What You Spend In Retirement Is More Important Than How You Invest
A critical element of establishing a plan for retirement is setting an appropriate asset allocation, especially as you approach the time when you begin living on your savings. Typically, this entails determining how much of your portfolio should remain invested in stocks, and how much should be allocated to safer, lower-return investments like bonds. Investors get very concerned (and rightly so) about the level of risk in their investments once they become dependent on those investments for day to day spending. After all, most of us recall being told to invest heavily in stocks when we are young, when we have plenty of time to recoup short-term losses and achieve the most growth. It is logical to conclude that we should begin to reduce our risk as we age by investing in "safer" assets such as bonds and cash. The question we often hear is: how much stock should be in my portfolio at retirement?
What's Your Withdrawal Rate?
Before looking at your asset allocation, you should first evaluate your expected portfolio withdrawals. Your withdrawal rate is the percentage of your total investable assets that you need to liquidate and distribute to meet your annual income needs. Specifically, after accounting for income from Social Security, pensions or any other business interests, what additional money will you need to withdraw each year to meet your total expense budget? This amount as a percentage of your total liquid investable assets (excluding personal real estate, and illiquid holdings) is what we call your initial retirement withdrawal rate.
"Your withdrawal rate is the percentage of your total investable assets that you need to liquidate and distribute to meet your annual income needs."
For example, assume that you have a total portfolio of $1,000,000 and require $40,000 per year from your portfolio to supplement your Social Security and other income. $40,000 represents a withdrawal rate of 4% of your total investment assets. The most important test of retirement readiness is whether your nest egg is sufficient to support your initial withdrawal rate. Studies have shown that regardless of what asset allocation you employ, the higher this initial withdrawal rate, the more risk you have of depleting your assets during retirement. Likewise, the lower this rate, the lower your risk of running out of money.
One of the reasons the initial withdrawal rate is so important is because of the long term impact of inflation. For example, if a 60 year-old retiring today requires $40,000 from her portfolio to meet her needs, assuming a 3% rate of inflation, she will require twice that amount ($80,000) by the time she reaches 84. Obviously, this means she is forced to take out more and more money in dollar-terms each year to keep up with rising costs. If her initial withdrawal rate is too high, she will rob her portfolio of principal in the early years, and miss out on the future growth she’ll need to meet her long term spending goals.
How Much Spending Is Too Much?
Since the mid-1990s, financial planners have embraced something called the “4% Rule” as the reasonably “safe” maximum rate for retirees to withdraw in their first year of retirement. You then increase the resulting dollar amount each year to keep pace with inflation, while the rest of the funds remain invested. There are lots of issues with the 4% rule, and like all rules of thumb, it can be dangerous if followed blindly. When the rule was introduced, it relied on testing from prior market periods which typically enjoyed higher returns from stocks and bonds than investors have experienced in recent years. Furthermore, with life expectancies on the rise, the amount of time a person can expect to live in retirement has increased as well, meaning retirees need their monies to last longer than in the past. This has put a lot of pressure on the merits of using the 4% rule for distribution planning.
"Maintaining investments in stocks is one of the few ways a retiree can increase the odds of living well throughout what could be several decades."
For example, in 2012, Vanguard published updated research that showed a very conservative portfolio of roughly 20% stocks and 80% bonds had about an 85% probability of lasting 25 years if the investor initially withdrew 4%, and then increased that amount by inflation. For a healthy 65 to 70 year old, 4% might indeed still be a reasonable withdrawal rate --- but only if you expect to live just 25 years! If a person expects to live longer, 30 or even 35 years, a conservative investor would likely need to reduce their withdrawal rate to between 3.1% and 3.5% in the early years, just to enjoy the same probability of success.
Or, looked at another way, if that same investor could endure the risk associated with a portfolio of about 60% stocks and 40% bonds, she should be able to initially withdraw up to 3.9% and not expect to deplete assets within 30 years. In this example, taking additional risk in the portfolio’s asset allocation improves the odds of not running out of cash in retirement, and with a slightly higher spending rate. The reality is that to keep pace with inflation and longer lifespans, most people will require more growth than can reasonably be expected from a bond-centric portfolio -- at least in the early years of retirement -- and stocks need to be a significant part of their asset mix.
It’s important to note, however, that a retiree cannot simply continue to increase their spending and then increase the risk of their portfolio to offset it. Returns from stocks and bonds are not linear — meaning they are not consistent year to year — and short term market corrections can result in dramatically different results, especially if the investor has to sell riskier assets like stocks when they are down.
For example, what if an investor wants to withdraw between 6% and 7% from their portfolio and increase that amount by inflation each year? Can the investor just invest more aggressively and expect to live 30 or 35 years in retirement? Maybe. But not likely. From the same study above, regardless of how conservative or risky the underlying portfolio was — the funds were not expected to last more than about 15 years with such a high withdrawal rate. So, if you’re 80 years old, perhaps a 7% withdrawal rate is reasonable. A much more conservative portfolio with less stocks and more bonds is probably also prudent. But for most younger retirees, with 25 to 30 years of life ahead of them, even a 5% withdrawal is probably too high.
Stocks For The Really Long Term
With interest rates at historic lows and life expectancies continuing to rise, maintaining investments in stocks is one of the few ways you can increase the odds of living well throughout what could be several decades of retirement. Another is to keep a tight rein on spending.
At the end of the day, having a prudent retirement plan starts by understanding what you will need to spend, and how your nest egg stacks up by comparison. As we have said, the rate at which you spend has an even larger impact on retirement success than your portfolio’s allocation. While there is no way to guarantee results or predict safe distribution rates in the future, it is prudent in our opinion to view the old 4% rule as an upper maximum on one’s initial retirement spending. And for younger retirees looking to enjoy 30 or 40 years, a initial withdrawal rate of 3 to 3.5% makes more sense.
This also assumes investors are willing to maintain significant exposure to more growth oriented assets, like stocks, for the first decade or so of retirement. This may fly in the face of what most retirees hoped for — to greatly reduce (or eliminate) stocks from their portfolios at retirement and give up worrying about the day to day gyrations of financial markets. However, unless retirees can dramatically reduce their spending as a percentage of their overall portfolio, they will likely need to embrace stocks, and the risks they entail, for a while longer.
 Vanguard Research, Revisiting the ‘4% spending rule,’ August 2012.