Setting a strategy for retirement withdrawals
How to know what you can spend
Self-control is a personal trait that can make someone a great saver, but paradoxically, it can lead them to struggle when it's time to benefit from those savings.
Many studies—including our own research*—have shown that well-off retired investors often don’t spend much of their retirement savings, and their accounts can continue to grow. It's not a terrible problem to have, of course—but it could mean they don’t know how much is "safe" to spend and thus are overly frugal, sacrificing their enjoyment of retirement.
See other behavioral factors that can affect retirement spending
As you plan how to use your retirement money, you want a strategy that accomplishes 2 often-competing goals: 1) having enough money to support your desired lifestyle, and 2) ensuring there's plenty left for the future, including any money you plan to leave to heirs. We've got a withdrawal strategy that can help you with both. But first let's review the traditional approaches.
Traditional withdrawal strategies: Pros and cons
The dollar-plus-inflation strategy calls for you to spend a percentage of your portfolio the first year and adjust that amount in subsequent years based on inflation. Here are a few things to note about this strategy:
- The "4% rule" is a popular example of dollar-plus-inflation. If your expenses won't change much throughout retirement, it ensures you'll be able to cover your yearly costs for as long as the portfolio lasts (goal 1).
- It ignores market conditions, so you could end up running out of money (in down markets) or spending much less than you can afford (in up markets).
- It could be best for you if your main priority is maintaining a steady level of spending from year to year.
The percentage-of-portfolio strategy calls for you to spend a fixed percentage of your portfolio every year. This strategy:
- Gives you complete confidence of achieving goal 2—not running out of money.
- Results in yearly spending amounts that are completely market-driven and could fall short of what you need to live.
- Could make sense for you if your main concern is ensuring you don't deplete your portfolio and you can adapt your budget to a wide range of spending levels.
You want a strategy that accomplishes 2 often-competing goals: 1) having enough money to support your desired lifestyle, and 2) ensuring there’s plenty left for the future. We’ve got a strategy that can help you with both.
-Vernell Peter-Koyi, CFP®, Senior Financial Advisor
How to choose an initial withdrawal amount
No matter which strategy you choose, you'll start by selecting a withdrawal amount for the first year. In the planning phase, many retirement calculators rely on this as a critical component to determine how much you need to save.
Although 4% is a popular guideline, research has established it as "safe" only for specific time frames and allocations. And safe means different things to different people. For you, 4% could be too much—or too little. Here are the factors we consider when choosing a withdrawal rate for an individual client:
4 levers affecting withdrawal rates
This graph illustrates the 4 factors that influence how much or how little you should withdraw. The first line, time horizon, shows that you should withdraw at a lower rate if you have a longer horizon and at a higher rate if you have a shorter one. The second line, asset allocation, shows that you should withdraw at a lower rate if you have a more conservative asset allocation and at a higher rate if you have a more aggressive one. The third line, spending flexibility, shows that you should withdraw at a lower rate if you don't mind less spending flexibility and at a higher rate if you'd prefer more spending flexibility. The fourth line, degree of certainty desired, shows that you should withdraw at a lower rate if you desire a higher degree of certainty and at a higher rate if you're comfortable with a lower degree of certainty.
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Need a retirement withdrawal strategy? Our advisors are here for you.
Dynamic spending strategy
Since many people equally prioritize spending levels and portfolio preservation, we created a retirement strategy that achieves both important goals—covering current spending while aiming to preserve enough money for the future.
Dynamic spending—a hybrid of the dollar-plus-inflation and percentage-of-portfolio rules—does just that. It builds on people's natural tendency to spend more when markets are up and less when markets are down—but moderates the wild swings you get when giving market performance free rein over your spending.
In other words, it achieves a happy medium. Your spending is more flexible than with a dollar-plus-inflation approach but also more stable than with the percentage-of-portfolio approach. It's also completely customizable, so in addition to deciding how much to withdraw the first year, you decide how much you're willing (and able) to raise or lower your spending in response to market movements.
To use dynamic spending, you calculate the upcoming year’s spending by adjusting the amount of this year’s spending based on your portfolio return for the year. But you don’t go any higher than the “ceiling” or any lower than the “floor” you set as part of your strategy.
Spectrum of spending rules
This graph shows the spectrum of the 3 spending rules. On the left is the dollar-plus-inflation rule with a 0% ceiling and floor, in the middle is the dynamic spending rule with a 5% ceiling and –1.5% floor, and on the right is the percentage-of-portfolio rule with an unlimited ceiling and floor. Underneath the spending rules are 4 lines showing the different portfolio characteristics and how each rule impacts them. The first line, market performance, shows that dollar-plus-inflation ignores market performance, dynamic spending is somewhat responsive to it, and percentage-of-portfolio is highly responsive to it. The second line, short-term spending stability, shows that short-term spending stability is stable with dollar-plus-inflation, fluctuates within limits with dynamic spending, and is variable with percentage-of-portfolio. The third line, spending flexibility, shows that spending flexibility is less flexible with dollar-plus-inflation, more flexible with dynamic spending, and highly flexible with percentage-of-portfolio. The fourth line, portfolio viability, shows that portfolio viability is unpredictable with dollar-plus-inflation, is more stable with dynamic spending, and can't be depleted with percentage-of-portfolio.
This framework allows you to decide how much you want to benefit from good markets by spending a portion of those gains. And it enables you to weather bad markets without substantially reducing your spending.
Best of all, dynamic spending can mean greater spending levels throughout retirement. For example, our historical research† showed that a retiree with a portfolio of 50% stocks/50% bonds could withdraw 4.3% a year with 85% confidence that the portfolio would last through 35 years of retirement. But by incorporating dynamic spending, with a –1.5% floor/5% ceiling, that retiree could withdraw 5.0% a year and have the same level of confidence.
Dynamic spending on FIRE
Careful spending is even more important for early retirees. We looked at sustainable withdrawal rates for the "financial independence retire early" (FIRE) community and found a safe withdrawal rate of 3.3% for someone with a 50-year time frame using the dollar-plus-inflation strategy. But by using dynamic spending instead, the safe rate increased to 4.0%.‡
Setting your floor and ceiling as well as deciding on the right initial withdrawal rate means you'll need to make several decisions and maintain an additional level of oversight to use dynamic spending. And since all these factors depend on your personal time horizon, allocation, retirement income sources, and priorities, there's no right answer for everyone.
If you're interested in incorporating dynamic spending into your withdrawal strategy, you can learn more in our research paper. Or set up a consultation with an advisor from Vanguard Personal Advisor®.
*Source: Vanguard, Drawdown from Financial Accounts in Retirement (Thomas J. De Luca and Anna Madamba, July 2021).
**This is an example of a possible ceiling/floor combination. When you use dynamic spending, you set your ceiling and floor based on your individual situation. An advisor can help you choose the combination that makes sense for you.
†Source: Vanguard, From Assets to Income: A Goals-Based Approach to Retirement Spending (Colleen M. Jaconetti, CPA, CFP®, et al., April 2020).
‡Source: Vanguard, Fuel for the F.I.R.E.: Updating the 4% Rule for Early Retirees (Paulo Costa, Ph.D., et al., June 2021).
Ready to build your withdrawal strategy?
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All investing is subject to risk, including the possible loss of the money you invest.
When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.
We recommend that you consult a tax or financial advisor about your individual situation.
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