Aug. 21 2018 — Fortunate retirees, those with a good amount of retirement savings, agonize over a perplexing problem: how much can you safely take out of your retirement funds? Spend those hard earned savings too fast and, if you live too long, live in poverty. Hold on too tightly, and you will go on to your greater reward with a big pile of unspent money in the bank. Your heirs will be able to fly first class, even if you didn’t!
The traditional rule of thumb for spending is the 4% rule. Originally popularized by Bill Bengen in 1994, the idea was pretty simple – you have pretty good odds of spending of not running out of money if you take out 4% of your savings every year of retirement. The theory is at least partially based on the assumption that traditional stocks and other investments return 6% or more over the long haul. While that has been true for equities since 2009, anyone invested mostly in bonds or CDs during this span would have experienced a much lower return.
Like all theories, however, the 4% rule might not apply to everyone. For example, if you have substantial earnings in retirement, or if you have a nice pension, withdrawing 4% would have you seriously underspending. If you have major expenses late in life, you might not have enough money left.
Balancing Income with Safety – Competing Approaches
There are many competitive solutions to the spending conundrum. One different approach is the constant dollars approach (take out the same amount of money each year, regardless of investment performance). Another is the remaining life expectancy theory (keep adjusting the payout to reflect your adjusted life expectancy).
David Blanchett, head of retirement research at Morningstar Investment Management, has explained what he thinks is a better theory, the “Probability of Failure Mortality Updating” method. In that one you continue to recalculate the withdrawal amount based on your expected longevity, adjusted for the “failure” risk that your remaining investments might tank. A simple explanation is that at age 65 you have a life expectancy of around 85, so you need to take that length of time into account in your distributions. But, once you make it to 75, you have fewer years of risk, so you can withdraw at a much higher rate. A drawback is that younger retirees might have more uses for the money than older ones.
A hybrid approach to the RMD Method
Another theory like we like even better because of its simplicity was researched by Wei Sun and Anthony Webb of the Center for Retirement Research at Boston College. Their RMD Plus theory builds on the RMD (Required Minimum Distribution) method required by the IRS. The RMD requires that when you reach age 70.5 you have to begin disbursing your 401k and/or IRA according to a percentage that changes each year with your life expectancy. The required IRS distribution percentage starts at 3.13% at age 65 and goes to 15.87% at age 100. Sun and Webb believe that the RMD approach is superior to the 4% rule because it continually adjusts for life expectancy.
But Sun and Wei believe there is a hybrid of the RMD strategy that works even better. According to them the highest performing retirement withdrawal approach modifies the RMD by adding in interest and dividend income, but not capital gains. This modification gives extra income to younger retirees without jeopardizing future losses to inflation. Here is how they explain it in their paper:
“To illustrate, a 65-year-old couple with financial assets of $102,000 who received $2,000 of interest and dividends in the last year, would spend $5,130: the $2,000 in interest and dividends, plus 3.13 percent (the age 65 Annual Withdrawal Percentage under the RMD strategy) of $100,000. In contrast, a household following the unmodified RMD rule would spend just $3,130.”
The Bottom Line
If you are fortunate to have saved significant amounts of money for your retirement, congratulations. You have done the hardest work. Now you have to make a decision on the optimum way to spend your savings so as to maximize income and minimize the risk of running out. That decision is not as cut and dried as you might have thought. In our opinion, the 4% rule, where you simply decide once and forget about it, isn’t nearly as thoughtful as a careful year by year review of your situation.
Making financial decisions this important are difficult, so we always recommend that you consult a qualified professional before acting. A good way to evaluate a professional, besides checking out their references, is to probe to see how much they know about the different withdrawal theories that exist, and ask which is the best for your unique situations. Good luck!
For further reading:
How Much Can You Take from Your Retirement Funds: RMDs as a Guideline?”
What is Your Number?
Is Even $1 Million Enough?
Can You Afford to Retire and What If You Don’t Like the Answer
Firecalc is a free tool that gives you probabilities of success against different rates of return.