Are You Spending Too Much in Retirement?

Christine Benz: Pitfall 2 that I want to touch on is overspending in retirement, and this is something that I do observe when I work on some of the portfolio makeovers for people who are actively drawing upon their portfolios. I would just start by saying setting an in-retirement spending rate is one of the hardest problems in financial planning, in part because it rests on a lot of unknowables. At the top of the list would be how long you’ll live. None of us knows how long we’ll live. It’s very difficult to plan for that uncertain time horizon. Will it be 15 years? Will it be 35 years? We don’t really know at the outset of our retirements.

We also don't know how the market will perform or behave over our specific drawdown period. That's another big wild card. We don't know what inflation will run. We had several decades leading up to this year where inflation was nice and low. Now we're seeing inflation run at more meaningful levels. We don't know whether that will persist in the future. People who are setting up their in-retirement withdrawal plans today don't know how high to make inflation to adjust their spending in retirement.

And finally, you don't know the trajectory of your own spending. Even though you may have done your forecasts and even factored in big-ticket items like cars that you'll need to buy or home repairs that you'll need to make, it's difficult to account for each and every last expense in retirement. In fact, I often hear from retirees who talk about some big wild-card expense that came out of the blue, like big dental bills or big home repairs, things that they just didn't account for, and a biggie in many plans today especially is uninsured long-term-care expenses. Many people have decided to forgo long-term-care insurance because their portfolio values have been so nicely enlarged, but they're not sure whether they will have long-term-care expenses, and they're not sure how large those expenses might be.

This slide, I think, nicely illustrates how the right withdrawal rate is so time-period-dependent and so dependent on how stocks and bonds perform over your specific drawdown period. This is a slide that was prepared by my former colleague David Blanchett, and this looks at the right starting withdrawal rate over rolling 30-year time horizons in market history. And you can see that over various points in time that the retiree got lucky and was able to take more out of his or her portfolio because the markets performed really well, and at other points in time, retirees weren't so lucky and would have had to make do on less if they wanted their portfolios to last over a 25- or 30-year time horizon.

I would just call your attention to the period in the mid-60s to early 70s. That's the period that financial planner Bill Bengen focused on when he did his seminal research on in-retirement withdrawal rates and concluded that even if you encountered an Armageddon-type market that roughly 4% was the most you could have taken out in that very bad time period. That's where the 4% guideline came from. But this slide illustrates how the right withdrawal rate really has been all over the map depending on what the stock market did, depending on what the bond market did over the specific 30-year horizon.

Before we go any further, it's important to understand what the 4% rule stipulates. First of all, it doesn't mean that you take 4% of your balance year in and year out. That's largely because most retirees don't want that kind of fluctuation in their annual portfolio withdrawals. If you think about it, taking 4% of a balance in 2022 when almost everything in your portfolio is down would mean a meaningful reduction in your spending. Most retirees just aren't comfortable with those types of radical adjustments. Instead, the 4% guideline assumes that someone takes a 4% starting withdrawal in year one of retirement and then inflation-adjusts that dollar amount thereafter. So, assume that someone has a $1 million portfolio. Four percent of that $1 million portfolio would translate into a $40,000 portfolio withdrawal in year one of retirement. That would be $41,000 and change in year two of retirement, assuming a 3% inflation rate. But the base idea there was that Bill Bengen knew from working with clients that retirees didn't want to have huge fluctuations in their portfolio cash flows. They wanted something resembling their paycheck in retirement. They wanted a stable standard of living from the portfolio. Bengen, as I mentioned, stress-tested the 4% guideline over many different market environments. It's been subsequently stress-tested and has held up pretty well. So, I think that's one reason why I think it's a reasonable starting point as you think about your in-retirement spending rate and setting that spending rate.

But there are a couple of important caveats to bear in mind in line with that 4% guideline. One is that it's based on historical market returns. But of course, we all know that the future could look quite different than the past. If the market turns out to be worse over your own 25- or 30-year time horizon than it was in any of the periods that Bengen observed, the risk is that if you take the 4% guideline and run with it, you could overspend and then have to cut back later in life. I think that's something that most of us would rather avoid if we possibly could.

On the other hand, if the market is meaningfully better than the 4% guideline assumes, you'll have underspent relative to what you might have. And that was really a problem that has been encountered by many retirees over the past couple of decades. That's why many retirees have found that even as they have maintained a stable standard of living in retirement, they've seen their portfolios grow nicely. They're nowhere close to spending all of their funds during their retirement. But again, it's luck of the draw. For new retirees, it's generally better to be safe rather than sorry—to start a little bit more conservatively and potentially give yourself a raise if the market returns turn out to be better than you had expected.

Then another big caveat in the realm of the 4% guideline is that, even though Bengen assumed that retirees wanted something resembling a paycheck in retirement, when we examine the research, we see that retirees don't actually spend this way. This is some research that my former colleague David Blanchett did on the topic of how retirees actually spent. And the pattern he observed was that spending tended to trend down throughout the retirement years. It started strong in those pent-up demand years, the early years of retirement, the go-go years they're sometimes called, then tapered down in what have been termed the slow-go years, really, really declined in sort of the mid-80s, and then trail back up later in retirement to account for healthcare expenses, oftentimes uninsured healthcare expenses. This is a pattern that David Blanchett observed looking at retirees' spending across the in-retirement time horizon. This certainly syncs up with the experience that I've had with older adults in my life, helping them manage their portfolios and their spending, I've definitely observed a pattern along these lines. Arguably, the 4% guideline, in that it assumes that static standard of living, perhaps overaccounts for spending in the mid- to later years of retirement relative to how retirees actually spend.

A couple of key takeaways as you set your retirement spending rate: A key one is that flexibility pays. Pay attention to your portfolio balance. You don't need to use just a fixed portfolio withdrawal, but if you can tune into your portfolio balance and take less in down markets like 2022, that will tend to read down to the benefit of your spending plan. It will tend to lead to a more sustainable spending plan. And the other nice thing about being flexible is that you can take potentially more in good markets. In environments like 2019 through 2021, for example, retirees who saw nice gains in their equity portfolios could potentially take more during those years. Staying flexible is a great takeaway. Even if you're using something like the 4% guideline, planning to make those periodic course corrections is really valuable.

A key point I would make, though, and this is top of mind in 2022′s inflationary environment, is if you are taking those downward adjustments, they may not feel great, especially when inflation is high or in those early years of retirement, in those go-go years where you had a lot of plans to do, say, heavy travel or other big outlays, having to take a downward adjustment to account for the fact that your portfolio hasn’t performed especially well—that may not feel especially great.