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How Much Can You Spend in Retirement?

Is the 4% rule for generating income in retirement right for you?

By Massimiliano De Santis

Questions like “How much can I spend in retirement?” “Can I afford to retire?” or “When will I be ready to retire?” have one thing in common: In all cases you are trying to determine how much income you can generate from a given level of savings and for how long.

Masso De Santis

Massi De Santis

You may have heard that a spending level equal to 4% of initial portfolio value adjusted for inflation every year is a good rule. According to the rule, if you have accumulated one million dollars, you can afford to spend $40,000 a year. 

Say you need $50,000 a year in retirement, then you need to accumulate $1.25 million, according to the rule. Many have written about the 4% and similar rules, and lately you may have read that at current interest rates and possibly lower future returns, the rule may be outdated. However, low or even negative interest rates and low rates of returns have been experienced by retirees before, even before the rule was popularized in the 1990s. 

So, is the 4% rule still relevant? What should a good income strategy be like?

Uncertainty and Safety

Here is how we can derive a rule like the 4% rule. Start with data on historical returns of stocks and bonds, then ask the question: over any 30-year period in history, what would be the maximum withdrawal amount that a balanced portfolio of stocks and bonds could have sustained? For example, take the 30-year period that started in 1990 and ended in December 2019. If you had a portfolio of $1 million in January 1990, how much income could you sustain over time?

Assuming the returns of a 60/40 portfolio, we can answer that question. It turns out the answer is $64,000 in 1990 adjusted for inflation every year after that. That’s 6.4% of initial value. We can repeat the same for 1989, 1988, and so on all the way back to 1871. Figure 1 shows the results.

Figure 1: Maximum Sustainable Withdrawal Over 30 Year Periods

Maximum Sustainable Withdrawal Over 30 Year Periods

For illustration purposes only. Source: Max withdrawal rate from DESMO Wealth Advisors, LLC calculations using a line search algorithm. Historical data from Robert Shiller from 1871 to 1925, and Ibbotson data from Dimensional Fund Advisors since 1926.

The range of sustainable rates goes from a low of 4% in 1966 to a high of 9.9% in 1877. Given the lowest observed sustainable rate is 4%, it seems safe to withdraw 4% of initial value. That’s the rationale for the 4% rule, safety.

How Good is the 4% Rule?

We can’t know what the future holds. However, given that in the past we have experienced banking crises, the Great Depression, wars, the Great Inflation, and global financial crises, assuming that 4% is quite safe sounds reasonable. In fact, given the historical data, the biggest risk of the rule maybe that, if blindly followed, it may lead to underspending. Because 4% is the minimum rate that has been sustainable across all of the 30-year periods in the data, following the rule would have resulted in a surplus at the end of the 30 years in the vast majority of the cases. 

For example, for the period started in 1990 and ended in 2019, a retiree that started with $1 million would have ended the period with $1.6 million in 1990 dollars! The red line in the figure above shows the ending wealth for each of the periods considered, in percentage of initial portfolio value (refer to the right axis for the ending wealth). In half of the cases, ending wealth is 125% of initial value!

A Key Lesson

The key lesson from the data of figure 1 is that an optimal spending strategy should be safe enough to protect a minimum level of spending while allowing you to increase spending if portfolio performance is good. A good spending rule should be dynamic. If you start with the 4% rule and 10 years later you find that your portfolio is greater than you started with, chances are you’ll try to spend more. And that may be OK.

If well designed and monitored, the spending strategy allocates more spending to stated goals as portfolio growth is realized, and accumulates as little unplanned surplus as possible at the end of the planning horizon.

Sequence of returns and opportunities

On average, 30-year periods of high returns are associated with higher withdrawal rates, as can be expected. However, it turns out that the sequence in which portfolio returns are experienced, like five years of good returns followed by five years of bad returns or vice versa, matters more than average returns. In particular, our research shows that the returns over the first five to 10 years of each 30-year period are good predictors of sustainable withdrawal rates. Historically, periods with relatively good returns over the first five to ten years are associated with higher sustainable withdrawal rates. In contrast, all of the periods with low withdrawal rates are associated with low 5-to 10-year returns. The figure below shows the pattern.

Figure 2: First 5 Years Returns and Withdrawal Rates

First 5 Years Returns and Withdrawal Rates

For illustration purposes only. Source: DESMO Wealth Advisor, LLC calculations. Historical data from Robert Shiller from 1871 to 1925, and Ibbotson data from Dimensional Fund Advisors since 1926.

Advisors call this pattern ‘sequence risk.’ But a better point of view is to think of 5- and 10-year returns as containing information about opportunities to adapt our spending. Instead of following a blind rule, we can adjust our spending behavior by monitoring the performance portfolio over time and adapting our spending to it.

A Goals-Based, Dynamic Strategy

Here is how we can use these results. First, set meaningful goals and prioritize them. One general approach is to start with essential needs, then subtract Social Security to figure out what you will need from your portfolio. For example, say you need $60,000 a year in essential expenses and $30,000 comes from Social Security, then you’ll need $30,000 from personal savings. Multiply the amount by 25 (the 4% rule in reverse) to figure out how much capital you need to cover those expenses. This is your “essential portfolio.” In this example, you need $750,000 for essential needs.

If there is any capital left after taking care of essential needs at 4%, you devote the rest of your assets to high priority goals that have a shorter horizon, within the next five years or so. This contains items like vacations and other nonessential expenses. At some point, you get to goals that are not affordable at the starting 4% rate, but may become affordable if returns in the essential portfolio are higher than expected. These are goals that should be part of the plan with lower priority.

If returns are relatively good, you will have excess capital in your essential portfolio. If so you can consider devoting some of your essential assets to achieve other goals. If not, you continue to monitor the portfolio for opportunities to increase spending in later years.

You can’t predict future returns, but you can navigate the uncertainty of future returns with greater confidence if you have a solid plan based on a dynamic strategy that takes advantage of growth opportunities while safeguarding the spending you need for a comfortable retirement.

A goals-based approach can help define your dynamic strategy. So start thinking about your goals and priorities today!

About the author: Massimiliano De Santis

Massi De Santis is an Austin, TX, fee-only financial planner. DESMO Wealth Advisors, LLC provides objective financial planning and investment management to help clients organize, grow, and protect their resources throughout their lives. As a fee-only, fiduciary, and independent financial advisor, Massi De Santis is never paid a commission of any kind, and has a legal obligation to provide unbiased and trustworthy financial advice.