Are you in the 4%?

You may have heard about the 4% rule for retirement spending. It’s a simple but imperfect guide to how much you can safely spend each year during retirement.

There are different nuances to it but the basic concept is that when you begin retirement, spend 4% of your savings in the first year. Then, increase your spending by an inflation adjustment each year going forward. At this rate of spending, you should safely fund a 30-year retirement.

While it’s easy to understand and financially conservative, this rule of thumb has drawbacks and is probably not the best strategy to budget for your retirement. Why not?

1. Retirement age. We retire at different times. If you retire at age 60, your savings needs to last longer than if you retire at 72. The same spending rule is not going to be optimal for both of you.

2. Life expectancy. Similarly, we have different life expectancies. There’s no joy in having a short life expectancy but you can spend at a higher rate than someone who’s going to live to 95.

3. Investment strategy. Investing your savings too conservatively (e.g., all invested in bank CDs) will generate less investment income than investing more aggressively. If you invest more cautiously, you’ll have to spend more cautiously.

4. Taxes. If your savings are in a pre-tax IRA, then you’ll pay tax on those distributions and your actual net worth is lower than what it nominally appears to be. Savings in Roth IRAs will be worth more to you in retirement as you won’t be sharing your spending with the tax man.

5. Estate preferences. Some of us would like to die having just spent our last dollar while others want to leave behind an inheritance for others. Your rate of spending should reflect that choice.

So, what’s a better way to determine a safe spending rate in retirement?
There’s no one-size-fits-all answer for everyone. Here’s the approach I use in my Retirement Readiness service.

  1. Determine your adjusted net worth after accounting for the tax status of your assets and any liabilities you have such as mortgages and other outstanding loans.
  2. Determine an appropriate asset allocation based on your age, life expectancy, net worth, personal risk tolerance, and sources of income such as Social Security and any pensions. Based on this asset allocation, derive a reasonable rate of return assumption.
  3. Project out the rate at which your net worth will decline over your lifetime as you spend down your savings.
  4. Run multiple spending scenarios to accommodate different assumptions for life expectancy, inheritance preferences, unforeseen future financial demands, and investment rates of return.

From the results of these multiple scenarios, you will have an actionable picture of how financially secure you will be in retirement. You can assess the risks you face and determine the options you have to mitigate them.

It’s not as simple as a 4% rule but it’s more accurate, gives you flexibility and control over your finances, and increases the likelihood of avoiding both over- and under-spending during your retirement.

If you want to learn more about how to estimate a safe spending rate during retirement, get in touch.

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