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The reason we save money for retirement during our working years is so that we can spend it in the future when earned income shuts off. In fact, one popular study on this topic concludes that the ideal outcome for most retirees is one where they spend their very last dollar on the last day of their life. But actual spending behavior in retirement, specifically the spending behavior of affluent retirees, tells a different story.
Affluent retirees are defined as individuals with non-housing assets of at least $200,000. And according to a recent study by Greenwald and Associates, only 14% of affluent retirees are drawing down principal to fund their retirement expenses. In other words, 86% of people with more than $200,000 in savings and investments are not withdrawing more than their portfolio earns each year.
Said another way, six out of every seven affluent retirees dies with more money than when they entered retirement. And surprisingly, this spending behavior doesn't seem to change when retirement expenses increase unexpectedly either. Instead of dipping into principle, retirees are twice as likely to reduce other spending to absorb these unforeseen larger expenses.
Based on research, the majority of people with at least a couple hundred thousand dollars of retirement savings will underspend and leave more money behind than intended.
And while there's no shortage of withdrawal strategies to help retirees maximize their income and safely spend down their savings while mitigating the chances of running out of money, their emotions often prevent them from doing so. They're used to seeing their balance grow in the accumulation phase of life and struggle to watch it go the other way. Or they aren't naturally great spenders, hence why they've done such a great job accumulating a healthy nest egg.
It could also be that they just don't know how to create a safe withdrawal plan in retirement, or they're not sure how to accurately interpret the health of their plan through different market environments and different life events as they begin spending down. And I don't necessarily blame them. Evaluating all the different retirement withdrawal strategies that are out there, finding one that fits your unique needs, following every little rule outlined in a nerdy research paper...
And implementing it properly year over year for 30 to 40 years can be a daunting task, which leads many retirement savers gravitating to something simple and conservative like the 4% rule. While there are far worse approaches, a study by Michael Kitsis revealed that a retiree with a 30-year time horizon using the 4% rule is more likely to end up with four times their starting balance than below it.
How about something in between the advanced withdrawal strategies implemented by financial professionals and something simple and perhaps too conservative like the 4% rule? Something that encourages retirees to safely spend and enjoy more of their hard-earned money.
Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm sharing the details of a new withdrawal strategy that I recently came across. It's simple to implement, it's dynamic, and it can help retirees spend more money in retirement while protecting them from running out before end of life. For the links and resources mentioned in today's episode, just head over to youstaywealthy.com forward slash 192.
Two years ago, I published a four-part series on creating income in retirement. If you missed it or want to listen to it again, I'll be sure to link to the episodes in today's show notes. But in the final episode of that series, I talked about and introduced the concept of dynamic withdrawal strategies, strategies such as Guyton's guardrails, which is sometimes referred to as the Guyton-Klinger rule.
Unlike the 4% rule, which would be considered static, dynamic withdrawal strategies like Guyton's guardrails adjust the amount a retiree can withdraw each year based on the performance of the market or more accurately, the underlying investments. In short, dynamic strategies permit higher spending during good years but require reductions during difficult ones.
The dynamic nature and unique rules allow retirees to have a much higher starting withdrawal amount than the 4% rule, something closer to 5% to 6% depending on a few variables. A dynamic withdrawal strategy also allows retirees to spend more money to maximize their spending and avoid leaving a mattress full of money behind at end of life.
While we systematically implement the guardrail strategy at my firm to create a healthy, reliable income stream for our clients, and I do think it's the superior approach, I realize it's not easy for people navigating retirement without a professional to implement it on their own, which is why a recent article written by a friend of the show, Nick Maggiuli, caught my attention.
He refers to this new proposed approach as a flexible spending strategy. It's more complex than the static 4% rule, but it's simpler than the popular dynamic withdrawal strategies implemented by professionals. Given the additional complexity, a retiree adopting this strategy could potentially begin withdrawing at a rate much higher than 4%.
In some very extreme cases, he argues the starting withdrawal rate could be as high as 7%. But more on that later. Let's first cover the basics. The flexible spending strategy starts by asking retirees to separate their fixed expenses from their discretionary. Fixed expenses are those things that you need to spend money on in retirement. Things like food, housing, groceries, gas, insurance premiums, etc.,
While you have some control over how much you spend on these items, they are must-haves and things you can't just eliminate from your budget entirely. Discretionary expenses, on the other hand, are expenses that you have full control over. These are things that you would like to spend money on if your plan allows for it, but they aren't necessary. Travel, eating out, country club or gym memberships, and even charitable giving are some examples.
You can be flexible with discretionary expenses. You can reduce them or cut them out entirely if you had to. So step one is to add up all of your expenses and then determine what percentage of your total living expenses in retirement are discretionary. This percentage will help drive what your starting withdrawal rate is based on the rules of this strategy.
More specifically, the starting withdrawal rate assumes an investor has an 80% stock, 20% bond portfolio, and adjusts up or down depending on two things. Number one, the percentage of your total expenses that are discretionary. So in short, the higher the percentage, the higher your starting withdrawal rate can be. And then number two, the probability of success or the amount of risk you're willing to accept.
If you want a 0% chance of outliving your money, your starting withdrawal rate will be lower than if you're willing to take a little risk and accept a, let's say 5% chance of outliving your money.
Let's go through a quick example. Let's say your total living expenses are estimated to be $55,000 per year, and you've determined that half of them are discretionary. Well, if your discretionary expenses represent 50% of your spending and you wanted a 100% chance of success, a 100% chance of never running out of money over a 30-year retirement, your starting withdrawal rate, according to the flexible spending strategy, would be 5.5%.
Once you determine your starting withdrawal rate, you can then apply it to your retirement nest egg and begin following the dynamic rules to adjust portfolio withdrawals as required each year.
As mentioned, this strategy is intentionally simple, so simple that it only has three potential outcomes each year. And the only variable impacting these outcomes is the performance of the U.S. stock market as represented by the S&P 500. So here's how it works. On December 31st of each year, you would check to see how far the S&P 500 is from its all-time highs.
Based on that number, you would fall into one of three possible scenarios. The first is what's considered a normal market. In this scenario, if the S&P 500 is less than 10% away from its all-time highs on December 31st, then you are permitted to spend all of your discretionary spending in the following year.
The second possible scenario is what's called a correction. And the rule states that if the S&P 500 is more than 10% away from its highs on 1231, but less than 20% away from its highs, you are only permitted to spend half of your discretionary spending in the next year.
The last possible scenario is labeled a bear market. And this is where you're really forced to cut back. In this scenario, if the S&P 500 is more than 20% away from its all-time highs, you don't get to spend any money on discretionary expenses in the following year. So let's put some dollar figures to this. Let's say we have a $1 million portfolio.
50% of our expenses are discretionary. And again, we want a 0% chance of running out of money over a 30-year retirement. We want a 100% success rate. In that case, as previously mentioned, our starting withdrawal rate based on the table provided in the article would be 5.5%.
Since half of our expenses are fixed, we would cut that 5.5% in half and 2.75% or $27,500 would be earmarked specifically for our fixed expenses. And here's the interesting part that speaks to the simplicity of this approach.
That $27,500 annual withdrawal that's earmarked for your fixed expenses is now set in stone and it never changes for the rest of your retirement except for adjusting it for inflation each year. The performance of the portfolio or the U.S. stock market does not change the withdrawal amount for your fixed expenses.
The only dynamic changes that are made for the next 30 years are to the withdrawal amount earmarked for discretionary expenses, the other half of that 5.5% or the other $27,500. The changes to this withdrawal are directly influenced by the performance of the S&P 500 each year as explained in those three scenarios.
And according to the rules, your discretionary expenses are never adjusted for inflation. This is because research suggests that discretionary spending in retirement decreases over time. And this natural decrease just helps to offset the impact of inflation over a three decade retirement.
So theoretically, if you projected your fixed expenses correctly, you can now sleep at night knowing that these expenses will be safely covered for the rest of your 30 year retirement. We could go through 08, 09 round two, the stock market could be cut in half, but you would still be withdrawing your $27,500 adjusted for inflation each year.
It's your discretionary expenses that will be impacted by the different market environments. The three scenarios that we just discussed. If we're in a normal market on 1231 of this year, you would be permitted to withdraw that $27,500 next year to pay for your discretionary expenses.
If we're in a correction based on the definition previously shared, you would only be permitted to withdraw and spend half that amount or $13,750 on your discretionary expenses in the following year. And if it's a bear market, you would not be permitted to withdraw anything next year for discretionary expenses. You would only be permitted to withdraw the $27,500 adjusted for inflation to pay for your fixed expenses.
To summarize why this approach could be appealing, in two out of the three scenarios, the normal market and correction scenario, in those two scenarios, you get to spend more than you otherwise would have if you were using the 4% rule. But as Nick notes, this comes at a cost. You have to completely cut your discretionary spending during all years following a bear market.
He further states that, yes, bear markets, they only happen about 20% of the time or one out of every five years. However, they tend to cluster together. His extreme example was if someone retired in 1930 using the flexible spending strategy, they would have had to cut all discretionary spending for 14 years.
While that may never happen again, one would need to expect that it's very possible to have a series of years where they will be required to eliminate all discretionary spending. In addition to offering up a simple approach to dynamic spending in retirement and helping retirees spend more money, the flexible spending strategy helps protect against one of the biggest threats to retirement, and that is sequence of returns risk.
The rules that we discussed, they prevent retirees from over withdrawing from their portfolio during the bad years and getting into a position where it may be impossible to recover and get through retirement safely without making some major life changes.
Just like there's no free lunch with investing, there is no free lunch with retirement withdrawal strategies. If we want to spend more in retirement, we can either work longer and build up a larger nest egg, we can take more risk with our plan, or we can accept that we'll need to make some adjustments to our spending from time to time, i.e. we can be flexible.
Now, while I love the simplicity and cleverness of the flexible spending strategy, and I think it's a big improvement over the 4% rule, there are a few things that immediately jump out to me that I think people should take into consideration.
First, as previously mentioned, the research was based on an 80% stock, 20% bond portfolio. And maybe you caught this and maybe you thought the same thing. It's possible that a retiree, especially a retiree attempting to implement this on their own, is not able to stomach that aggressive of an allocation for 30 years.
For reference, the original 4% rule was based on a 50% stock, 50% bond allocation, and the Geithenklinger rule or guardrail strategy is based on a 65% stock, 25% bond, 10% cash allocation.
In addition, the guardrail strategy allows investors to adjust their starting withdrawal rate up or down based on their desired allocation or desired level of risk. So if you prefer to take less risk and reduce your exposure to the stock market, you can do that with the caveat that you'll have to accept a lower starting withdrawal rate.
The second thing is the flexible spending strategy is based on a 30-year time horizon, while other dynamic withdrawal strategies like the guardrails are based on a 40-year time period. And to be fair, the Guyton paper was eventually updated to include rules and withdrawal rates for a 30-year time horizon as well. But I typically lean on the 40-year rules, and that's because there are a lot of future unknowns in retirement. If we can develop a 40-year plan that gets someone safely to, let's say, age 100, it
then we know we have some extra buffer if something catches us off guard. It's a way to help stress the plan and potentially give clients more confidence to spend money. Just know that if you retire earlier than the traditional retirement age, or you like the idea of having a plan that stretches out 40 years to create some extra buffer, you'll need to make some adjustments to the proposed rules in the flexible spending strategy or adopt a different withdrawal strategy altogether.
The third thing I want to mention is the flexible spending strategy rules are based on the performance of one single asset class, the S&P 500. The argument is that if the S&P 500 or the U.S. stock market is in bear market territory, well, it's likely that the rest of the world is too.
And therefore, to keep the strategy as simple as possible, they concluded that basing the spending changes on that one index was sufficient. And while I understand the rationale and appreciate them staying true to keeping things simple, it is possible for a retiree's properly diversified portfolio to behave differently than the S&P 500 for extended periods of time. For example, the last decade in the early 2000s.
And it sure wouldn't make for a fulfilling retirement to be forced to cut discretionary expending just because of the performance of a single index that may not match the individual's allocation or portfolio performance. The guardrails rules, on the other hand, are based on the performance of the individual's portfolio and not on any one single index. And
And then lastly, the flexible spending strategy kind of assumes that retirees want to spend their discretionary money equally each year. But it's quite common for people in the first 10 years of retirement to want to spend a lot more than in the remaining 20 years or 30 years. It's also common for retirees to want to spend more in those early years ahead of social security and pensions kicking in later on that will take pressure off the portfolio.
To create a withdrawal strategy that allows for extra spending in the first 10 years while mitigating the sequence of returns risk and not putting the back half of retirement in jeopardy, it requires some advanced planning. Again, the simplicity of the flexible spending strategy is very much appreciated, but it can still leave some retirees wanting something that aligns more closely with their spending goals and their unique needs, especially in those go-go years.
In that case, a more advanced and customized withdrawal strategy might be required.
There is no one size fits all retirement income strategy. It's important to adopt one that works for you and allows you to achieve your unique needs and goals. And just like investing, the best withdrawal strategy is ultimately the one that you understand and you can stick with for long periods of time. If you jump from a dividend spending strategy to buying an annuity to trying out the 4% rule, you're likely going to introduce more stress than needed, both on you and your investment portfolio.
Once again, to grab the links and resources mentioned in today's episode, including links to the research papers referenced today, just head over to youstaywealthy.com forward slash 192. Thank you as always for listening, and I'll see you back here next week.
