There are a lot of questions that retirees need to answer for themselves before making
the jump to full retirement status.
We covered a few of them already on this channel such as how much money you need in order to
be able to retire, various types of retirement and ways to save money throughout your working
years to set up for retirement, and today we're going to be tackling one more of those
questions namely what to consider when deciding how to actually withdraw your money in retirement.
Similar to my budgeting series this question has a lot of different answers and depending
on what it is you value and are trying to accomplish.
So since there isn’t a one-size fits all correct answer in this mini-series we’re
going to be examining a bunch of different retirement withdrawal strategies people use
to effectively withdraw money in retirement.
But first in order to understand which of the strategies we will eventually be going
over will work best for you we need to first understand what we are grading these strategies
on.
What are the things that actually matter when it comes to choosing how to withdraw your
money in retirement?
That's where we're going to be covering today.
In today’s video we're going to be covering the four factors you should be considering
when choosing your retirement withdrawal strategy.
Let's get started.
Hey everyone Daniel here and welcome to Next Level Life a channel where you can learn about
investing, debt, retirement, and many other financial topics besides, because, let’s
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So there are 4 major factors, at least financially speaking, that all successful retirement withdrawal
strategies should be considering and they are income, risk, predictability, and buying
power.
The importance of each of these factors is going to vary from person to person because
some people are going to value income a lot more than the risks associated with generating
it, but others are going to really want stability and predictability in their finances especially
when they've retired and no longer have a job to pay the bills.
It all depends on who you are, so none of these are inherently any more important than
the other and it all depends on what you want to accomplish, but all should still be taken
into consideration.
So let’s start by defining these four factors.
The first factor of a successful retirement withdrawal strategy is income.
In the context of retirement withdrawal strategies income is not merely how much money you have
coming in, that is part of it, but the income factor also takes into account when that money
is coming in.
Some retirement withdrawal strategies, such as the 1/N method, are designed to last you
a shorter amount of time than others, such as the 3% or 4% rules, because they focus
on generating comparatively larger amounts of income for you, particularly in the early
years of your retirement.
This can be extremely intriguing to those who are retiring a little older and aren’t
likely to need their money to last them as long as someone following the financial independence
retired early movement would.
To quickly illustrate the difference this can make let’s assume that John has retired
at the age of 70 with a $1,000,000 nest egg.
Since statistically speaking, the average lifespan here in America is roughly 80 years
old, he’s not likely to need his money to last him much more than 10 years or so.
In this situation, John may decide that he doesn’t want to spend the last 10 or so
years of his life living extremely frugally.
In other words, he is deciding that he values income over other factors like risk, predictability,
and to a lesser extent, buying power in his retirement withdrawal strategy.
As such he decides not to use the 4% rule, which simply isn’t known to be the best
strategy in terms of relative income generation.
Instead, he decides to use the 1/N Method, with N equaling the number of years John expects
he needs his money to last, which he will update each year as he gets closer and closer
to the end of his retirement.
Since John is expecting to only need his money to last him 10 years, N is going to equal
10 in this case.
The 1/N Method tells you what fraction of your nest egg you can withdraw each year.
In John’s case, this fraction is 1/10 of his total nest egg in his first year or $100,000
in his case.
Each year John will adjust the N in his equation to reflect the amount of years John still
expects to need his money.
So assuming nothing changes his N will be 9 in his second year of retirement, 8 in his
third year, 7 in his fourth and so on until he withdraws whatever remains of his nest
egg in his final year of retirement.
Compare this to the 4% rule which allows you to withdraw 4% of your total nest egg in the
first year of retirement and adjust for inflation each year after that, thus conserving your
buying power.
In John’s case, he would withdraw $40,000 in the first year of his retirement, instead
of the $100,000 that he withdrew using the 1/N Method and he would adjust his future
withdrawals for inflation every year thereafter.
And unless John experiences some major inflation during his retirement he’s going to have
to wait quite a while before he is withdrawing $100,000 a year in retirement (for the record
assuming a 3% average inflation rate he would withdraw about $53,750 in his tenth year of
retirement, or barely more than half of what he started withdrawing using the 1/N Method),
and of course, he will never draw the equivalent of $100,000 in today’s dollars using this
method.
So you can see the difference that choosing a different retirement withdrawal strategy
can make on your income during retirement.
The second factor of a successful retirement withdrawal strategy is risk.
Risk encompasses a few things, it is not necessarily just about risk management when it comes to
investing such as moving more money from stocks and bonds as you get older in order to limit
the volatility of your portfolio.
That may be part of the equation but risk encompasses a bit more than that.
It also takes into account anything that you can do to limit or entirely eliminate the
possibility of you running out of money in retirement.
Let’s take a look back at our friend John.
Given his situation he took a more income-oriented approach to his retirement withdrawal strategy,
however, a high-income strategy will oftentimes carry a bit more risk than a more conservative
strategy.
As we covered, the 1/N strategy is a withdrawal strategy that tries to maximize your income
over a predefined length of time, in John’s case 10 years, however, what happens if John
lived longer than 10 years?
After all, there’s no foolproof way to know how long your retirement is going to last
right from the beginning.
Let’s assume, just for the sake of easy illustration that John’s investments stayed
flat throughout his 10-year retirement, in other words, they didn’t go up but neither
did they go down.
Basically, they did about as much for him in his investment accounts as they would’ve
done for him had he just stuck his money in a mattress.
Highly unlikely, I know, but this is just to make the numbers easy.
John would withdraw $100,000 or 1/10 of his nest egg in his first year of retirement,
bringing the value of his nest egg down to $900,000.
He’d withdraw 1/9 of his nest egg, which is again $100,000 in his second year of retirement.
He’d continue withdrawing that $100,000 each year since that’s how the math would
work out with no returns up to and including his tenth year when the value of his nest
egg would be $100,000.
After that last withdrawal, John would have a $0 nest egg.
So… what happens if he lives into year 11?
Well, that is the trade-off for using this particular retirement withdrawal strategy.
You get a considerably higher level of income in comparison to more conservative (and less
risky) strategies like the 4% rule, but you do have a higher risk of outliving your savings.
Now there are ways that you can combat this risk, at least to a certain extent, using
the 1/N Method, and I will cover those in my upcoming video when I go into greater detail
on this strategy, but it’s still not going to change the fact that this method is primarily
focused on maximizing income over that predetermined time frame than it is on minimizing risk.
And, again, for some people, that’s perfectly fine, desirable even, but it is something
to consider when choosing your retirement withdrawal strategy.
The third factor of a successful retirement withdrawal strategy is the predictability
or stability factor.
This factor is not necessarily focused on maintaining a stable, or more accurately,
static level of income from year to year, despite what the name might imply.
I mean, that may happen with some of the strategies, such as the fixed dollar withdrawal strategy,
but it isn’t the primary concern that this factor looks at.
The predictability or stability factor is primarily concerned with finding strategies
that, to the best of their ability, avoid undesired changes to your income streams.
These changes could come in the form of freezes (because certain strategies force you to temporarily
stop the upward adjustments to your income if certain things happen), reductions (again
because depending on what happens in your retirement certain strategies will force you
to actively reduce your income for the year or until certain other conditions are met),
or major fluctuations (which, admittedly, is not always just about the strategy you
choose, but often times also the performance of your investments).
One strategy that illustrates the importance of this factor well is the Guyton-Klinger
Rule, which I will also be going in depth on in a future video, probably very soon.
And it’s very complicated compared to most other methods so I won’t go through the
whole rule here, but one part of the rule is the concept of financial guardrails.
Basically, one part of the rule says that if at any point, your withdrawal rates increase
beyond 20% above what your initial target withdrawal rate was set to when you first
set up the rule, then you will lower your current year’s withdrawal by 10%.
This is called the capital preservation rule and it’s there to help improve your chances
of not running out of money in retirement because it stops your withdrawals from getting
dangerously high, so it does have a purpose and does reduce your risk, but it would be
considered a reduction in income, which means it would lose some points in the predictability
factor.
There is also another part of the Guyton-Klinger Rule that stops you from adjusting your withdrawals
for inflation in years where your investments had a negative return (this is generally referred
to as a freeze on your income since it stops your income from changing).
This would also be considered an undesirable change (or lack of a change I suppose) to
your income and it would also have an effect on our fourth and final factor of successful
retirement withdrawal strategies.
The fourth and final factor of a successful retirement withdrawal strategy is buying power.
Buying power is important for one simple reason: $1,000,000 a year in income is chump change
when a Big Mac costs you $3,000,000.
So maintaining your buying power can be incredibly important especially if you're going to have
a long retirement.
This is one thing that the 4% rule does incredibly well, because your withdrawals, regardless
of investment performance, are adjusted for inflation each and every year.
There are no freezes, there are no reductions, there are no financial guardrails, which admittedly,
can have negative repercussions in some of the other factors over time depending on investment
performance and withdrawal rates, but theoretically, this approach keeps your effective buying
power exactly the same from your first year of retirement to your last year of retirement.
For someone like John who retired at 70 and likely wouldn’t be retired for more than
10 to 15 years or so, this may not be that big of a deal, but to someone retiring early,
it’s an entirely different story.
Let’s say that Jane retires at 30 with the same $1,000,000 that John had in our previous
example.
If she followed the 4% rule, Jane would withdraw $40,000 in her first year of retirement and
would adjust her withdrawals every year after that to account for inflation, thus maintaining
her effective buying power at $40,000 a year in today’s dollars.
However, what if Jane took a different approach to her retirement withdrawals?
Just for the sake of illustration let’s say that Jane decided to use a fixed dollar
withdrawal strategy.
In other words, Jane decided to withdraw $40,000 a year, every year for the rest of her retirement,
regardless of investment performance or any other outside factor.
In the beginning, it would look very similar to the 4% rule, after all the initial withdrawals
are exactly the same.
However, over time things become more expensive thanks to inflation.
So Jane’s $40,000 today isn’t going to get her as much as $40,000 will 20, 30, 40,
or 50 years from now.
Assuming a 3% annual rate of inflation, Jane’s $40,000 would be worth about $29,750 in 10
years, $22,150 in 20 years, $16,480 in 30 years, $12,250 in 40 years, and just $9,125
in 50 years!
That, in a nutshell, is why buying power is an important factor to take into consideration
when choosing your retirement withdrawal strategy, especially for the early, or just the long-lived,
retiree.
But that'll do it for me today once again if you enjoyed this video be sure to smash
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