Dynamic Spending in Retirement

You’ve probably heard of the 4% rule. It argues that, in order to make your retirement savings last through the end of your life, you first withdraw 4% of your retirement savings balance. Then, every year after that, you withdraw the same dollar amount adjusted for inflation.

The 4% rule was introduced by financial planning icon Willam Bengen in the early 1990s. Bengen used the historical returns available at the time and assumed a 30 year retirement time horizon.¹

While the 4% rule could still a useful guideline, there are other, more flexible and dynamic ways to approach spending in retirement you may want to consider.

A more flexible approach

Instead of a set percentage or dollar amount each year, a dynamic approach to spending in retirement allows retirees to reduce withdrawals in years when the markets decline, and increase spending and withdrawals in years when the markets rise.

The reduction in the withdrawal rate in down markets can help preserve your retirement nest egg over time. While in some years these reductions may seem negligible, over time, taking less when your accounts are down a bit can really help to preserve your assets.

The increase in the withdrawal rate in up markets can be used to splurge on expenses like travel, or a number of other priorities that go beyond everyday bills.

Here are four flexible approaches to retirement withdrawals and spending that you might consider.

The guardrails approach

The guardrails approach establishes guardrails of 20% above or below the initial withdrawal percentage. If the initial withdrawal dollar amount falls outside these boundaries, adjusted for inflation, it's then modified by +/- 10% to bring it in line with the guardrails.

Let’s look at how this might work for a hypothetical retiree with an initial retirement portfolio valued at $1.5 million, and an initial withdrawal plan of 4.5%.

In the first year, they would withdraw the initial 4.5%, or $67,500.

In subsequent years, the guardrails, or upper and lower limits on withdrawals, would be set at +/- 20% of the original distribution rate of 4.5%. In this example, that sets the guardrails at 5.4% and 3.6% of the amount of their portfolio each year, respectively.

The guardrails approach in an up market

Let’s say that in a subsequent year, the market goes up, and the portfolio is now worth $2 million with an inflation rate of 3%. The $69,525 withdrawal amount ($67,500 plus the 3% inflation) on a portfolio value of $2 million equates to a 3.476% withdrawal rate.

In this case, because the 3.476% falls outside of the guardrails, you would add 10% to the withdrawal amount of $69,525 to bring it to $76,478. This would be 3.8% of the current portfolio amount, and would fall within the 3.6% lower guardrail percentage.

The guardrails approach in a down market

Let’s say that in a different year, the market decreases, and the portfolio is now worth $1.2 million with an inflation rate of 3%. The $69,525 withdrawal amount ($67,500 plus the 3% inflation) on a portfolio value of $1.2 million equates to a 5.794% withdrawal rate.

In this case, because 5.794% falls outside of the guardrails, you would decrease the amount of the withdrawal by 10% to bring it to $62,573. This would be 5.2% of the portfolio amount, and would fall within the 5.4% upper guardrail percentage.

Why it works

The 20% guardrail in both directions serves to keep the investor from withdrawing too much in a down market, and also bumps up their distributions in an up market. The down market guardrail is especially important if the investor is hit with a sequence of returns risk situation early in retirement.

Note that hitting the guardrail in a down market does not necessarily mean a retiree will need to cut their overall spending. If withdrawals come from pre-tax retirement accounts, like a traditional IRA or 401(k), part of the reduction could come from the reduced taxes that will be due. Many retirees also have alternative sources of retirement income they can draw from in down markets.

As retirement continues, the sequence of returns risk becomes a much smaller concern. In this approach, the guardrail for down markets is done away with during what is estimated to be your final 15 years of retirement to account for that shift.

The annual inflation adjustments approach

Another strategy involves foregoing any inflation adjustment to your withdrawal rate in the calendar year after a market decline.² This approach assumes that the initial withdrawal amount from the first year is what you’d normally withdraw, adjusted for inflation.

For example, if the initial withdrawal amount was $67,500 in 2022, the S&P 500 declined by 18.11% in 2022, and the inflation rate was 8.3%, then instead of withdrawing $73,103 ($67,500 plus the 8.3% inflation), the investor would still withdraw $67,500 in 2023.

While in any single year the impact of this approach might be relatively minor, over longer periods of time these periodic reductions can help preserve your retirement accounts, which can go a long way to help ensure that your retirement savings last throughout your retirement years.

A phased approach

A phased approach to retirement spending entails spending more in your earlier retirement years. These are often the years when you're presumably healthier, more active, and more likely to travel. One important caveat is that spending on healthcare often increases as we get older.

This approach can be very flexible, but it is one that requires at least annual monitoring. Consulting with your financial advisor can really help.

The RMD approach

The RMD approach to retirement spending and withdrawals is patterned after the process for required minimum distributions, which uses the IRS Single Life Table to calculate the withdrawals for the coming year.² Instead of just dealing with an account or accounts where RMDs apply, this method applies the RMD withdrawal rate to all accounts.

As with actual RMDs, the percentage you withdraw becomes higher every year. However, because the percentage is calculated from the year-end value of your accounts, you’ll withdraw more or fewer dollars depending on the market’s performance.

Because it relies on the market’s performance, this approach can mean more volatility in your annual withdrawals.

Conclusion

The flexible spending and withdrawal strategies discussed above are four options that you can consider if you’re looking to build more flexibility into your withdrawals or spending than the 4% rule allows.

As you consider any retirement spending and withdrawal methodology, it's important to look at how it fits into and affects your personal priorities. These might include:

• Lifetime withdrawal rates
• Taxes
• Leaving a legacy for loved ones and/or charity
• The stability of your cash flow

No matter the methodology you choose, we recommend you review your withdrawal and spending rates on a regular, annual basis. Your wealth advisor can share their perspective on issues such as spending rate versus portfolio preservation, and of course any general tax implications that arise.

You also don’t have to pick one methodology and commit to it throughout your retirement; you can switch methodologies as appropriate. However, that doesn’t mean withdrawing “willy-nilly.” Even a flexible spending and withdrawal strategy needs ongoing monitoring and discipline to make sure that you don’t outlive your retirement savings.