By Cooper J Howard and Rob Williams
You've worked hard to save for retirement, and now you're ready to turn your savings into a paycheck. But how much can you afford to spend? If you spend too much, you risk being left with a shortfall later in retirement. But if you spend too little, you may not enjoy the retirement you envisioned.
One frequently used rule of thumb for retirement spending is known as the 4% rule. It's relatively simple: You add up all of your investments, and withdraw 4% of that total during your first year of retirement. In subsequent years, you adjust the dollar amount you withdraw to account for inflation. By following this formula, you should have a very high probability of not outliving your money during a 30-year retirement according to the rule.
For example, let's say your portfolio at retirement totals $1 million. You would withdraw $40,000 in your first year of retirement. If the cost of living rises 2% that year, you would give yourself a 2% raise the following year, withdrawing $40,800, and so on for the next 30 years.
The 4% rule assumes you withdraw the same amount from your portfolio every year, adjusted for inflation
Source: Schwab Center for Financial Research. Assumes an initial portfolio value of $1 million. Withdrawals increase annually by 2%. For illustration only.
While the 4% rule is a reasonable place to start, it doesn't fit every investor's situation. A few caveats:
- It's a rigid rule. The 4% rule assumes you increase your spending every year by the rate of inflation - not on how your portfolio performed - which can be a challenge for some investors. It also assumes you never have years where you spend more, or less, than the inflation increase. This isn't how most people spend in retirement. Expenses may change from one year to the next, and the amount you spend may change throughout retirement.
- It applies to a specific portfolio composition. The rule applies to a hypothetical portfolio invested 50% in stocks and 50% in bonds. Your actual portfolio composition may differ, and you may change your investments over time during your retirement. We generally suggest that you diversify your portfolio across a wide range of asset classes and types of stocks and bonds, and that you reduce your exposure to stocks as you transition through retirement.
- It uses historical market returns. Analysis by Charles Schwab Investment Advisory, Inc. (CSIA) projects that market returns for stocks and bonds over the next decade are likely to be below historical averages. Using historical market returns to calculate a sustainable withdrawal rate could result in a withdrawal rate that is too high.
- It assumes a 30-year time horizon. Depending on your age, 30 years may not be needed or likely. According to Social Security Administration (SSA) estimates, the average remaining life expectancy of people turning 65 today is less than 30 years. We believe that retirees should plan for a long retirement. The risk of running out of money is an important risk to manage. But if you're already retired or older than 65, your planning time horizon may be different. The 4% rule, in other words, may not suit your situation.
- It includes a very high level of confidence that your portfolio will last for a 30-year period. The rule uses a very high likelihood (close to 100%, in historical scenarios) that the portfolio would have lasted for a 30-year time period. In other words, it assumes that in nearly every scenario, the hypothetical portfolio would not have ended with a negative balance. This may sound great in theory, but it means that you have to spend less in retirement to achieve that level of safety. By staying flexible and revisiting your spending rate annually, you may not need to target such a high confidence level.
Beyond the 4% rule
However you slice it, the biggest mistake you can make with the 4% rule is thinking you have to follow it to the letter. It can be used as a starting point - and a basic guideline on how much to save for retirement - 25x (or the inverse of 4%) of what you'll need in the first year of a 30-year retirement from your portfolio. But after that, we suggest adopting a personalized spending rate, based on your situation, investments, and risk tolerance, and then regularly updating it.
How do you determine your personalized spending rate? Start by asking yourself these questions:
1. How long do you want to plan for? Obviously, you don't know exactly how long you'll live, and it's not a question that many people want to ponder too deeply. But to get a general idea, you should consider carefully your health and life expectancy, using data from the Social Security Administration and your family history. Also consider your tolerance for managing the risk of outliving your assets, access to other resources if you draw down your portfolio (for example, Social Security, a pension, or annuities), and other factors. This online calculator can also assist you in determining your planning horizon.
2. How will you invest your portfolio? Stocks in retirement portfolios provide potential for future growth, to help support spending needs later in retirement. Cash and bonds, on the other hand, can add stability and can be used to fund spending needs early in retirement. Each investment serves its own role, so a good mix of all three - stocks, bonds and cash - is important. We find that asset allocation has a relatively small impact on your first-year sustainable withdrawal amount, unless you had a very conservative allocation and long retirement period. However, asset allocation did have a significant impact on the portfolio's ending asset balance. In other words, a more aggressive asset allocation had the potential to grow more over time, but the downside is that the "bad" years were worse than with a more conservative allocation.
Asset allocation can have a big impact on a portfolio's ending balance
Source: Schwab Center for Financial Research. Assumes a constant asset allocation, a 75% confidence level, and withdrawals growing by a constant 2.19%. Assumes a starting balance of $1 million. Confidence level is defined as the number of times the portfolio ended with a balance greater than zero. See disclosures for additional disclosures on allocations and capital market estimates.
Remember, choosing an appropriate mix of investments may not be just a mathematical decision. Research shows that the pain of losses exceeds the pleasure in gains, and this effect can be magnified in retirement. Picking an allocation you're comfortable with, especially in the event of a bear market, not just the one with the greatest possibility to increase the potential ending asset balance, is important.
3. How confident do you want to be that your money will last? Think of a confidence level as the percentage of times in which the hypothetical portfolio did not run out of money, based on a variety of assumptions and projections regarding potential future market performance. For example, a 90% confidence level means that, after projecting 1,000 scenarios using varying returns for stocks and bonds, 900 of the hypothetical portfolios were left with money at the end of the designated time period - anywhere from one cent to an amount more than the portfolio started with.
We think aiming for a 75-90% confidence level is appropriate for most people and sets a more comfortable spending limit, if you're able to remain flexible and adjust if needed. Targeting a 90% confidence level means you will be spending less in retirement, with the trade-off that you are less likely to run out of money. If you regularly revisit your plan and are flexible if conditions change, 75% provides a reasonable confidence level between overspending and underspending.
4. Will you make changes if conditions change? This is the most important issue, and one that trumps all of the issues above. The 4% rule, as we mentioned, is a rigid guideline which assumes you won't change spending, change your investments, or make adjustments as conditions change. You aren't a math formula, and neither is your retirement spending. If you make simple changes during a down market, like lowering your spending on a vacation or for expenses you don't need, you can increase the likelihood that your money will last.
Putting it all together
After you've answered the above questions, you have a few options.
The table below shows our calculations, to give you an estimate of a sustainable initial spending rate. Note that the table shows what you'd withdraw from your portfolio this year only. You would increase the amount by inflation each year thereafter - or ideally, re-review your spending plan based on the performance of your portfolio. (We suggest discussing a comprehensive retirement plan with an advisor, who can help you tailor your personalized withdrawal rate. Then update that plan regularly.)
We assume that investors want the highest reasonable spending rate, but not so high that your retirement savings will run short. In the table below, we've highlighted the maximum and minimum suggested first-year sustainable withdrawal rates based on different time horizons.
We have also matched those time horizons with a general suggested asset allocation mix for that time period. For example, if you are planning on needing retirement withdrawals for 20 years, we suggest a moderately conservative asset allocation and a withdrawal rate between 5.5% and 5.9%. For simplicity, these same suggestions are summarized in the table below as well.
The tables are based on projections using future 10-year projected portfolio returns and volatility, updated annually by Charles Schwab Investment Advisor, Inc. The same annually updated projected returns are used in retirement saving and spending planning tools and calculators at Schwab.
Choose a withdrawal rate based on your time horizon, allocation, and confidence level
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.