by Michael
It’s about time again for another post in my Ultimate Retirement Guide Series. As a refresher, the goal of this series will be to provide an in-depth answer to this question: “what do I need to do to retire?” As well as any questions that could stem from that initial question. The goal is to have this cover all of the information I’ve looked at since I started really becoming interested in retirement saving, both early or traditional. I hope to mostly focus on items that have been relevant to me in my own experience and where I am in my journey at the time of writing. Throughout, I will try to present as unbiased a position as possible, but I’m sure that I will not be perfect.
In the last post we laid out the following five large steps needed to retire:
- Determine when to retire.
- Determine the amount needed to retire.
- Save that amount.
- Prepare to transition from working to retirement.
- Retire.
Currently we’ve been working through step 2 by breaking it into the following subsections.
- The 4% rule of thumb
- Other withdrawal rates
- Other withdrawal strategies
- Length of retirement (and sequence of return risk)
- Inflation
- Asset Allocation
- Different types of investment strategies (rentals, stocks, ect.)
- Other expenses
- Visualizing retirement
Last time we talked about the 4% rule and some of its drawbacks. To summarize, the 4% rule provides a high chance of success for retirements that are to last for about 30 years. In a longer retirement, a significant drawdown in the market during retirement could derail one’s retirement. I think it makes for a great starting point when someone is far from retirement and needs a rough ballpark estimate for how much you need to save.
But as you refine what retirement will look like, such as the length of your retirement or other changes that complicate your plans, you may need a different withdrawal rate or strategy. This time, I thought we should talk about some of those different strategies.
Changing the Withdrawal Rate
Changing the amount you withdraw is probably the simplest way to increase the chance of survival of a portfolio for longer retirement. Put simply, with a higher withdrawal rate, a portfolio doesn’t have as much time to recover from a downturn than a comparatively lower withdrawal rate.
This adjustment is definitely more of an art than a science, what chance of success at what retirement length someone will be comfortable with is personal and may differ from person to person. Just like much of personal finance, what this number will be kind of depends on an individual’s own goals.
It does help refine the number needed to retire a bit however if the withdrawal rate to be used changes slightly. As retirement draws nearer it’s probably best to adjust from the 4% rule to whatever number is more appropriate.
To put an example to it, we’ll look at my withdrawal rate. I plan to have an approximately 60 year retirement. The 4% rule has a decent chance at success at this length of retirement but it’s a lower chance than I feel comfortable taking. Instead, I’ve adjusted my withdrawal rate down to be closer to 3.5% (with rounding to an easier to remember number it comes in at about 3.2%). This provides a chance of success that I’m happy with.
To put some mostly unfounded opinion into this post, I think the sweet spot for most retirement periods is somewhere between 3-4% (assuming the retiree does not care about their sustainable withdrawal amount being left to their heirs). Knowing that at 2% any length of retirement has almost a guaranteed chance of success, barring black swan events. I would not suggest going above 4% though other than for extremely short retirement periods (10-20 years), at such lengths where you have already saved close to that amount of years of spending.
One last note on withdrawal rates, I’ve mentioned chances of success throughout this post but I’ve never shown how to calculate them. The first reason is that individual asset allocation could affect success chances. Controlling for asset allocation though, calculating the success chance isn’t easy and isn’t set in stone. Most methods I’ve seen either look at purely historical data (pick all the 60 year periods in your data and see how many of them survive) or use historical data to run monte carlo simulations (use the past to inform patterns for sets of random simulations of the future). These two approaches can give slightly different numbers and neither is truly what an individual’s chance of success will be. Past returns are not a guarantee of future returns. I leave it up to the reader to chose the simulation methods that they prefer and to run their own analysis for their situation.
Other Strategies
Just using a withdrawal rate isn’t the only option. There are a handful of other ways to adjust the 4% rule to try and increase the chance of survival of a portfolio. For this guide we’ll look at the three of the most general of them. However I will note that for planning purposes, I believe that one should plan to have a high chance of success just at a withdrawal rate and then these other strategies can be employed in the small chance that the worst events occur.
One of the more commonly discussed, at least in my experience, is a flexible approach. Usually this is put as follows, “If the market drops by x% I’ll just reduce my withdrawal rate by y% until my portfolio is back to z% above where it was. In the meantime I’ll have to cut some discretionary spending.” Often z is 0. At first glance it actually looks like a solid plan, if the market drops by a certain amount, adjust your spending to a newer safe withdrawal rate that allows for your retirement savings to recover.
The problem with a flexible approach is that during these periods actual spending power is reduced. Using the same value dollars, let’s say in year 1 I withdraw $48,000 from my portfolio at a 3.5% withdrawal rate. During year 1, the market tanks by 20%, below my threshold of 10% (x in the above statement), as such I adjust my spending down by 0.5% (y from above) and instead withdraw $41,000 for year 2. During year 2 the market screams back up by 25% bringing me to where I was at retirement, I then adjust back to $48,000 for year 3.
Part of the hard part of planning for retirement is planning income needs around actual cash flow. How can I plan for more than a year out if I could be spending $7,000 (or more) less a year. That could potentially affect my ability to retire, especially for retirement budgets that have a lot less room to curb spending. What if it’s a prolonged downturn like the 2008 Financial crisis? All this is really doing is simulating a lower withdrawal rate based on what the market is doing. Using my example above, my actual average spending is about $45,000 (or a withdrawal rate of about 3.2%) the retiree just doesn’t actually know what their actual average yearly spending will be until they die.
Although on the flip side, a retiree shouldn’t be so focused on withdrawing and spending $x every year. If a year is cheaper that’s perfectly fine. Plan for a set number and let reality be slightly different if it is. A retiree should regularly calculate their withdrawal rate and adjust their withdrawals accordingly. I do think that in certain really bad downturns/events, the flexible approach could help retirees that have both the spare amount in their budget to cut and ride out exceptionally bad storms.
Another solution to a sudden downturn for higher withdrawal rates is to get some form of job either part-time or full-time after the downturn reaches a specific point (x% drop or y years of a downturn) to augment lower withdrawals. I don’t actually have any problems with retirees working, as long as it’s something they’re passionate about. However if a significant, prolonged downturn occurs then most likely the job market will take a hit and it could be hard to find a job, especially for those further into their retirements. What about 20 years after retirement, what jobs will be available to the retiree then? The amount of money you’re making now may not be a realistic assumption for these simulations once you get out far enough from work.
This is kind of a modified Barista FIRE strategy. But from the outset that should be understood.
Occasionally I’ll see a strategy that allows for spending to get asymmetrical with inflation before being adjusted up again as needed. If the market drops by “x% I just won’t do inflation adjustments until the market recovers.” Like the flexible strategy, the problem with this strategy is that buying power declines over that period of time. If it’s a prolonged downturn, the buying power at the end could be significantly lower than at the start. Although I do believe retirees should be open to adjusting for personal rate of inflation rather than CPI rate.
Another strategy that I won’t talk too much about here but have seen is one based on equity valuations. As equity valuations change, the withdrawal rate is adjusted accordingly (as the CAPE ratio increases compared to the average CAPE ratio withdrawals decrease). The idea is that as price to earnings gets higher, adjust withdrawal downwards preemptively for the next downturn. I like the idea of this strategy conceptually, I think it’s especially good as one approaches retirement if you know that equities are at historically high values it might be a good idea to adjust your withdrawal rate in case of a reversion to the mean. There’s a lot more to this strategy, but I think that’s enough to get started on.
What is the best Approach?
So if no method is perfect how is someone supposed to figure out how much they need to retire? I think it’s a mix of all of these.
When decades out from retirement, use 4% for a ballpark estimate. As retirement draws nearer, settle on a better withdrawal rate that more realistically reflects the planned length of your retirement (4% estimate at the start can be adjusted if you already have a goal retirement length and initial goal withdrawal rate), the plan should be to provide a constant amount in buying power during retirement with a high enough chance of success to not be keeping the planner up at night. Once in retirement, be open to adjusting the withdrawal rate (up or down) if possible. If it is appealing, be open to some form of part-time work, although plan around how useful your current skills will be 20 (or more) years from today. Although these other methods should not be the first line of defense.
Overall, no withdrawal strategy is perfect, nor should it be expected to. But all of them can provide some useful ideas that can be used when planning for retirement. Alternative strategies can be used to help raise the overall success chances of your individual plan and I think that is the greatest individual benefit they can provide.
