Thought saving for retirement was hard? Spending that money — and ensuring it lasts through old age — is even harder.
It may not sound tough at first blush.
But consider all the unknowns: how long you’ll live; the need for costly health care or long-term care, perhaps decades from now; the future returns of stocks and bonds.
These can blindside a retiree. And overzealous spending early on, without a course correction, could prove dire. Seniors may not be able to return to work to make up a shortfall.
“It is super complicated, if you want to do a good job,” David Blanchett, head of retirement research at PGIM, the investment management arm of Prudential Financial, said of drawing down retirement savings.
“You make a series of choices when you first retire,” he added. “If you follow those choices for a long time and you made bad decisions, at some point you’ve driven toward a cliff and you can’t slow down — you’re doomed.”
Fortunately, there are strategies retirees can use to spend their hard-earned nest egg with a high degree of confidence that the funds will last.
Important points
First, there are some important points to bear in mind about these strategies.
Retirees should think of them as guides rather than prescriptions to follow to the decimal point. Retirees will almost never spend exactly what their preferred models suggest from year to year.
Directionally, they will inform whether you’re spending a safe amount, too much, or whether you can afford to spend a little more from year to year, according to retirement experts.
“People often want a gut check, especially if things are volatile,” Blanchett said.
Also, these methods only examine spending from an investment portfolio. Retirees likely also have guaranteed income from Social Security, pensions or maybe an annuity, for example.
A retiree who can pay for their fixed expenses (like food and housing) with guaranteed income have more leeway with their portfolio spending, which would largely fund discretionary costs (like travel and entertainment).
Which is all to say: “Safe” spending will vary greatly from household to household.
And a portfolio roughly split between stocks and bonds generally yields the best results, research shows.
There are many positive financial decisions retirees can make before even touching their nest egg, too.
For example, delaying when you claim Social Security boosts monthly payments for life. Reducing fixed expenses (e.g., paying off a mortgage, selling a second home, throttling back support for adult children) when heading into retirement can also help reduce your reliance on investments — and therefore the risk of not having enough money later.
“If you can find a way to cover fixed expenses with non-portfolio income, it makes things much more flexible,” said Christine Benz, personal finance director at Morningstar.
Be dynamic
Among the most important factors is to be flexible, to the extent possible. That means adapting to market conditions — if the stock market takes a dive, for example, be prepared to throttle back spending accordingly.
This limits so-called “sequence of return” risk — the hazard of pulling too much money from investments falling in value, leaving less of a runway for them to recover when the market rebounds.
“Any strategy where you can adjust in response to portfolio performance really helps you manage sequence risk,” said Wade Pfau, a professor of retirement income at The American College of Financial Services.
Dynamism is a key feature of the following strategies recommended by retirement experts.
1. The 4% rule with a twist
The 4% rule is a well-known rule of thumb for retirement spending.
It says people should withdraw 4% of their total nest egg in the first year of retirement. To determine later annual withdrawals, they’d adjust the prior year’s dollar figure upward according to the inflation rate.
For example, an investor would be able to withdraw $40,000 from a $1 million portfolio the first year. The next year, a 2% inflation rate would add another $800 (or $40,800 total). In year three, another 2% inflation rate would yield a $41,616 total withdrawal, and so on.
One of the merits of this approach is it feels like a quasi-paycheck since it’s a steady stream of income.
But it’s likely too rigid, experts said — retirees take the same amount, without regard to market fluctuation.
The better approach is to forgo an inflation adjustment in the year after a portfolio has a loss, according to Benz of Morningstar.
Using the above example, if the $1 million nest egg has a negative return in year one, the retiree would take a $40,000 withdrawal in year two (instead of the higher, inflation-adjusted $40,800).
This approach may work well for people on fixed budgets without a lot of wiggle room, Benz said. And it’s relatively straightforward for do-it-yourselfers.
“It’s not nothing, especially in the current environment where inflation is high,” Benz said of the haircut. “But it’s a simple tweak — one I think many people could live with,” she added.
(Note: Morningstar research shows future retirees would likely be better served using a 3.3% instead of 4% first-year withdrawal rate.)
2. Required minimum distributions
This strategy involves the same IRS calculation retirees use to determine their minimum withdrawal each year from pre-tax 401(k) plans, individual retirement accounts and other pots of money.
However, it applies to all of a retirees’ savings, not just the accounts subject to federal RMD rules.
Here’s how it works: Determine the appropriate “distribution period” on this IRS worksheet according to your age. Divide your total portfolio by this distribution period. This calculation will tell you the safe spending amount for that year.
For example, let’s say a 70-year old has a $1 million portfolio. They’d divide $1 million by 27.4 (the distribution period), yielding a roughly $36,500 withdrawal that year.
Consult the IRS worksheet each year, repeating the calculation according to current age and portfolio value.
(Note: The IRS publishes different worksheets according to individual circumstance.)
One potential downside: The tables are conservative, which may lead to lower-than-desired annual spending.
As an alternative approach, retirees can use an online life-expectancy calculator instead of the IRS distribution tables.
Retirees would divide their portfolio value by the estimated duration of life expectancy. Let’s say a 70-year-old with a $1 million nest egg expects to live another 20 years; they’d divide $1 million by 20 — yielding a $50,000 withdrawal that year.
PGIM’s Blanchett prefers this method, since it’s simple and more responsive to retirees’ current state of health. (The IRS tables are pegged to average life spans by age.)
The downside of these approaches is they can create highly variable cash flow from year to year, since withdrawals move up and down with portfolio values.
Further, they can cause balances to be “ultra-low” later in life, at a time when costs typically increase due to higher health-care costs, according to a Morningstar analysis.
3. Ceiling and floor
This strategy involves establishing an initial withdrawal rate (4%, for example).
Retirees would then withdraw that same percentage from whatever’s left of the portfolio each year. However, they also set a “floor” and “ceiling” — hard-dollar levels under and over which they cannot spend each year.
Pfau of The American College prefers this method because it responds to market movements, but still keeps spending within a range.
The floor is most important, he said. A household would budget how much money it needs to live and still be comfortable.
Let’s say a retiree determines $40,000 as a reasonable sum to spend each year from a $1 million starting nest egg. That’s a 4% withdrawal rate.
They proceed to set a $25,000 annual spending floor and a $60,000 upper limit. The household would take 4% withdrawals from the remaining portfolio each year — but those withdrawals can’t be less or more than their pre-set floor and ceiling amounts.
4. Guardrails
This system involves more complicated arithmetic. Its basic premise: You get a raise when markets do well and a pay cut when they don’t.
It piggybacks on the 4% rule methodology, but with a key difference: In years when the market performs well, retirees get a 10% raise in addition to the inflation adjustment and a 10% pay cut in down markets.
A 10% raise occurs when the withdrawal rate dips below 20% of its initial level. (In this case, that would be less than 3.2% relative to a 4% initial rate). Conversely, a 10% pay cut occurs when the withdrawal rate increases above 20% of its initial level (or over 4.8% in this example).
Withdrawal rates fall when markets do well because a retiree would be drawing the same dollar amount but from a larger portfolio; they rise when markets do badly because the fixed dollar amount is a larger share of the smaller portfolio.
Here’s an example of how the strategy works, according to a recent Morningstar paper.
Let’s say a retiree withdraws 4% of $1 million (or $40,000) the first year.
The portfolio grows to $1.4 million by the start of year two. The retiree withdraws $40,000 plus an inflation adjustment as required by the 4% rule methodology (a total $41,200, based on a 3% inflation rate).
To judge if you also get a 10% raise: Divide $41,200 by the portfolio balance ($1.4 million) to determine the withdrawal rate. In this case, $41,200 amounts to a 2.9% withdrawal rate — which meets the criteria for a raise (i.e., being at least 20% less than the initial 4% rate).
The retiree would add 10% to the $41,200 inflation-adjusted figure — amounting to a total $45,320 withdrawal that year.
In the opposite scenario (if the $41,200 inflation-adjusted withdrawal is at least 4.8% of the current portfolio value), the retiree would cut the $41,200 by 10% — for a total $37,080 withdrawal that year.
