Don’t spend too much or invest too conservatively
Individuals in retirement must balance longevity risk and lifestyle risk while facing sequence of return risk. Holding a balanced diversified portfolio and managing withdrawals over the long-term may help manage these competing risks.
Effects of traditional withdrawal rates and portfolio allocations
- When estimating an initial withdrawal rate and an appropriate portfolio allocation sufficient to sustain 30+ years of spending in retirement, many investors use the 4% rule, which has been the rule of thumb for several decades. The 4% rule is the withdrawal percent applied to the initial retirement portfolio value, translated to an amount that is grown by inflation each year to preserve purchasing power for thirty years. The goal is to provide a steady stream of income to the individual that ensures that he/she does not run out of money in retirement. Taking too much out of a retirement portfolio—like a steady 5 or 6 percent initial withdrawal—could deplete the account too soon, and being invested too conservatively or taking on too much risk, may also have adverse outcomes.
- The chart on the left illustrates the effects of different initial withdrawal rates at a 40% equity / 60% bond allocation. It compares initial withdrawal rates of 4, 5 and 6 percent from the portfolio over a potential 30+ year time horizon, and shows that setting a higher initial withdrawal rate may not provide the lifetime income needed to sustain a 30+ year retirement. A 4% initial withdrawal rate may be sufficient to ensure that the individual will not run out of money in retirement.
- The right portfolio allocation is key to aligning with the withdrawal rate set: a conservative portfolio allocation may fall short of an investor’s needs but a balanced portfolio may allow the investor to withdraw the amount necessary to meet retirement needs.
- Consider a more dynamic approach-in setting an initial withdrawal rate and building a balanced portfolio- to ensure that individuals efficiently use their savings while making sure that they don’t run out of assets too quickly.
Changes in spending
- While the 4% rule may be standard guidance for investors when setting an appropriate initial withdrawal rate for retirement, it does not reflect realistic spending behaviors throughout an individual’s life. In fact, by setting an initial 4% withdrawal rate, an investor is making a tradeoff between the immediate need for income to satisfy his/her current lifestyle against the fear of running out of money later in retirement.
- Spending behaviors change over an individual’s lifetime. For average households, spending peaks between ages 45- 54 and thereafter declines with age.
- This slide illustrates what the average college educated household spends on major expenditures at specific ages.
- Consider that the largest lifetime expenditure is housing, in light and dark blue, and that health care spending in orange continues to increase into retirement.
Dollar cost ravaging - timing risk of withdrawals
- One of the biggest risks in retirement is sequence of return risk: this occurs when an individual retires at the beginning of a declining or bear market and when withdrawals begin.
- As the top chart illustrates, a volatile market early in retirement while taking withdrawals may ravage a retirement account, even if the market recovers in later years.
- Entering retirement with a well-diversified portfolio that manages the level of risk and provides downside protection, along with adjusting withdrawal rates along the way may help to alleviate the damage.