You’ve worked and saved for years, most of a career. Maybe you’re looking at a traditional retirement in your 60’s, or you’re one of the fortunate few who are able to consider earlier retirement. Either way, you’ve amassed a sizable nest egg. Your assets are likely well into seven digits, unless you live very frugally, or can rely on a guaranteed pension. That sounds like a formidable sum. You know it will last for years. But how long, exactly? And how should you start living off of it, making withdrawals, to guarantee it won’t run out?
Most of us without pensions will face these questions in our retirement. How do we safely withdraw from a lump sum over time so that it lasts as long as we do? We know there is some baseline of living expenses that we must support. But then there are a host of discretionary and one-time expenses on our plate — travel, maintenance, new vehicles, emergencies. When is it OK to spend this money, and when might it be damaging to the long-term survival of our portfolio? Is there a system, a technique, an investment, a product, that will keep us safe?
Below I’ll do a high-level survey of all the many ways to withdraw from your nest egg in retirement. I’ll cover every method or strategy that I’m aware of, from a general perspective. I’ll also discuss what I’m doing, at this stage of my retirement. I won’t get into hard numbers or simulations just yet. We’ll leave that kind of analysis to future posts, where I’ll explore new research and what it means for you, and me, in more detail.
By the end of this post you’ll have a good, general sense of your retirement withdrawal options — both their positives and negatives. And you’ll understand why there is no perfect answer to this question. Every solution has its strengths, and its potential weaknesses. Only by understanding the possible approaches, then mixing them together into a personal solution, while remaining flexible, and still accepting some risk, will you be able to move forward and enjoy your retirement.
Let’s start with one of the simplest and therefore most popular withdrawal methods. That is withdrawing a fixed amount from your portfolio on a periodic basis. Typically this is implemented by also adjusting for inflation annually, so the nominal amount actually grows over time, but remains constant in real terms. In other words, you are maintaining the same lifestyle from year to year.
If the amount you start with, in year one of your retirement, is 4% of your portfolio, then this is the classic, but possibly obsolete, 4% Rule.
The advantages of this withdrawal method are that it is relatively simple to implement. And it has been studied exhaustively so you can easily find statistics on the survival probabilities for your portfolio, given a time span and asset allocation.
And this strategy is perfectly predictable — to a point. Your lifestyle is “locked in.” You know much you have to spend each year. Until your money runs out.
That is the chief drawback of the fixed withdrawal amount. Nobody can say for sure how long your money will last. Yes, studies based on historical data show it might last for 30 years. But history may not repeat. And, unless you implement some kind of annual review, you will have no flexibility to make your money last longer, if needed. Nor will you be able to deal with emergency expenses, or enjoy splurges, if your portfolio is doing well.
If you don’t withdraw a fixed amount from your portfolio every year, then it stands to reason you’ll be withdrawing a variable amount. But there are many formulas for computing that fluctuating withdrawal. Let’s review them.
You could withdraw a fixed percentage of your portfolio every year. Say you chose to withdraw exactly 5% of your portfolio every January, regardless of its current value or how the market had performed. This is often called an endowment withdrawal approach. The great advantage of this is that it automatically builds some flexibility into your withdrawals as a function of market performance. If the market is up, your fixed percentage will be a larger sum. If the market is down, it will be smaller. Even better, you will never run out of money! Because you are always withdrawing some percent of your portfolio, it will never be wiped out, mathematically speaking. That sounds great until you look at the downside: your portfolio could get very small! Your lifestyle will fluctuate, perhaps dramatically, over the long term. Lastly, although this withdrawal strategy is variable, it isn’t truly flexible, because the market, not you, controls the size of annual withdrawals.
(For a different approach to a market-based withdrawal percentage, there are market valuation-based strategies. These advocate that you actually withdraw less when markets are high, because the projected returns going forward will be lower. There are pages of debate on this topic. For one view among many, see leading researcher Wade Pfau who concludes in one article that valuations “may not really be of central importance when building an overall retirement income strategy.”)
Another approach to computing a variable withdrawal sum every year has been gaining ground recently, and that is to base the withdrawal on your life expectancy. In its simplest form, each year you would withdraw one divided by your remaining life-expectancy in years. (For a simple source of life expectancy data, see the IRS RMD tables). So if your age was such that your life expectancy was 30 years, you’d withdraw 1/30 or about 3.3% in the current year. This approach has some intuitive appeal. You are dividing your money up evenly according to how many years you expect to remain living. And that expectation is updated annually based on statistics. Again, you will never run out of money! But again, there is no guarantee exactly how much money you’ll have in your last year. However, if you consider how the denominator in that formula works, along with the potential for asset growth, you’ll likely wind up with smaller withdrawals in early retirement, and possibly large withdrawals later. That would be a potential criticism of this withdrawal method: Instead of “front loading” withdrawals so that you spend more in your early years when you have a greater chance of being alive, and are healthy to enjoy it, you are likely to “back load” the withdrawal process, saving too much until the end.
If you want to allow for more generous withdrawals up front, plus potential flexibility, yet institute some safety measures, you can go with a variable withdrawal strategy consisting of a fixed percentage with some bounds or guardrails. There are some more modern versions of this strategy, but one of the first and simplest approaches came from Bob Clyatt in his groundbreaking book on early retirement Work Less, Live More. He calls his approach a better Safe Withdrawal Method with “The 95% Rule.” You start by calculating 4% of your portfolio value every year. Then, to accommodate bad market years, you can withdraw either that 4% amount, or 95% of the amount you withdrew the previous year, whichever is larger. That means you never have to cut your lifestyle more than 5% in any given year. Clyatt reports that there is minimal impact on portfolio success rates (generally just a few percentage points) from using his 95% rule. So you are able to “smooth” changes in your lifestyle, without taking on much additional risk of running out of money.
What if you want even more retirement guarantees? On the surface, annuities appear to solve almost all the problems of fixed and variable withdrawals. Almost.
With an annuity, you hand an insurance company some or all of your retirement portfolio. In exchange they give you income payments for life. That eliminates the possibility of outliving your assets. That’s a very good thing. Of course that guarantee depends on the solvency of the insurance company and its backing state guaranty association, both of which ultimately depend on the markets and economy. That’s the first flaw in the annuity’s glossy exterior.
Annuities get high points for consistency. You are party to a contractual obligation that you will receive the same amount, year after year. But that’s also the chief problem with an annuity. It’s inflexible. If you die early, you will likely have left quite a bit of money on the table. If you have an emergency and need a lump sum of money, you probably can’t get it. Only if you live a long time, and your expenses stay relatively constant, does the annuity solution come into its own.
But let’s take a closer look at those “lifetime” payments. We’re talking two, three, four or more decades of cash flow. Is it inflation adjusted? Inflation can be a big deal over such time spans. And, today at least, true inflation-adjusted annuities are hard to find and feature minuscule payouts. (Looking at my latest inflation-adjusted annuity quote, I’d rather take my chances in the markets.)
The final drawback to an annuity is that you don’t get to keep your principal. So there is no option for emergency cash or leaving an inheritance with that particular portion of your assets.
Flexible Capital Preservation
We’ve discussed fixed and variable withdrawals, and annuity payments, including the positives and significant negatives of each. These are all relatively static, idealized, or inflexible systems for withdrawing from assets in retirement. They make great case studies for performing research, running simulations, and publishing scholarly articles. The problem is that to be simulated they must all make assumptions about the future of the economy and your personal financial situation. Assumptions that may not apply, or may not come to pass.
Now let me discuss what I think most people actually tend to do in retirement, at least early retirement. And, this is also what I’m doing, until I see better ideas and a more complete picture.
I will call this “Flexible Capital Preservation” — living off interest, dividends, growth, and some part-time work income, all with an eye to preserving assets. This is, in my view, the only sensible strategy for early retirement, where there are still decades of uncertainty yawning in front of you. If you retire in your 50’s or earlier, with no inflation-adjusted pension in sight, it is simply unwise to draw down your retirement assets in any significant way. The goal should be to preserve (though not necessarily grow) your net worth, keep your powder dry, and not burn any bridges, until you are much further down the road.
How does this work in practice? Well, if your assets are large enough, or the markets are strong enough, you can afford to spend only your annual dividends and growth each year. If that isn’t the case, then you will need to work part-time, possibly leveraging your relative financial independence to create a lifestyle business that supplements your investment income while in no way detracting from your quality of life.
So how exactly do you go about withdrawing from investments when taking this flexible approach? I’ve been doing this now for nearly three years, in a generally rising market. That tailwind has made my financial life much easier. But, regardless of the state of the economy, I would take a total return approach that might be characterized as “just in time,” or “active safe withdrawals” (as opposed to active investing). In other words, once or twice a year, when I need money, I sell some of my most appreciated assets.
Isn’t that a bit like market timing, in reverse? Maybe, maybe not. But a critical distinction is this: I’m selling in response to my own routine income needs, and not in response to market events.
But isn’t that still risky? What if the market tanks all of sudden? How do you avoid being forced to sell your assets at a loss?
This is where asset allocation comes into play. Some have formalized this as a buckets system — keeping less volatile assets like cash and bonds on hand for near-term living expenses. One prominent buckets strategy has been discredited, but the concept is intuitive to many and still useful for discussion purposes. In truth “buckets” are nothing more than another way to manage your asset allocation.
For me, it makes no sense to live off your conservative cash and bond buckets when stock markets are up. That’s like dipping into the storehouse when there is fresh, healthy grain available in the fields. Much better to be selling volatile equity assets when they are in favor, and to preserve your safe “buckets” for the bad times.
When, those bad times come, as they inevitably will, then the flexible withdrawal approach begins dipping into the safe cash and bond buckets that have been set aside. Ours are large enough to live off for a decade or more, before we might even have to consider spending more volatile equity assets at a loss.
There is even new research suggesting that it may actually be better to spend bonds first, producing a rising equity allocation for the long term. So, if required by economic events, it is probably OK to spend down your conservative buckets to very low levels.
For optimal retirement income, you must take into account your economic environment. A flexible approach is best, validated by both intuition and the laboratory.
Every retirement withdrawal technique described above has drawbacks. Some can’t guarantee that you won’t run out of money: you could die broke. Some can’t guarantee your lifestyle: you could be living out of a trailer and eating cereal in your later years. Some don’t guarantee principal: you might not have any money available for emergencies, and you might not have any left to pass on to your heirs. Some require active involvement and financial management: you or a spouse must be able and interested.
Despite all those drawbacks, the biggest problem with most of these withdrawal systems is precisely that they are an artificial system. Ask yourself if it is really possible to maintain any “system” consistently for the 20-40 year time span of a modern retirement? Has there been any significant process that you undertake today precisely as you did decades ago? Whether it’s fixing your meals, maintaining your vehicles, planning your vacations, or managing your investments, there are ceaseless changes — both subtle and vast — over time.
The way I invest now is quite different from how I invested just 10-15 years ago. There is more and better information available. There are new, better, lower-cost investments available. My understanding and needs are different. Try as we might to stick with any financial system, things change.
Even annuities, which are arguably the most “reliable” retirement withdrawal system, suffer from change. Their payouts may seem predictable, but the world changes around them. Inflation could take off, seriously eroding their buying power. You could die early, or have serious emergency expenses — scenarios that are negative for annuities.
That’s why, when all is said and done, I believe most of us are going to construct a flexible, “hybrid” system for living off our assets in retirement. We’ll pick and choose from the options, combining them in an attempt to harvest most of the benefits, while minimizing the liabilities and preserving our flexibility. In many cases we’ll try to create a guaranteed, inflation-adjusted income floor plus an upside of investment growth for recreation, emergencies, and legacy.
Though research is underway to compute the “optimal” formula for this hybrid retirement income stream, I remain somewhat pessimistic that there will ever be a perfect, turnkey, “just tell me what to do,” solution. All the same, I know that many of us will find solutions that are “good enough” to enjoy our retirement safely and comfortably.
My own evolving strategy for retirement income will be the topic of future posts. If you have ideas or lessons learned for your own ideal retirement income solution, I’d love to hear about them below….
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So, that’s a wrap for 2013. It’s been an eventful year here at Can I Retire Yet? — publishing my first book, selling our house, downsizing, and moving west. I’ll be taking the rest of the month off to enjoy the holiday season. And I hope you are able to do some of the same. Thanks for all the support this year, and be sure to check back here in the New Year for more posts on planning and living comfortably in retirement!