Determining exactly how much money you will need in your retirement years is no simple feat. No one wants to spend too much early on in retirement only to find themselves having to make up the difference later in life. At the same time, you want to enjoy retirement and the financial freedoms you have worked so hard for. Despite the risk involved in retirement planning, there are several standard rules of thumb to help you figure out how to spend safely during this period of your life.
There are several schools of thought when it comes to annual withdrawals in retirement, but we will focus on these two primary ones: the 4% rule and the Spend Safely in Retirement plan. The 4% rule is more standardized and can be easier to apply; however, it can have shortcomings. The alternative strategy is slightly less straightforward, but it accounts for some occurrences that the 4% rule does not. In either case, it is important to remember that these strategies are guidelines, and investors should evaluate their individual situations to determine a plan of action best for their lifestyle.
The 4% Rule:
This rule requires that individuals sum their savings and investments and withdraw 4% of that total amount in their first year of retirement. In every year following, one adjusts that first year’s 4% draw for inflation. Based on repeated scenario analyses, there is a low probability that one will actually outlive the money they have stashed away (using a typical 30-year retirement plan).
It seems simple and it is, but herein lies the issue. For one, it assumes that the investor will spend in a linear fashion; their outlays of cash will remain the same no matter the year. Most people will have some years where they spend more or less than others, due to discretionary spending changes or unforeseen events.
Additional research suggests that spending during retirement follows what is known as a “retirement spending smile” model rather than a typical linear model. According to the Bureau of Labor Statistics’ 2017 Consumer Expenditure Survey, retirees spend more in the early years of their retirement than later ones. If their spending increases in late retirement years (the last part of the “smile”), it is typically due to increasing costs of healthcare. Thus, the 4% rule could be requiring investors to save more than they will need.
The second main issue with the 4% strategy is that the investor is predicted to increase spending by the inflation rate, which does not take into account market conditions and portfolio performance. We believe that a better approach is to take portfolio performance into account and adjust accordingly. That is, the 4% rule can be used as a guideline, but it needs to be adapted based on these factors.
Spend Safely in Retirement Plan:
Alternatively to the 4% Plan, the ‘Spend Safely in Retirement’ plan aims to delay fund withdrawals as long as possible. In contrast to the 4% rule, the Spend Safely in Retirement plan advises retirees to withdraw only 3.5% per year before the age of 70. From 70.5 onward, retirees then use the Required Minimum Distribution (RMD) formula to determine how much they should withdraw from their portfolio. IRAs, SEP IRAs, and Simple IRAs all require retirees to begin drawing on their funds by age 70.5 at the latest – although there are some notable exceptions to this rule.
RMD is calculated by dividing the retirement account’s previous year-end fair market value by a factor number that is based upon your age in the current year. Unlike the 4% rule, this method is taking into account the performance of the portfolio each year and adjusting the withdrawal amount accordingly. Investors can spend what the RMD requires, plus their Social Security. Since this amount will probably change by more than the rate of inflation, investors may need to alter their lifestyle to accommodate market changes.
Both of these models must be adapted for each individual’s situation. Important things to consider include your investment timeline, how long you want your funds to last, and how confident you want to be that you will not run out of funds. These factors will help you to determine your rate of withdrawal during retirement.
The financial advisors at Morris Financial Concepts know that retirement planning can be a daunting task. It is one that requires investors to take an honest look at their financial situation, medical and family history, spending habits, and risk tolerance. When you are ready to begin or continue your retirement planning, we are here to answer any questions you may have and assist in setting you up for financial success.
The opinions expressed herein are those of Morris Financial Concepts, Inc. and are subject to change without notice. This material is for informational purposes only and should not be considered investment advice. Morris Financial Concepts, Inc. is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about Morris, including our investment strategies, fees, and objectives can be found in our ADV Part 2, which is available upon request. MFC-19-11.