Living in Retirement
The 4% rule and a dynamic retirement spending plan
April 04, 2014
Colin Kelton: We have a question from Jonathan in Philadelphia, right in our backyard. Jonathan asks, "What is your position on the 4% withdrawal rule at the time of retirement?" We talk about this a lot. Maria, why don't you start?
Maria Bruno: I think it's a good foundational question because that by far, I think, is the major question that we get these days primarily around the interest rate environment that we're in. We do believe that 4% is a reasonable starting point for someone who is entering retirement. I think it's probably a good idea to just take a step back and talk about what's baked into that 4%.
There's two main factors, one being time horizon. So, when you think about the 4% spending rule of thumb, what it's predicated upon is it assumes a balanced portfolio anywhere from 40% to 60% equity, for example, and over a 30-year time horizon research shows—and our research supports it as well—that by spending 4% inflation, dollar-adjusted, over a 30-year time horizon, there's a very strong likelihood that the portfolio would be sustained through that period.
When you think about that in terms of time horizon, if you have someone who is an early retiree, for example, retiring in their 50s, then they would probably need to spend on the lower side of that, maybe around 3%. The flipside would be if you have someone who's in advanced retirement, maybe somebody in their 80s, they shouldn't be tied into a 4%; they can probably spend more.
So time horizon is important. Asset allocation is another factor that's important. So we assume in these simulations of balanced portfolio anywhere, as I said, 40% to 60% equity. If you're more conservatively invested, then certainly, a lower sustainable withdrawal rate would make sense.
Conversely, if you're more aggressively allocated, then you could feasibly spend more, but the thing to keep in mind is, particularly with shorter time horizons, that the portfolio is basically exposed to more market risk or volatility risk. So the frequency of losses may not change, but the magnitude of losses might.
That's some context around the 4% spending rule. The other thing that I would probably mention to that would be, it is based upon a dollar inflation-adjusted withdrawal, and what that means, let's just use an example. So we have $1 million portfolio and you want to spend 4%. That means in the first year you could spend $40,000, and then what you do every year thereafter is increase that amount by inflation. So it's designed to provide a very predictable income stream.
What it doesn't do, though, it doesn't look to the portfolio. So it totally ignores market performance and subjects an investor to market risk or return of sequence risk. So what happens, particularly if you're a retiree and during your early retirement you sustain some losses, that's where the risk is with this, because you're increasing your spending, but your portfolio balance may be low. You may think you're spending 4%, but it really could be 6% or upward. So you really need those checks and balances.
An alternative approach would be percent of portfolio, which is exactly that. You take 4% of your portfolio balance every year and you spend that. The trade-off to that is, technically you would never run out of money but it does subject the portfolio to more annual volatility. So some trade-offs there. In reality, investors don't pick one or the other, probably more of a hybrid approach.
Colleen Jaconetti: We actually would recommend and advocate, more of a hybrid or dynamical approach to spending that kind of combines the two methods that Maria has talked about. Our dynamic approach is actually in one of our papers and it kind of says we are going to base the portfolio withdrawals each year based on a percent of portfolio, but then we will put some checks and balances in. So then we would compare that spending amount to, say, a ceiling and a floor. If someone were to decide to spend more or less, kind of the market gave you more than the ceiling amount, you would limit your spending to the ceiling. If based on the market performance the withdrawal amount was below the floor, you would actually only drop your spending by that amount.
Colin Kelton: I think our audience right now is looking at a chart that kind of shows that. How would you calculate the ceiling and the floor?
Colleen Jaconetti: If we started with an example, say $1 million portfolio with a 4% spending, so the initial year you would spend $40,000. If you assume a 10% return, at the end of that year you would have $1,060,000 left in the portfolio, which would be shown in that middle column there on the example. So 4% of that would be $42,400, and then the ceiling and the floor are actually the year-over-year change in real spending.
What we would do is, say we take the $40,000 from the prior year and grow it by 5%. We would say the year-over-year change in spending can't be more than 5%. And then we would also calculate a floor, so we would say the year-over-year change in real spending can't drop by more than 2.5%. What this does, it kind of provides guardrails, so there is some stability in spending. It's not percent of portfolio, where your amount of spending each year is really dictated by what happens with the market, but it does take market performance into account, which is helpful as well.
In this example, the ceiling is $42,000, so it would be the 5% of the $40,000 from the prior year, or the floor would be $39,000, which is the $40,000 less $1,000 for the floor. So because the ceiling of $42,000 is higher than the calculated percent for the year, you would actually limit your spending to $42,000 as opposed to spending the $42,400. Hopefully, that $400 will get reinvested in the portfolio, so that in future years if there were bad times you could actually use that.
And while I went through that example maybe a little bit quickly, there is detailed calculations and there should be a URL at the bottom of the screen to direct you to a paper where all the assumptions and this actual example is written out in a lot more detail
Colin Kelton: There's a lot there, it's great that we point people to that. But two things that strikes me when you kind of read through the answer, one is it's not necessarily a "set it and forget it" strategy.
Colleen Jaconetti: Definitely not.
Colin Kelton: But you need to have some sort of strategy, just don't enter it and start winging it. Have a strategy and then adjust as you go forward, but make sure you know what you're doing.
Colleen Jaconetti: Absolutely.
All investing is subject to risk, including the possible loss of the money you invest.
For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
This webcast is for educational purposes only. We recommend that you consult a financial or tax advisor about your individual situation.
© 2014 The Vanguard Group, Inc. All rights reserved. Vanguard Marketing Corporation, Distributor.
You can use a hybrid spending approach
What's baked into the guideline of spending 4% of your portfolio annually in retirement? Vanguard retirement experts Maria Bruno and Colleen Jaconetti suggest adopting a flexible spending plan that combines both percentages and dollar amounts when taking withdrawals.
Other excerpts from this webcast:
- Tax-savvy withdrawals in retirement
- Required minimum distribution basics
- Annuities and your retirement portfolio
- The biggest mistake people make with their retirement portfolio
- All investing is subject to risk, including the possible loss of the money you invest.
- For more information about Vanguard funds, visit vanguard.com or call 877-662-7447 to obtain a prospectus. Investment objectives, risks, charges, expenses, and other important information about a fund are contained in the prospectus; read and consider it carefully before investing.
- When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
- Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.
- This webcast is for educational purposes only. We recommend that you consult a financial or tax advisor about your individual situation.