Retirement: the state of having enough savings and income to live comfortably, avoid work, yet not run out of money. Reconciling the “live comfortably” amount each year, your withdrawal rate, to inflation and the amount of investment return on your savings, is a tough nut to crack. Your retirement withdrawal must be sustainable, on target, or close to it, year after year, to win the game.
The 4% Rule
William Bengen, a financial advisor, devised the 4% retirement withdrawal rule in 1994. In a nutshell, the theory states that if you withdraw 4% or less of your initial portfolio amount during the first year of retirement and maintain a moderate stock/bond portfolio you can increase each subsequent year’s retirement withdrawal accounting for inflation and have a very high probability of not running out of money.
For example, if your retirement portfolio is $1.5 million and inflation is 2% a year, you would withdraw $60,000 the first year of retirement, $61,200 the second year, $62,424 the third, and so on.
Mr. Bengen based his findings on stock and bond returns from 1926 through 1976. Since retirement usually does not last 50 years and that period included a few significant events, like the Great Depression and World War 2, there was an acceptance of the 4% withdrawal rule, rightfully so, as a rule of thumb.
“If you don’t save enough before retirement, you’ll probably spend too much in retirement.”
The problem isn’t the 4% rule of thumb. The problem is expecting retirees to survive on 4% of their retirement savings when they aren’t saving enough, the reliance on pensions is decreasing, those with debt in retirement is on the rise along with, of course, healthcare. It’s both a savings and spending problem.
4% of $200,000 vs. 4% of $2 million is quite a different number. If you don’t save enough before retirement, you’ll probably spend too much in retirement. You need to know how much to save for retirement along with the amount you can withdraw without depleting your accounts. You only get one shot to get it right.
Retirement withdrawal survival tips
The purpose of these recommendations is to both prepare for your retirement during your saving years, and after, with withdrawal guidelines to follow during retirement. There are no guarantees, but the odds of success are significantly improved if you implement these nine steps.
1. Have a budget – before and during retirement
Technology makes it simple, and it doesn’t take hours and hours. If you know your monthly income needs before retirement, projecting your needs in retirement is a snap. Some expenses may go away, like a mortgage, or 401(k) contributions, only to be replaced by additional expenditures for health care or hobbies.
Without a spending baseline, you really cannot be sure of exactly how much you’ll need to survive retirement or how much you can and should be saving beforehand.
2. Have an emergency fund – before and during retirement
Emergencies happen. An emergency savings fund before retirement prevents debt and allows you to save more for retirement.
During retirement, why tap into your retirement savings when you don’t have to? The market could be down, or that additional withdrawal could push you into a higher tax bracket. Keeping an emergency fund may prevent you from tapping into your retirement savings at an inopportune time.
3. Don’t forget about taxes in retirement
Unless all of your retirement funds are in a Roth, you’re going to have to pay taxes on distributions. Let’s assume you have $800,000 in your traditional IRA and are in the 24% tax bracket. A 4% withdrawal would be $32,000. The average tax after deductions, etc., called your effective tax rate, may be 15%. If that’s the case, you’ll net $27,200 after tax. It doesn’t seem like much, but over 30 years of retirement the tax portion of the 4% rule adds up.
The $27,200, equals a net retirement withdrawal rate of 3.4%, the gross is 4%. I propose advisors communicate net and gross withdrawal rates with clients. Not discussing taxes in retirement when it comes to determining retirement income needs is like going on vacation and not knowing how much you’ll spend on food. You’re going to need to eat on vacation, and you’re going to need to pay taxes in retirement.
4. Determine your housing needs
Housing needs are another significant retirement expense – you need to live somewhere. Have a long-term housing plan when you retire, whether you’ll be in your home, with a child, in a retirement community, or an assisted living facility. You need to face the fact that you may not be independent throughout retirement. Prepare for all possibilities.
Do you want to maintain a property? Maybe not. Renting then may be the ticket for you. Again, plan out the possibilities and potential outcomes beforehand. If you have a plan in place, then you won’t be scrambling to figure things out when the time comes.
5. Maximize your Social Security
There are occasions when you should take Social Security at 62, but deferring Social Security guarantees an 8% return each year. Yes, you need to live to the certain age to make up for that, and there are different scenarios, but hey, if you don’t make it to the break-even age, you also probably didn’t outlive your money either. In many cases, maximizing Social Security benefits can be the most reliable form of insurance against outliving your retirement funds.
Have a Social Security analysis completed. It’s not just about deciding to take it at 62, 67, or 70, many factors go into this decision. Read more about it in my blog post When Should You Take Social Security?
6. Have a distribution plan
We can project your expenses, Social Security, taxes, and retirement withdrawals down to the dollar for every year in retirement. Have your advisor run through scenarios. Make a retirement income pie chart breaking down your income sources – Social Security, pension, retirement savings, Roth and/or Traditional IRAs. You should have a plan to know how much will be coming from each and when (it’ll also help your taxes if you plan well).
7. Investment risk vs. investment returns
This is tricky. Each person has a different risk tolerance, how much risk you are comfortable taking, and risk capacity, how much risk you can take, based on your financial condition.
Too much risk and there’s a possibility of loss, too little risk and there’s a possibility of not keeping up with inflation. There isn’t a wrong answer or investment allocation. It’s a balance of your needs, your risk comfort, and how much risk you can afford to take.
Retirement could be 30+ years, enough time to go through a recession or two. It will happen. This is also a part of the retirement withdrawal equation.
8. Build flexibility into the plan
Some years you need more, some years you need less, every year of retirement is different – housing expenses, health, travel, market downturns, etc. Retirement income needs to be flexible.
Instead of a precise target, have a range, for example, 3% – 6%, or 2% -5%. Whatever it ends up being, build in flexibility. Rigidness leads to failure. Have a target and let that be the average, some years will be higher, some lower.
Medical expenses increase faster than the average inflation rate and are the big wild card as we age. Yes, I understand the argument that if you’re paying a substantial amount for medical care, there will probably be a reduction in other areas like travel, hobbies, etc. However, I don’t think you can assume your expenses will balance out. Be prepared and understand your medical costs could be higher.
9. Have a gatekeeper
Impulse buys, panic sells when the stock market drops, financially helping out a loved one. We can be our own worst financial enemy. One additional withdrawal here, an extra one there, what’s the harm?
Yes, I have to gently, and sometimes not so gently, remind folks that they’re spending too much in retirement (you know who you are!). I’m not here to be a “yes man,” and sometimes the truth hurts.
We continually track our retired clients’ retirement withdrawal rates. If we find a few continual deviations above the appropriate range, then a phone call, email or meeting is in order.
It’s not like you’re getting called to the principal’s office, but the facts and potential outcomes from withdrawing too much need to be on the table. If you need someone to be the gatekeeper or coach to keep your spending under control, then get one.
It’s a saving and spending thing
The only way you’ll win the game of retirement is by coordinating your savings and spending. It’s never too late to start. You should work with a trusted CERTIFIED FINANCIAL PLANNER™ to help you develop a personalized retirement saving and retirement withdrawal plan that works best for you and your financial situation.
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