Beyond the 4% Rule
By Cayucos Wealth
Published On August 26, 2024
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How Much Can You Spend in Retirement?
By Rob Williams and Chris Kawashima, Charles Schwab, May 14, 2024
How much can you spend without running out of money? The 4% rule is a popular rule of thumb, but you can do better. Here are guidelines for finding your personalized spending rate.
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 withdraw from savings and 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
While the 4% rule is a reasonable place to start, it doesn’t fit every investor’s situation. A few caveats:
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 to help you save for retirement. If you want $40,000 from your portfolio in the first year of a 30-year retirement, increasing annually with inflation, with high confidence your savings will last, using the 4% rule would require you to have $1 million dollars in retirement. But after that, we suggest adopting a personalized spending rate, based on your situation, investments, and risk tolerance, and then regularly updating it. Further, our research suggests that, on average, spending decreases in retirement. It doesn’t stay constant (adjusted for inflation) as suggested by the 4% rule.
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 carefully consider 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 help you determine 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 have a very conservative allocation and a long retirement period. However, asset allocation can have a significant impact on the portfolio’s ending asset balance. In other words, a more aggressive asset allocation may have the potential to grow more over time, but the downside is that the “bad” years can be worse than with a more conservative allocation.
Remember, choosing an appropriate mix of investments may not be just a mathematical decision. Research shows that the pain of losses exceeds the pleasure from gains, and this feeling can be amplified 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% to 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 reducing or cutting 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 withdrawal 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 withdrawal rate, but not so high that your retirement savings will run short. In the table, we’ve highlighted the maximum and minimum suggested first-year sustainable withdrawal rates based on different time horizons. Then, we 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 an initial withdrawal rate between 5.4% and 5.9%.
The table is based on projections using future 10-year projected portfolio returns and volatility, updated annually by Charles Schwab Investment Management (CSIM). 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
Here are some additional items to keep in mind:
Stay flexible—nothing ever goes exactly as planned
Our analysis—as well as the original 4% rule—assumes that you increase your spending amount by the rate of inflation each year regardless of market performance. However, life isn’t so predictable. Remember, stay flexible, and evaluate your plan annually or when significant life events occur. If the market performs poorly, you may not be comfortable increasing your spending at all. If the market does well, you may be more inclined to spend more on some “nice to haves,” medical expenses, or on leaving a legacy.
Bottom line
The transition from saving to spending from your portfolio can be difficult. There will never be a single “right” answer to how much you can withdraw from your portfolio in retirement. What’s important is to have a plan and a general guideline for spending—and then monitor and adjust, based on your circumstances, as necessary. The goal, after all, isn’t to worry about complicated calculations about spending. It’s to enjoy your retirement.
1 The tables show sustainable initial withdrawal rates calculated by simulating 1,000 random scenarios using different confidence levels (i.e., probability of success), time horizons and asset allocation. “Confidence” is calculated as the percentage of times where the portfolio’s ending balance was greater than $0. The initial withdrawal amount, in dollars, is then increased by a 2.28% rate of inflation annually. Returns and withdrawals are calculated before taxes and fees. The moderately aggressive allocation is left out of the summary table, because it is not our suggested asset allocation for any of the time horizons we use as an example. For illustrative purposes only.
*Regulatory assets under management are assets where Sowell provides continuous and regular supervisory or management services to client portfolios. Assets under administration is a measure of the total assets for which Sowell provides administrative services.