How to Balance Spending and Safety in Retirement
Darrow Kirkpatrick Feb. 19, 2015
Every retirement withdrawal method has its pros and cons. Understanding the differences will help you tap your assets in the way that’s best for you.
You’ve saved for years. You’ve built a sizable nest egg. And, finally, you’ve retired. Now, how do you withdraw from your savings so your money lasts as long as you do? Is there a technique, a procedure, a product that will keep you safe?
Unfortunately, there is no perfect answer to this question. Every available solution has its strengths and its weaknesses. Only by understanding the possible approaches, then mixing them together into a personal solution, will you be able to move forward with an enjoyable retirement that balances both spending and safety.
Let’s start with one of the simplest and most popular withdrawal approaches: spending a fixed amount from your portfolio annually. Typically this is adjusted for inflation, so the nominal amount grows over time but sustains 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 4% rule.
The advantages of this withdrawal method are that it is relatively simple to implement, and it has been researched extensively. Statistics for the survival probabilities of your portfolio, given a certain time span and asset allocation, are readily available. This strategy seems reliable—you know exactly how much you can spend each year. Until your money runs out. Studies based on historical data show your savings might last for 30 years. But history may not repeat. And fixed withdrawals are inflexible; what if your spending needs change from year to year?
Instead, you could withdraw a fixed percentage of your portfolio annually, say 5%. This is often called an “endowment” approach. The advantage of this is that it automatically builds some flexibility into your withdrawals based on market performance. If the market goes up, your fixed percentage will be a larger sum. If the market goes down, it will be smaller. Even better, you will never run out of money! Because you are withdrawing only a percent of your portfolio, it can never be wiped out. But it could get very small! And your available income will fluctuate, perhaps dramatically, from year to year.
Another approach to variable withdrawals is to base the amount on your life expectancy. (One source for this data is the IRS RMD tables.) Each year you could withdraw the inverse of your life expectancy in years. So if your life expectancy is 30 years, you’d withdraw 1/30, or about 3.3%, in the current year. You will never run out of money, but, again, there is no guarantee exactly how much money you’ll have in your final years. It’s possible you’ll wind up with smaller withdrawals in early retirement and larger withdrawals later, when you aren’t as able to enjoy them.
What if you want more certainty? Annuities appear to solve most of the problems with fixed or variable withdrawals. With an annuity, you give an insurance company some or all of your assets, and, in exchange, they pay you a monthly amount for life. Assuming the company stays solvent, this eliminates the possibility of outliving your assets.
Annuities are good for consistent income. But that’s also their chief drawback: they’re inflexible. If you die early, you will leave a lot of money on the table. If you have an emergency and need a lump sum, you probably can’t get it. Finally, many annuities are not adjusted for inflation. Those that are tend to be very expensive. And inflation can be a large variable over long time spans.
What about income for early retirement? It’s unwise to draw down your assets in the beginning years, when there are decades of uncertainty looming ahead. The goal should be to preserve net worth until you are farther down the road. If your assets are large enough, or the markets are strong enough, you can live off the annual interest, dividends, and growth. If not, you may need to work part-time, supplementing your investment income.
Every retirement withdrawal technique has drawbacks. Some require active management. Some can run out of money. Some don’t maintain your lifestyle. Some can’t handle emergency expenses or preserve principal for heirs. Some may be eroded by inflation.
That’s why 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 available options, combining the benefits, while trying to minimize the liabilities and preserve our flexibility.
Darrow Kirkpatrick is a software engineer and author who lived frugally, invested successfully, and retired in 2011 at age 50. He writes regularly about saving, investing and retiring on his blog CanIRetireYet.com.