One of the biggest adjustments my clients make in retirement is to how to view spending. As Katherine* put it, “My head is twirling. All of our lives, we have saved, saved, saved. Now there is no new money coming in, and it just feels wrong to be spending. How do we do this?”
It is a little scary when the faucet closes and infusions into your portfolios dry up. Clients want to know what they can spend and not go broke. But they also want to embrace their retirement dreams.
Not too long ago 4% was the number generally accepted as a safe withdrawal rate from investments. The safe withdrawal rate was the amount you could, presumably, spend each year (adjusted for inflation) and not run out of money during retirement. Certain assumptions about investments and mortality applied. Over the years, this rate was so popular that it became known as the “4% Rule.”
But in the last decade, academic studies have tested the 4% and found it faulty. “It’s too low” some studies say, because portfolio values have fallen relative to inflation over the last 13 years, starting amounts for retirement’s nest egg are more attractive. “It is too high,” other studies say, because returns on portfolios are likely to be less than previously assumed and retirees are increasingly averse to taking enough risk for long term portfolio growth. Recent articles focus on flexible adjustments to spending based on calculations of inflation and portfolio returns.
I contend that most people intuitively understand the need for flexibility in making spending decisions. If inflation is pushing the cost of what they like to buy higher and if their portfolio is performing well, they allow themselves to take out more than originally anticipated. If their portfolios aren’t keeping up, they understand they should take out less. Pretty logical.
You do need a starting number, however. Ideally, you should run retirement projections that track your cash flow and all of the varied sources and timing of income to determine the first year’s withdrawal rate. If you don’t have the opportunity to run meaningful retirement projections, then start with the 4% Rule. In spite of all the research attempting to move the decimal point, it is not a bad place to begin.
What happens next is far more important than picking the first withdrawal rate. The latest studies were correct in citing the need for flexibility. But the adjustments are far more nuanced than simply looking at inflation and returns.
A couple came in to my office not long ago. Two months into retirement, the husband had carefully crafted a budget and revealed what they planned to take out of their portfolios the first year. He had done his own calculations and determined that they wouldn’t run out of money until well into their 90s. I made a mental note that it was $20,000 higher than previous retirement projections we had created for him and his wife. By his own admission, he had decided not to include inflation. As a result, his starting withdrawal rate was 6% of his portfolio. I decided not to point out the flaw in his thinking – at least not at this meeting.
It is hard for many clients to know how much to spend initially in retirement. With some clients, there is a rush to do the things that have been put off (travel, renovations). If possible, we budget for these in advance. If not, then I wait a little while before doing a reality check. I find clients are much more receptive to reviewing the numbers when they have had a chance to digest their change in status.
With other clients, like Katherine, the instinct is to spend as little as possible initially. Again I wait before discussing adjustments to the budget – this time showing that a little extra indulgence won’t harm their long term plans.
I wouldn’t throw the “4% Rule” out the window. I find it handy, as a casual calculation, when clients are employed and growing their portfolios. It is a relatively conservative figure, which means I can use it to encourage clients to save more. But when retirement begins, the focus shifts from what is the first year’s withdrawal rate to the process of making adjustments. We are no longer calculating percentages, but massaging the numbers based on the retirement experience.
*In the interest of privacy, all names have been changed in this article.