way to look at this is your retirement spending stages. Sometimes people call this the go go, the slow go and the no go years. So right after you retire, you might be spending at a relatively high rate, these are your go go years, you've just finished working, you've saved all your life, you want to travel and have fun, and so you're going to do that while you're still young and healthy, but then you get into the slow go years, your spending might slow down a little bit, you've done a lot of the travel, you're spending more time just with friends or family or whatever the case may be, and then we get into the no go years where a lot of your leisure and entertainment recreation spending are going to decrease, but that healthcare spending ramps back up in the no go years, so if we're thinking of that in terms of withdrawal rates in the go go years, you're at a relatively high rate, slow go years, not quite as high, and the no go years, you're back into a relatively high rate, so I hope now you have a richer understanding of withdrawal rates.
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