IT’S CHALLENGING TO GO from saving during our working years to spending in retirement. Our solution: Use a modified version of the 4% rule.
Financial planner William Bengen was the first person to articulate the 4% rule. He wanted to know how much people could withdraw from their investments each year and still not run out of money. Through extensive back-testing, he found that if folks withdrew 4% in the first year, and thereafter increased this amount each year for inflation, in almost all cases they wouldn’t run out of money over a 30-year retirement.
With Bengen’s 4% rule, the amount withdrawn is driven only by the initial portfolio value and subsequent inflation. History suggests this approach should be okay despite sequence-of-return risk—the danger that the financial markets perform poorly during the years immediately after a person retires. Still, folks who retire and keep taking out an inflation-adjusted 4% do run some risk of running out of money.
I believe it’s reasonable to increase spending when the markets are doing well, while also cutting back when markets perform poorly. Bengen’s model doesn’t incorporate this. Vanguard Group developed a withdrawal method which does. I have read its guide several times and, I must confess, I still don’t understand it.
What to do? For my wife and me, I had three criteria for our retirement withdrawal strategy. First, it should be simple, something I can use when I’m 90 years old. Second, the approach should be responsive to market returns. Finally, it should be financially conservative, meaning there’s reasonable certainty we won’t run out of money before we die.
A withdrawal each year that’s simply 4% of the prior year-end balance—without the inflation adjustment in Bengen’s approach—meets these three objectives. With such a plan, a person would never run out of money. Each year, you always leave 96% of your portfolio invested. And it’s certainly simple. But a major drawback is that the amount withdrawn each year fluctuates widely because market returns are so erratic.
That’s why I nixed the idea of simply withdrawing 4% of our prior year-end balance. Instead, I’ve made two modifications, which I have found to be extremely helpful.
First, rather than using last year’s Dec. 31 balance, I apply a percentage to a three-year rolling average of year-end balances. It allows for significant spending increases only if there have been sustained market gains, while cutbacks are only required if there’s a prolonged bear market. Second, because I’m financially conservative, instead of 4%, I use 3%.
The upshot: We limit our annual withdrawals to no more than 3% of our average investment balance for the prior three year-ends. I believe this is a simple yet elegant solution. Because of a lifetime of frugal habits, we’re in the fortunate position that we could live on Social Security and a modest pension I receive. We use withdrawals from our nest egg primarily for gifts to individuals, contributions to charitable organizations and to fund a major overseas trip every few years.
Because we’re heavily invested in stocks and limit our withdrawals to 3%, I fully expect our investments to continue to grow. When the time comes, hopefully a decade or more away, we’ll spend what we need to for assisted living or nursing care, even if it exceeds the 3%.
We have just three investment accounts: a traditional IRA, a Roth IRA and a regular taxable investment account. Each January, I enter the year-end amounts for the three accounts in a simple spreadsheet. It totals the three accounts and calculates the three-year rolling average. The calculation could also be done by hand. If I pass away first, my wife can easily take over.
After a lifetime of saving, we initially found it unsettling to make withdrawals from our investments. But with this plan, we sleep well at night, enjoy the fruits of our earlier saving and remain confident we won’t run out of money.
Larry Sayler is the only person with a Wharton MBA who also graduated from Ringling Bros. and Barnum & Bailey’s Clown College. Earlier in his career, he served as CFO for three manufacturing and service organizations. For 16 years before his retirement, Larry taught accounting at a small Christian college in the Midwest. His brother Kenyon also writes for HumbleDollar. Check out Larry’s earlier articles.