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 can be 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. At this rate of spending, you should safely fund a 30-year retirement and hopefully not over- or under-spend.
While it’s easy to understand, this rule of thumb may not the best strategy to budget for your retirement. Why not?
1. Retirement age
We retire at different times. If you retire at age 55, your savings will need to last longer than if you retire at 75. The same spending rule is not going to be optimal for both of you.
2. Life expectancy
We have different life expectancies. There’s no joy in a short life expectancy other than you can spend at a higher rate than someone who’s going to live to 100.
3. Investment strategy
Investing your savings too conservatively (e.g., all invested in bank CDs) will generate less investment income over the long run than investing more aggressively. If you invest more cautiously, you’ll have to spend more cautiously.
4. Investment returns
What if your invested savings do particularly well or poorly one year? Should you adjust your spending or just keep going at the same rate indefinitely?
5. Inflation
How much do you adjust for inflation each year? What if the inflation rate becomes meaningful (as it is at the moment)? Will you be able to sustain those increases over time?
6. Taxes
If your savings are in a pre-tax IRA, then you’ll pay tax on those distributions and your spendable net worth is lower than what it nominally appears to be. Roth IRAs are worth more in retirement as your distributions are tax-free. Taxable savings are in the middle as you’ll likely pay investment taxes on distributions but these would be significantly lower than with a pre-tax retirement account.
7. 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.
What’s a better way to determine a safe spending rate in retirement?
There’s no one-size-fits-all answer. Here’s the approach I use in my Retirement Readiness service.
- Determine your after-tax net worth after adjusting for embedded taxes and any liabilities such as mortgages and other outstanding loans.
- 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 long-term rate of return assumption and project out the rate at which your net worth will decline over your lifetime as you spend down your savings.
- Run multiple spending scenarios to accommodate different assumptions for spending, life expectancy, investment rates of return, and unforeseen future financial surprises.
There’s no precision but the results of these multiple scenarios will offer you an actionable picture of how financially secure you’ll be in retirement. You’ll understand the risks you face, how sensitive your situation is to the various future uncertainties, and the options you have to adjust and mitigate the risks.
It’s not as simple as a 4% rule but it’s more accurate, flexible, and likely to avoid both over- and under-spending during your retirement.
If you want guidance in how to estimate a safe spending rate during retirement, get in touch.