How much can you withdraw from your savings each year in retirement?
Well, the answer seems to depend on when you look, and Morningstar recently
published some updated research aimed at answering that question. They identified
some withdrawal rates that might make sense, or if you prefer to look
at it a different way, it helps you estimate how much you might
need to save up for retirement if you're going to withdraw at a
so called "safe" rate. Now, sticking to a rigid withdrawal strategy is not
something I see many people do. I don't have any clients doing it.
I don't know of any other financial advisors who do it,
but still you can get some valuable insight out of these types of
studies, even if you don't follow a withdrawal rate. So let's highlight
a couple of those little gems right up front. One takeaway is that
the future might look brighter now than it did for somebody retiring a
year ago. In other words, you might expect higher returns in the future,
although of course there are no guarantees, than you might have a year
ago. As a result, you might be able to start with a higher
withdrawal rate if you're going to retire in the near future.
That's probably not surprising. After a downturn, the expected returns would
intuitively be higher going forward. Again, there's no guarantee of anything
like that, and the markets will still move up, down, and sideways,
and we certainly can't predict exactly when or how fast any returns will
materialize. You can still run out of money no matter what strategy you
use. Another key finding is that changing your withdrawals even a little
bit can help. So that might mean skipping an inflation adjustment or living
with less when the markets go down, for example. Ideally, that's a temporary
thing, but by taking small steps you can hopefully avoid more drastic consequences
down the road. We'll talk more about all of that, but as a
refresher, a withdrawal rate is something designed to help you figure out
how much you can sustainably spend over the course of your lifetime without
running out of money. The challenge for retirement planning is always that
you want to spend enough to enjoy yourself and get your wants and
needs met, but at the same time we don't want you to run
out of money before you run out of life. For many people thinking
about retirement, those withdrawals might need to last 30 years or maybe
more if you retire early. And another way of looking at it is
these rates can help you estimate how much you need to save if
you back into the calculation. So you might say, if I want to
withdraw at a rate that is hopefully sustainable, how much would I need
to build up on my retirement date to supplement any other sources of
income like social security or a pension? So we might look at the
traditional 4% rule which helps to keep the numbers easy, and with that
approach you would multiply the amount you want to withdraw each year by
25, giving you a target amount to have saved at retirement.
In other words, if you wanted to withdraw $50,000 per year,
you multiply that by 25 and that results in $1.25 million that you
would want to have saved up at retirement. But you can also do
the calculation a slightly different way. Let's say you want to be more
conservative and withdraw 3%. In that case, you would take the amount you
want to withdraw each year and divide it by your desired withdrawal rate.
So here we would take $50,000, we would divide that by 3%
or.03, and the result is going to be the amount you need.
That's $1.67 million in this case. So the results from Morningstar tell
us that the withdrawal rates in the current environment have risen just
a bit from where they were about a year ago. So we'll look
at each of those rates and go over why they're different and what
everything here means. But I'd note that it's interesting how these change
over time and that's kind of a signal that these withdrawal rate strategies
should really be nothing more than a rough rule of thumb that you
use for estimating. It's really best to do more robust and detailed planning
as you get ready for retirement. Again, I don't really use withdrawal rates
with clients and that's because life is kind of hard to fit into
a withdrawal rate. So for most people, retirement spending is kind of lumpy
and unpredictable. Maybe you need a new car one year, you have a
health care event, or something else comes up.
Plus, the data suggests that retirees don't necessarily spend at a rate
that matches inflation perfectly, which we'll get into more later. But a
traditional withdrawal rate strategy is going to assume that you want to
march in lockstep with inflation and keep up with it perfectly.
That can put a lot of stress on your portfolio. So instead of
using a withdrawal rate, I prefer to look at the big picture with
some estimates on market growth and specific cash flows you might need throughout
retirement, inflation, taxes and certain strategies you might use to manage
your taxes, and then any health care surprises that might come up.
Once you start to imagine all of these variable expenses, you can see
why a withdrawal rate might be an oversimplification. For example, let's
say you're doing a social security bridge strategy. That's where you delay
claiming social security instead of taking it right when you stop working.
And that might make sense if you retire in your early 60s because
your social security benefit grows a little bit for each month that you
wait. And that allows you to get more inflation adjusted, tax favored,
and government guaranteed income later in life. It can also mean a bigger
survivor benefit for a surviving spouse, so it's really an important strategy
to consider. You don't need to feel bad if you're going to claim
early, but it's definitely worth looking at and seeing if it makes sense.
The bridge strategy can also help you spend down some pre tax savings
to hopefully reduce your taxable income later in life. And all the while,
you're taking income in years when you have a relatively low income,
so you're hopefully in relatively low tax brackets. Ultimately, the strategy
might make it so that your required minimum distributions or your RMDs aren't
quite as big, which can potentially help you stay in lower tax brackets
later in life. And that might also reduce the chances that you have
to pay higher Medicare premiums in retirement, which can rise if you have
a high income. But to make this strategy work, you need to have
sufficient assets to spend, and you need to spend down a significant amount,
which can be terrifying. So you want to evaluate the strategy carefully.
Ultimately, you might be withdrawing at a relatively high rate in the early
years, and then it drops down to a much lower rate later in
life. So again, a single withdrawal rate strategy might be an oversimplification.
Now back to that Morningstar study, and by the way, you can see
this study yourself, which I highly recommend, and there's a link to it
in the description. And you'll also find some other resources about retirement
planning there in the description. So be sure to check out all of
that information. And if you didn't already know, I'm Justin Pritchard,
and I help people plan for retirement and invest for the future.
And I think you'll get a lot out of those resources,
so be sure to check them out. Now, this study assumes a 50
50 portfolio, 50% stocks, 50% in bonds, and a desire to have the
money last for at least 30 years with a 90% probability of success.
And importantly, the withdrawals are inflation adjusted in most cases.
So the amount you withdraw typically increases each year to keep your purchasing
power intact over time. That's important for most people because even small
amounts of inflation can erode your purchasing power over the decades,
and we don't want that. So what changed in the latest version of
the study? Well, for starters, they assumed higher stock and bond returns
going forward. And inflation was also higher in their assumptions. Of course,
these are all assumptions, and they'll ultimately turn out to be wrong.
But researchers use their best guesses to figure out how things might unfold
in the coming decades. Again, there's no guarantee, so use all of these
assumptions at your own risk. For a traditional withdrawal rate, they landed
on 3.8%, which is higher than the previous year when it was 3.3%.
So you might have heard that the 4% rule is no longer the
4% rule, it was never a rule in the first place.
But at this point, Morningstar is calling it potentially 3.8%.
They also noted that with this system, you could potentially go down to
as low as 30% in stock instead of 50%.
Whether or not that's the right thing to do, I'm not sure,
but that could be comforting to those of you who are more conservative.
As a refresher, the way a withdrawal rate strategy works is you take
your starting account balance at retirement, and you multiply it by the
withdrawal rate you're going to use, and then each year you increase your
withdrawals to match inflation. Using some round numbers, let's say you
have 1 million saved for retirement. I know some of you have more,
and many of you have much less, but it's just a nice round
number to work with. So let's say you have a 3.8%
withdrawal rate here. That would produce $38,000 of withdrawals in the first
year. Then, if inflation was 4% over the year, you'd add 4%
to your withdrawal for the following year. So in that case,
38,000 times 104% is 39,520. And you just keep repeating this year after
year. This approach allows you to keep up with inflation step by step,
but it can put some hefty demands on your portfolio. So it might
be worth looking at some ways to improve your chances. For example,
you might be willing to adjust your spending each year, or you might
be willing to take a probability of success that's lower than 90.
Or maybe you have no desire to leave any assets to your heirs.
So while any withdrawal strategy could mean that you spend down your assets,
you'll see that in many cases, these strategies leave you with more money
than you started with after 30 years. So that money might not be
worth as much as it was in the beginning of your plan,
but there's often a cushion in those cases. But there might not be
if things don't go favorably. If you end up with nearly twice as
much money as you started with, that's not necessarily the worst thing,
but it could mean that you ended up missing out on some fulfilling
experiences. Maybe you didn't take some vacations, maybe you could have
given some money away, something like that. So we want to be intentional
as we look at what our strategy is going to be.
At the same time, it's very reasonable to set money aside for unknowns
because as we know, health care and long term care in particular can
get very expensive. So having that cushion could come in handy.
So what might make it possible to withdraw at a rate higher than
3.8%, at least according to this study? Well, the researchers highlighted
dynamic strategies as potential solutions. You can see that each strategy
here has different characteristics and all of these characteristics are
important as you consider what you want your life to look like.
You can see that fixed real approach, which is the standard withdrawal rate,
like the so called 4% rule, now the 3.8% rule. And the term
real, by the way, means after inflation. So you receive a fixed amount
of inflation adjusted withdrawals each year. If you go with any of those
dynamic strategies, you need to be okay with some unpredictability. So uncertainty
can be uncomfortable, but it is reality and it's probably nothing new to
you by this point in your life. So let's start with the forgoing inflation
adjustments. In that case, you'd skip your inflation adjustment in years
following a loss in your portfolio. That way you withdraw less and that
reduced withdrawal kind of ripples out over all of the subsequent years
of your life. That little pause can be really helpful. Next,
you have guardrails, and with that system you give yourself a raise when
your investments are doing well and you reduce your withdrawals when markets
go down. So either way, there are going to be rules and limits
on how much those withdrawals will increase or decrease and those limits
are the guardrails. This strategy allows you to start with a higher rate
and if all goes well, that's great. But you need to be prepared
for the possibility of market downturns and spending cuts in the future.
There's also the RMD method. To use this, you withdraw based on your
life expectancy. So when you're younger and you have more years to live,
hopefully, you withdraw at a lower rate. And as you grow older,
you can withdraw at higher rates. So you're taking a bigger percentage of
your account each year. This will ultimately result in spending down most
of your assets by the time you reach life expectancy. So that's something
to keep in mind if you like the idea of leaving a cushion.
Next, you have the 10% reduction and with that option, you start with
a traditional withdrawal rate. But you reduce your spending by 10%
whenever your investments lose money during a calendar year.
Then after your portfolio has a positive year, you get back on track.
But it's not entirely clear if that means you go back to where
you would have been without the market losses. Or if you just resume
inflation adjustments based on that reduced amount. Finally, there's the
retirement spending smile, which they call the inflation haircut here.
And this is based on some research about how retirees actually spend their
money. And they don't always follow inflation exactly.
It turns out that many people actually spend at roughly inflation minus
1% during their retirement years. So that's what they modeled here.
I've got some other videos that discuss that. And if you think about
it, maybe you have already paid for your house or you have a
fixed rate mortgage that you're not going to change. And you're not subject
to rent increases, for example. As a retiree, you might not have higher
costs except for health care expenses, which typically do inflate at a faster
rate. And the retirement spending smile usually takes that into consideration.
Ultimately, you can take a lot of pressure off your portfolio if you
assume that 1% inflation reduction. There is a lot more to consider here.
As just one example, these withdrawal rate strategies don't take taxes into
account. But taxes are probably a reality for you and you won't be
able to spend every dollar that you withdraw. So you need to understand
how those work. There should be a video popping up right about now
that goes over what those taxes are going to be and helps you
set some realistic expectations. So check that out. And I hope you found
this helpful. If you did, please leave a quick thumbs up.
Thank you and take care.