Posted By Should you Plan your Retirement Savings according to the 4% Withdrawal Rate Rule or 70% of Pre-Retirement Income Rule?
By Steve Lowrie, CFA
Special to Financial Independence Hub
Last month, we kicked off our “Real Life Investment Strategies” series by taking on the geopolitical world. Today, we’re going to tackle an FAQ that hits closer to home.
Whether you’re an accumulator or preparing for retirement, how do you plan for saving AND spending your hard-earned cash in retirement?
My Answer: It depends.
All those popular retirement spending rules you hear about in the popular press or through your favourite financial guru really should be called guidelines. Augmenting blunt estimates with finer-pointed planning may not be as quickly accomplished. But it’s a far more effective way to plan for how much to save as you accumulate wealth, and how much to spend as you withdraw it. In fact, it’s best to consider retirement spending as being a variable process, versus a one-and-done equation.
Which is why it depends.
Let’s bend some Rules: the 4% Withdrawal Rate Rule & the 70% Pre-Retirement Income Rule
I do feel most popular retirement spending rules were made to be broken: or at least bent to fit your specific assumptions, and adjusted over time as you encounter various phases in your retirement lifestyle.
Take the 4% Retirement Rule, for example. The catchphrase has been around since 1994, when William Bengen published his Journal of Financial Planning paper, “Determining Withdrawal Rates Using Historical Data.” In it, Bengen suggested that under certain assumptions, retirees could avoid outliving their money by withdrawing no more than 4% of their wealth in the year they retire, and then adjusting this figure annually for inflation.
The 70% Retirement Rule is another popular retirement spending hack. Here you plan to spend no more than 70% of your pre-retirement income in retirement and save accordingly toward that figure. This is supposed to work because, in theory, retirees spend less in retirement to fulfill their lifestyle wants and needs.
There are many similar shortcuts for guesstimating your retirement numbers. It’s tempting to accept these simplified rules as close enough and assume they’re all you’ll need to proceed. But the thing is, while Bengen’s analysis was rightfully lauded as an innovative new way to think about withdrawal rates in retirement, I don’t think even he meant for the 4% figure to serve as a hard and fast rule for every retiree, under every assumption, throughout their entire retirement (during which your lifestyle is likely to evolve).
The same goes for the 70% rule, and similar retirement rules.
Financial Talking Heads’ Rants on Retirement withdrawal Rate and other Shenanigans
In lieu of rules of thumb, people are also known to follow the shotgun advice of popular financial gurus who spout sweeping generalities as perfect solutions for one and all.
A prime example is Dave Ramsey of The Ramsey Show, who recently assured listeners that an 8% retirement withdrawal rate should “last forever,” as long as you invest as he suggests. He said a 4% spending rate was “asinine,” based on calculations generated by “super nerds,”“goobers,” and “morons who live in their mother’s basement with a calculator.” He then goes on a Wizard of Oz tirade about flying monkeys stealing your ruby slippers. Seriously, you can’t make this stuff up. (Check out 01:19:20 in The Ramsey Show’s “You Can’t Win with Money if You Don’t Know Where Your Money Is” podcast episode.)
Ramsey’s math is simple, which makes it appealing and easy to understand: “If you’re making 12 [percent] in good mutual funds and the S&P is averaging 11.8, and if inflation for the last 80 years is 4%, if you make 12 and you need to leave 4% in there for average inflation raises, that leaves you eight. So, I’m perfectly comfortable drawing eight. But if you want to be a little bit conservative, seven. But, sure, not five or three.”
In a Rational Reminder rebuttal episode, “Retiring Retirement Income Myths with the Retirement Income Dream Team,” my super-nerd friends (David Blanchett, the Managing Director and Head of Retirement Research for PGIM DC Solutions; Michael Finke, a distinguished professor of wealth management at the American College of Financial Services; and Wade Pfau, Director of Retirement Research at McLean Asset Management) offer what I believe is a considerably more realistic assessment of the market’s risks and expected rewards over time, with no monkey business involved:
Without going too heavily into the math, the two main counter arguments against an 8% withdrawal rate from the Retirement Income Dream Team are:
- There can be large differences between geometric returns (what you earn in an investment) and arithmetic returns (the simple average). For example, an average 12% return doesn’t mean that a retiree’s portfolio grows by 12% per year. If $1 million invested in stocks falls by 20%, you now have $800,000. If it rises by 25% the next year, you’re back up to $1 million. The average return of -20% and positive 25% is 2.5%. But you still only have a million bucks. Your actual return was zero.
- A 100% stock portfolio significantly increases the sequence of returns risk. For example, a U.S.-based investor, owning U.S. stocks in the 2000s and following an 8% withdrawal rule would have run out of money in as little as 13 years.
Source: https://www.thinkadvisor.com/2023/11/13/supernerds-unite-against-dave-ramseys-8-safe-withdrawal-rate-guidance/
I would add from a behaviour side of things, that a 100% stock portfolio, especially during retirement would be virtually impossible to stick with.
When it comes to Retirement Savings, One Size rarely fits all
Besides, don’t you want your retirement numbers to be based on personalized levels of evidence and reason, instead of hope and hype? I know I do, which is why I treat sweeping assumptions and general rules of thumb as starting rather than ending points.
By necessity, generic advice involves making assumptions, often huge ones, that may or may not reflect your own realities. The original 4% Rule, for example, assumed the investor is investing their retirement nest egg in 50% stocks/50% bonds, held entirely in tax-sheltered accounts. It also assumed a 30-year retirement.
Not everyone wants or needs to invest this conservatively. At the other end of the spectrum, Ramsey appears to assume you’re going to put your entire nest egg in the U.S. stock market, mostly large-company growth. He also seems to assume (quite erroneously) that we can rely on this market to deliver an average 12% pre-inflation return forever.
My take: There’s nothing nerdy about wanting to avoid hoarding or squandering your wealth. If your retirement years are short enough, your income remains ample enough, and your market timing is lucky enough, spending 8% annually in retirement might be right for you. For others, even 4% is overly optimistic. Either way, I wouldn’t bank on any given number without first engaging in some serious reality checks, and revisiting your plans as you proceed.
Let’s return to our fictional investors to illustrate how real-life retirement planning, withdrawal rate, and spending works.
Almost Ready to Retire: Jim and Carol Oates
You may recall from our last post, “Real Life Investment Strategies #1: Will Geopolitics Ruin My Financial Plans?”, Jim and Carol are recent empty nesters in their early 60s. Jim’s preparing to sell his business, so he and Carol can transition into a satisfying retirement. Together, they hope to catch up on some travel dreams, maybe help their kids buy homes, and possibly acquire a snowbird home somewhere warm.
Let’s assume we’ve now tackled the planning steps from our last post. The Oates have …
- Identified their personal financial goals, and where they stand on achieving them.
- Funded their lifestyle reserve to cover several years of non-discretionary spending.
- Allocated the rest of their investment portfolio for funding their long-term and discretionary retirement spending goals.
- Completed a “lifeboat drill” to help them prepare for withstanding bear markets, without feeling the need to abandon their long-term investment plan during scary times.
With respect to their retirement spending, here’s how I might advise them … step one, plug in the right assumptions.
None of us knows whether today’s assumptions will still hold true tomorrow. But instead of depending on shaky, generic numbers, we’ll focus on the Oates’ own “it depends” assumptions.
Longevity Assumptions: How long will Jim and Carol be spending in retirement? The longevity card is not only among the most uncertain in life’s deck, it’s also among the most important to your retirement spending plans. Jim and Carol are both relatively healthy. Plus, Carol’s parents are still going strong in their 90s. It would be prudent to consider a minimum 30-year spending plan, if not longer.
Account Management Assumptions: The original 4% Withdrawal Rule assumed a family’s nest egg was invested entirely in U.S. tax-sheltered accounts, where the money could grow more tax-efficiently over time. Because Jim was careful about managing his business value with an eye toward retirement, the Oates have accrued a modestly funded RRSP and some CPP benefits. Still, a good deal of their retirement income stream is still tied up in the business itself. The fate of these assets could significantly impact their ability to spend in retirement.
Investment Allocation Assumptions: All things considered, the Oates should be able to tolerate a higher allocation than 50% stocks/50% bonds. A higher allocation to stocks, in the 60% to 70% range is more in keeping with their spending goals, existing nest egg, and expectations surrounding the sale of their business. But we won’t stop there. To acknowledge how uncertain future returns can be, we also want to diversify their stock positions across not just U.S. and Canadian growth stocks, but also small-cap and value stocks, domestically and abroad. I have written many posts on asset allocation, including “Play It Again, Steve – Timeless Financial Tips #5: Trust the Evidence” and “Three Times You Might Want to Change Your Asset Allocation”. So, I won’t elaborate here.
Spending vs. Giving Assumptions: As I’ve mentioned before in my post “Retiring Reliably, Leaving a Legacy or Balancing Both?”, there are really only two ways to use money: you can spend it on yourself or you can pass it on to others. How much would Jim and Carol prefer to do of each? For them, a balanced approach seems to make the most sense. They’ve been working hard for years and are ready to enjoy some personal spending. But they also hope to help their adult children while Jim and Carol are still around to enjoy the outcomes.
Timing Assumptions: Based on the Oates’ spending goals, along with all of the above, we can now estimate how much they can expect to spend in retirement. But it’s also important to consider when they plan to spend it. We know, for example, that the Oates would like to do some traveling while they still have plenty of energy for it. They’d like to help their kids get a good start as homeowners sooner than later. This leads to a critical “it depends” insight:
Jim and Carol’s ideal retirement spending plan likely calls for higher spending in early retirement, with a probable drop in discretionary spending as they age.
Given this understanding, we might financially position the Oates for confidently taking a higher withdrawal rate early on and dialing it back once their major goals are accomplished.
We’ll also continue tracking the Oates’ financial position moving forward, adjusting as needed across their evolving personal goals and market conditions. For example, if markets throw us a curveball, Jim could postpone selling his business, or they could trim or delay their discretionary spending goals. If markets do better than expected, they can come up with new discretionary ways to spend the extra wealth and/or adjust their portfolio to reduce their continued exposure to market risks.
In short, to form and maintain Jim and Carol’s ideal retirement spending plan, we need to make and revisit the assumptions that make sense for them, not some mythical “average” investor.
The Accumulators: Suzie and Trevor Hall
In our last post, we also explored the financial lives of Suzie and Trevor Hall, who are in their late 40s and still deep in their accumulation years.
Many of the same principles we used with the Oates also make good sense for the Halls. If anything, the earlier you start tracking your personalized retirement assumptions, the more time you’ll have to integrate them into your ongoing financial plans. Granted, the younger you are, the more likely your retirement goals will shift by the time you get there. But the longer you’re able to invest toward your own “it depends” particulars, the more likely your money will be there to depend on as the future unfolds.
Suzie and Trevor’s goals will shift, and the plan will be revisited over time, but starting their unique assumptions-based plan early gives them the best savings runway for retirement spending success.
How much Savings should you plan for your Retirement?
It depends… on you!
How much of your total wealth can you spend joyfully in retirement without ever having to worry (even remotely) about becoming impoverished?
For most of us, at any age, this is the crux of the retirement planning equation. Personal lifestyle goals may vary from magnificent to modest. How much you’d like to give away to family or philanthropy may also vary widely. But nobody wants to end up scrimping and be forced to choose between covering their room and board or fulfilling their heartfelt dreams.
In this fashion, our goal at Lowrie Financial is to help you make the most of your money, based on your own one life to live. Let us know if we can tell you more.
Steve Lowrie holds the CFA designation and has 25 years of experience dealing with individual investors. Before creating Lowrie Financial in 2009, he worked at various Bay Street brokerage firms both as an advisor and in management. “I help investors ignore the Wall and Bay Street hype and hysteria, and focus on what’s best for themselves.” This blog originally appeared on his site on March 19, 2024 and is republished here with permission.
