One of the biggest financial challenges we all face is how to accumulate enough money to last as long as we’ll need it during retirement. Once we pull the trigger and say goodbye to the working world, that doesn’t mean we can start spending like there’s no tomorrow. Moving from the accumulation phase into the spending phase of a retirement plan sounds really fun, but it has to be managed carefully so you don’t outlive your nest egg.
How Much Should You Spend in Retirement?
So, how do you know how much to withdraw from your portfolio each year during retirement so you don’t drain your finances? It’s a complex question because the answer depends on whether you have a guaranteed pension, how much you want to leave to your heirs, your health, the future state of the economy, and the performance of the financial markets.
If your idea of a perfect retirement is to have exactly zero dollars on the day you die, or to leave your care to family members once your financial assets run out, then you can spend more in the early years of your retirement. But if you want a sustainable income that allows you to leave an inheritance to your family, then you’ll want to create a spending strategy to accomplish those goals.
What’s the 4% Withdrawal Rule?
But what spending strategy is the right one to use? There’s a famous study by W.P. Bengen (1994) in which he determined that the optimal withdrawal rate for retirees is approximately 4%. He determined that this inflation-adjusted spending rate is sustainable for 30 years if a retiree’s portfolio has a 50/50 mix of stocks and bonds. In other words, if you have a nest egg with this asset allocation worth one million dollars, you should withdraw no more than $40,000 each year.
But what if your retirement is shorter or longer than 30 years or you don’t have a portfolio with 50% equities and 50% bonds? You’d probably spend differently if you knew you only had 10 years to live or that the value of your stocks would skyrocket, right?
Optimal Retirement Spending by Longevity
In order to consider some different variables, I want to highlight a study by Moshe A. Milevsky and Huaxiong Huang from the American Association of Individual Investors (membership required). They published their study results in a recent article called Retirement Spending on Planet Vulcan: Longevity Risk and Withdrawal Rates.
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The study looked at optimal spending during retirement that focused less on market risk and more on the uncertainty of your life span, which is called longevity risk. They took investment risk completely out of the picture by assuming that your retirement portfolio is made up of risk-free bonds only, such as Treasury Inflation-Protected Securities (TIPS). Granted, all of this takes place on a fictitious place called Planet Vulcan—but the point of the study was to consider optimal withdrawal rates when market risk is absent.
What Milevsky and Huang found is that when retirees don’t have investment risk to worry about, the only question they ponder when it comes to spending down their retirement nest egg is how long will I live? Though none of us knows the answer to that question, theoretically we could spend a varying amount of retirement money according to survival probabilities for our sex, age, and health, instead of withdrawing a constant percentage for life.
The study examined the real yields of TIPS over the last decade and assumed a return of 2.5%. When they assumed that a retiree had no pension to fall back on and didn’t want to leave any money to heirs, here’s what they found:
- at age 65 you should withdraw no more than 4.6%
- at age 70 you should withdraw no more than 4.54%
- at age 75 you should withdraw no more than 4.44%
- at age 90 you should withdraw no more than 3.59%
- at age 100 you should withdraw no more than 2.27%
These withdrawal rates are higher than the 4% Bengen rule in the beginning of retirement, but they drop as time passes. Spending might contract naturally like this as a retiree ages, unless you have increasing costs such as medical expenses.
Creating a Retirement Spending Strategy
Whether you want to withdraw a constant 4% from your retirement portfolio or a rate that fluctuates each year, remember is that your financial circumstances can change quickly and unexpectedly. The financial markets can return less income than you expect or your health could require you to pay more out-of-pocket. If you don’t have long-term care insurance, a pension, or you expect to receive little from Social Security, it’s better to be safe than sorry and adopt a conservative withdrawal plan.
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