There are a lot of complex strategies when it comes to withdrawing your money in retirement.
We’ve already gone over some of them such as the Guyton-Klinger Rule, but not all strategies
have to be complicated to work well. Sometimes the simplest strategy is the most brilliant
of all. And today that’s what we’re going to talk about. We’re going to be talking
about two of the most simple retirement withdrawal strategies out there, discuss their pros and
cons, as well as discussing who should be using them. Let’s get started.
So the strategies that we’re going to be covered today are very similar to one another
in that they are both known as fixed withdrawal strategies. They are the fixed dollar withdrawal
strategy and the fixed percentage withdrawal strategy. Let’s start with the fixed dollar
withdrawal strategy.
The fixed dollar withdrawal strategy is, exactly what it sounds like, you begin by withdrawing
a certain dollar amount from your nest egg every single month and keep that amount constant
throughout your entire retirement. Doesn’t get any simpler than that.
Say if John were living on this strategy in retirement. He has a $1,000,000 nest egg saved
and wants to live on $40,000 a year, He withdraws $40,000 in the first year of retirement, $40,000
the second, and so on. In other words, there are no adjustments for inflation using this
method.
When it comes to the four factors of retirement which for those who are new to the channel
are income, risk, stability, and buying power.
Income is measured both by how much money is coming in the door each month or year as
well as when that money is coming in. It’s measured this way because not all retirement
withdrawal strategies are systematic and linear with their income growth and since none of
us know precisely how long our retirement will be going in, so we tend to put more of
a priority in having abnormally high-income years in the earliest portion of our retirements
than in the later part of our retirement that we may or may not even get to.
Risk is essentially just the likelihood of outliving your money.
Stability is graded by how often you experience anything that would be considered an undesirable
change in your income from year to year. This could come in the form of a freeze on the
growth of your income or a decline in your income.
And buying power is defined just like it always is, by measuring what your money can actually
get for you at any given time and is largely tied to inflation.
The fixed dollar strategy is generally considered to be a little stronger on the income and
risk side of things in comparison to other popular withdrawal strategies like the 4%,
but does suffer a little more in the stability and buying power categories.
The reason for this is that, as long as your initial withdrawals are not too high, you
are relatively unlikely to outlive your money using this strategy, and you may be able to
live at a higher standard of living, at least initially, than you otherwise would have under
something like the 4% rule.
In fact, going all the way back to 1950 and looking all the way to March of 2019, which
is the most recent data I have at the time of this writing, if John had his $1,000,000
invested in something like the S&P 500, he would not actually outlive his money during
any possible 20, 30, 40, or 50 year retirements during that time span as long as he withdrew
no more than $54,000 a year or $4,500 a month. So even things like the Housing Crisis and
Dot-Com Crash didn’t cause him to run out of money here.
And as I said, this initially will give him a higher standard of living than the $40,000
a year income he would have under the 4% Rule would, though eventually, the inflation effect
would catch up with him.
And that’s where this strategy tends to fall short. It is not meant for longer retirements.
Because while John may be able to handle living on $54,000 a year, particularly if he is retiring
debt-free with a paid-off home, it becomes increasingly difficult to as the years go
on due to the inflation effect.
Inflation has historically averaged somewhere between 2% and 3% per year in the U.S. If
we assume that our personal average inflation rate in retirement is nearer the top of that
scale at 3% per year, then John’s $54,000 a year income will get him the equivalent
of what $40,000 would buy him today in just 10 years time! In 20 years his money would
only be able to buy him about what $29,900 would buy him today. And his money would be
worth the equivalent of $22,250, $16,550, and $12,300 in 30, 40, and 50 years respectively.
So let’s just for a minute imagine that John had decided to follow the financial independent;
retired early movement that we’ve seen pick up quite a bit of steam in the last several
years (and for good reason in my opinion), but instead of using the 4% rule which helps
to protect your buying power over longer retirements like those in that community are aiming for
he decided to use the fixed dollar withdrawal method.
If he retired at the age of 30 with a $54,0000, which again would be fine for him, however
the average life expectancy for people living in the U.S. is about 79 years old as of 2019
and I can only imagine that number will continue to grow as technology and medicine continues
to advance. So assuming he doesn’t die young, it isn’t out of the question that he would
have a near 50-year retirement and be living on the equivalent of about $1,000 a month
when he’s aging and his medical costs are at their highest.
So as you can see this strategy doesn't really work well with longer-term retirements.
But in terms of the four factors of retirement the fixed dollar strategy (assuming it is
used properly) is above average in income and risk, but below average in stability and
buying power at least in comparison to the 4% rule.
The fixed percentage method works very similarly to the fixed dollar method, except that you
are withdrawing a certain percentage of your nest egg every year as opposed to a raw dollar
value. This strategy also doesn’t adjust for inflation, but it does at least adjust
with the value of your portfolio and depending on what you invested in and what initial percentage
you choose to withdraw is this may work out alright.
Say John wanted to withdraw 4% of his investments each year in retirement. Since the value of
his investments were $1,000,000 when he retired he would withdraw $40,000 in his first year
of retirement leaving him with $960,000 leftover. If his investments went up by 10% that year,
the value of his portfolio would be somewhere in the neighborhood of $1,056,000 at the start
of his second year of retirement and he would withdraw 4% of that or $42,240.
Assuming inflation was 3% during that first year of his retirement his buying power would’ve
actually gone up. If he had merely adjusted his withdrawals for inflation (like he would
if he were using the 4% rule) his would’ve withdrawn $41,200 in his second year of retirement
(or about $1,040 less than he would’ve in the fixed percentage scenario).
The downside is that the reverse can also happen. Say that John’s investments fell
by 20% the next year, bringing the value of his nest egg down to about $845,000 and forcing
him to withdraw $33,800 in the third year of his retirement. That would be significantly
less than the $42,400 that John would’ve withdrawn in that third year using the 4%
rule.
So as you can imagine stability is something that this strategy has a very low score in
given that the value of a nest egg (if it’s invested in something like stocks) can grow
or shrink by 20%, 30%, or even 40% from year to year.
The bright side is that assuming you’re not withdrawing something crazy like 20% of
your nest egg every year, your risk of running out of money is theoretically very low, even
when compared to the 4% rule.
And I specifically say theoretically because like many things it’s true only to a point.
If we take it to a logical extreme this can break down. Say if John had $10,000 and he
wanted to live on 50% of his nest egg each year for the next 5 years… He’d technically
be fine in theory, but how many of us are able to live
on $5,000 a year? Not very many, but if you’re willing to take the hit to the stability of
your income in retirement, you usually can safely squeeze out a little more than 4% of
your nest egg each year in a typical retirement, it just means that your average raw dollar
income will shrink the further you go into retirement.
To illustrate this let’s say that if John withdrew 10% of his nest egg each year he
would start out with a six-figure income given his $1,000,000 nest egg, however, if he ended
up living longer than he planned on he could be living on what could only be generously
called a shoestring budget in his later years.
For example, in the simulations I ran covering the various retirement lengths starting from
1950 onward, assuming John had invested in the S&P 500 he would’ve had median monthly
incomes hovering around $6,500 in 20 and 30 year retirements (which when adjusted for
inflation would be about $3,600 a month in 20 year scenarios and $2,700 a month in 30
year scenarios), but that number dropped quite a bit as the retirements got longer. In his
50 year retirements, his average median monthly income was about $4,400. Which admittedly
doesn’t sound that bad, but you also need to consider his final few years’ worth of
monthly withdrawals, which were about $2,300 a month on average during those scenarios
which is considerably less than the six-figure income he started with.
Also remember, that’s $2,300 a month possibly as much 50 years down the road. Once we adjust
for inflation over that time period it may not even buy John about what $1,000 a month
would buy him today depending on exactly how far down the road we are. So similar to the
fixed dollar withdrawals your buying power could be taking a significant hit if the initial
percentages you’re withdrawing are set too high.
So in summation, the fixed percentage method scores reasonably well, though not necessarily
elite, when it comes to income (particularly early in retirement, though it does taper
off as time goes along), great in terms of risk (assuming you aren’t too aggressive
with your withdrawals), but horrible with stability (due to fluctuations in the value
of your nest egg), and below average in terms of buying power (unless you’re too aggressive
with your withdrawals, in which case it gets pretty bad over time).
So in the end who should use these strategies? Well, I’ll admit I am personally biased
here. I believe the list of people who should realistically use these strategies as their
retirement withdrawal strategies are very, very short. Mainly limited to those with very
short expected retirements so that their buying power doesn’t become too damaged over time
and even then ideally only by those who also are approaching retirement with little to
no debt because especially with the fixed percentage method you’ll often need to be
pretty flexible with your spending.
But for those who aren’t retiring early (and likely have no more than say 9 or 10
years that they expect to be retired), have little to no debt to speak of and want something
very simple to follow when figuring out how much money they should withdraw each year
one of these strategies can work out well for you giving you advantages in income without
significant increases in risk (though I would still rather they go with something like the
4% rule which is also fairly safe over those short periods of time, especially if you’re
thinking you’ll be in retirement for 10 years or more and are able to be flexible
with your spending during any major market downturns you may experience and have no debt).
But what are your thoughts, do you agree with my assessment of the strategy or do you think
that I’m missing something? Let me know in the comments section below.