How to Never Run Out of Money in Retirement With Dynamic Spending
Dear Rich Lifer,
Is 2020 the worst year ever?
It depends who you ask.
If you’re Netflix, Zoom, or Amazon, 2020 is shaping up to be one of the best years ever.
But if you’re one of the 20.6 million Americans who lost their job due to the coronavirus pandemic or you’re one of the many older workers forced into early retirement, you probably can’t wait for this year to end.
What if you did have to retire this year? How will 2020 affect your nest egg?
If you think retiring in 2020 is bad, just be glad you didn’t retire in 1966.
1966 was the year Star Trek premiered on NBC, it was the year the Doors recorded their debut self-titled LP, and the year the Baltimore Orioles won their first World Series…not so bad, right?
Well…1966 was also the worst year ever to retire, going as far back as 1871.
The Birth of the 4 Percent Rule
In 1994, a financial advisor named William Bengen published an article outlining how much retirees can safely withdraw in their first year of retirement so that their portfolio lasts a lifetime.
Bengen looked at data from 1926 through 1976, examining actual stock and bond market returns and inflation. The goal was to find the highest initial withdrawal rate a retiree could take without running out of money for at least 30 years, assuming the retiree would withdraw the same amount each following year but adjusted by the rate of inflation.
What Bengen found was that 1966 was the worst year ever to retire. If you retired in 1966, and you withdrew more than 4 percent, you would have depleted your retirement savings in less than 30 years.
This is how the 4 percent rule started. What a lot of people don’t realize, however, is the 4 percent rule is not derived from an average. It comes from taking the worst case scenario we’ve seen in modern times.
Another advisor named Michael Kitces, extended Bengen’s work all the way back to 1871. His findings were the same. 1966 is still the worst year ever to retire, but 1907, 1929, and 1937 were close runners up.
All this to say, a new year still can overtake 1966 as the worst year to retire (maybe 2020?). For now, following the 4 percent rule is a conservative approach to retirement planning.
But is the 4 percent rule the best approach?
Static vs. Dynamic Spending
Imagine you have a retirement portfolio worth $1 million.
Following the 4 percent rule, you would withdraw $40,000 in your first year of retirement.
The second year, however, your distributions are no longer calculated based on a percentage of your remaining portfolio. So, you would withdraw $40,000 but adjusted for inflation.
In this way, your withdrawals are static on an after-inflation basis.
The Issue With Static Spending Rules
As you can guess, the 4 percent rule and most static spending rules have their flaws. The three main issues with static spending rules are:
- They assume spending doesn’t change throughout retirement, when in reality it usually does.
- They’re based on the worst possible outcomes for market returns and inflation, which can cause retirees to withdraw and spend a lot less than they could otherwise.
- There’s no way to calculate future returns, so retirees don’t know if they’re over- or under-withdrawing. This makes it hard to make corrections mid-course.
Dynamic Spending Rules
Another approach to retirement withdrawals and spending is to look at distributions based on actual market performance and the inflation rate. This is called dynamic spending.
Dynamic spending rules also tend to incorporate “guardrails” to adjust annual withdrawals, either up or down, so that you don’t have to worry about over or underspending.
Here are two examples of dynamic spending you can try…
The Yale Spending Rule
Believe it or not, University endowments run into some of the same problems as retirees. They want to withdraw as much as possible each year to fund the school, but they also need to preserve their nest egg.
The solution Yale University has come up with looks like this:
- 70 percent of the amount of the distribution from the previous year, adjusted for inflation, plus
- 30 percent of the moving average of the endowment’s balance over the past three years multiplied by a set spending rate (e.g., 5 percent)
Step one accounts for inflation. Step two adjusts distributions based on the endowment’s portfolio performance.
Here’s an example: Assume you plan to withdraw 5 percent from your $1 million portfolio in your first year of retirement. We can also assume inflation is around 2 percent and the 3-year moving average for your portfolio balance is $960,000.
Your second year distributions would look like this:
- 70 percent of last year’s distribution ($50,000), adjusted for inflation: $35,700 ($50,000 x 70 percent plus the 2 percent inflation adjustment).
- 30 percent of the 3-year moving average portfolio balance ($960,000) times the initial spending rate (5 percent): $14,400 ($960,000 x 30 percent x 5 percent).
Add these two figures together and your second-year distribution would be: $50,100.
Lastly, the Yale Spending Rule also includes guardrails so that the university does not spend too much or too little each year. The calculated distributions must equal at least 4 percent of the portfolio but no more than 6.5 percent.
Kitces Spending Rule
Michael Kitces came up with an even simpler way to calculate distributions dynamically. He says:
- Start with a 5 percent initial withdrawal rate
- Adjust the amount each year by the rate of inflation
- Never take out more than 6 percent of your portfolio (guardrail)
- Never take out less than 4 percent of your portfolio (unless you don’t need the money)
Whether you choose a static or dynamic spending rule, it’s best to err on the conservative side.
The beauty of dynamic spending rules is the fact that you have the ability to change course if you find your nest egg growing or shrinking. We hope 2020 is not the new 1966, but even if it is you can still enjoy a comfortable retirement by following these three strategies.
To a richer life,
The Rich Life Roadmap Team