5 Must-Knows About In-Retirement Spending

Key Takeaways

• Beginning conditions in retirement matter a lot. Starting conditions at the outset of our retirement can give us a little clue as to how the market might behave, at least over the first 10 years of our retirement.
• Asset allocation is important. The goal is to maintain a balanced portfolio.
• Inflation is a force to be reckoned with. It’s really important to be mindful and take steps to protect against inflation in the plan.
• Retirees’ own spending is apt to be a variable of the lifecycle. Lifestyle considerations should be factored into withdrawal rates.
• Variable withdrawal approaches can enlarge starting and lifetime withdrawal rates.

Christine Benz: Hi, I’m Christine Benz from Morningstar.

One of the hardest problems in financial planning is determining how much is safe to spend in retirement. The reason it’s tricky is that you’re planning for a lot of uncertain variables. You don’t know how the market will behave over your time horizon, and you don’t know how long you’ll live. But there’s been a lot of great research in this area over the past few decades, and we’ve come away with some conclusions that we can use to make better informed decisions. I’m going to be discussing five key conclusions today.

So, let’s get on into the presentation. I’d like to give you a little bit of a road map of what I plan to cover today. I’m going to start by talking about why the safe withdrawal rate problem is such a hard one. I hinted at some of the uncertainties that you’re working with when you’re planning a sustainable withdrawal rate. Some may be a little less familiar to you. And so, I’ll share some of the things that make coming up with a safe withdrawal rate so difficult. Then I’ll talk about some of the key lessons that we have from the research that’s been done on withdrawal rates. We’ve done some of this research at Morningstar, and external researchers have certainly dug into this problem as well, and come away with some conclusions that you can use to feel a little bit more like you’re on safe footing as you embark on your retirement drawdown.

So, the first is that beginning market conditions matter a lot. This is what retirement researchers call sequence risk. If market returns are bad during your particular drawdown period, that argues for taking a more conservative withdrawal rate. If bond yields are good and inflation is nice and low and equity valuations are low, too, that suggests that you should be able to take more from your retirement portfolio. So, I’ll talk a little bit about how you can think about beginning market conditions as you embark on retirement.

Another conclusion is that asset allocation—the complexion of your portfolio—is very important when determining how much you can safely take out. Generally speaking, a very conservatively positioned portfolio will tend to deliver a lower sustainable return than one that has a little bit more in equities or at least one that’s balanced. I’ll talk about what our research says on this topic of what sort of portfolio you’d want to come into retirement with, and I’ll also share a sample model Bucket portfolio that you can use to inform your thinking on your portfolio’s positioning.

I’ll also talk about the role of inflation. Because one thing we know when we think about safe withdrawal rates is that inflation is very, very important. If inflation stays nice and low during your drawdown period, that tends to be a good sign for a higher safe withdrawal amount initially. On the other hand, if inflation is high, especially early on in retirement, that argues for being a little bit more conservative with that starting withdrawal rate. So, I’ll talk a little bit about how to think about inflation as a component of your drawdown plan and also how to make sure that your portfolio and your plan are protected against inflation.

I’ll spend a little bit of time talking about how retirees’ own spending might inform a starting safe withdrawal rate. We have some research from my former colleague David Blanchett about the trajectory of retiree spending. What we see is that retirees don’t typically take a fixed real withdrawal amount over the whole of their time horizon. They tend to spend a little bit less as the years go by and then they may spend a little bit more later on in their lifecycle. So, we’ll talk about how to incorporate that research into your own drawdown plan.

Finally, I’ll spend a bit of time exploring variable or dynamic withdrawal strategies. One thing we see in our research is that employing a little bit of variability in terms of your withdrawals and, specifically, plugging into what is going on in your portfolio and whether your portfolio has had losses or big gains can help ensure that you take a higher initial withdrawal amount, and it can also help in large lifetime withdrawal amounts. But there are trade-offs with some of these variable strategies, and so, we’ll explore some of those trade-offs, but the idea is that if you are willing to take a look at some of the variable strategies, you should be able to enlarge your starting withdrawal and you should be able to enlarge your lifetime withdrawal.

Market Conditions Are Tough to Predict

So, in the vein of why the withdrawal rate problem is such a tough one, the key one is that market conditions over your specific drawdown period are extraordinarily tough to predict. And I love this slide because each little point on each of these graphs depicts what would have been a starting safe withdrawal amount for the subsequent 30-year period for each of these portfolio mixes. So, you can see that the top line, which is the more equity-heavy portfolios—this is a 75% equity, 25% bond portfolio—in many market environments, it tended to deliver the highest starting withdrawal amount. You can see that that’s the top line on this slide. The balanced portfolio, the 50/50 portfolio, fell somewhere between the more aggressively positioned portfolio and the conservative portfolio. So, over many market environments, having more in equities helps you take more from your portfolio.

The tricky part is that there are some market environments—and I would focus your attention specifically on that period in the 1960s and 70s where it really didn’t matter what was in your portfolio, that if you were taking, say, 5% of that portfolio, that would have been too much if you were embarking on retirement in the late 1960s, and it didn’t matter whether you had a lot of stocks or whether you had a lot of bonds. Everything worked against retirees who were retiring into that specific time period. And the reason is that market conditions were bad. We had a terrible bear market for stocks in the early 1970s. We had runaway inflation for part of that time period. And we also had rising interest rates in a good part of the 1970s. And that led bond prices to decline. So, everything that could work against retirees from the standpoint of sequencing risk did in that specific period.

Incidentally, that is where we have the 4% rule, or the 4% guideline. William Bengen, when he did his seminal research on safe withdrawal rates, homed in specifically on that period. He looked back into market history and asked, “Well, even if a retiree comes into the worst possible market environment, what would have been the most that he or she could have taken over that time period?” And that’s where he came up with the 4% guideline. So, the tricky part of this is that it’s really luck of the draw, that we may have a little bit of leeway, a little bit of wiggle room to adjust our retirement date, but you probably don’t want to delay retirement five years because the market isn’t cooperating.

So, this is what retirement researchers call sequencing risk. If you happen to encounter a bad sequence of returns, if market conditions are poor early on in your retirement, that suggests that you should be conservative about your starting withdrawal. On the other hand, if market conditions are good as you embark on retirement, as was the case for people who were retiring in the early 1980s, for example, where they had a long-running equity bull market that persisted for the better part of three decades, they had declining bond yields, which was generally good for bond prices, and they had pretty mild inflation. That was a great time period in which to have retired. We don’t really know what market conditions will prevail over our specific retirement time horizon, but it is helpful to do a little bit of a check as you embark on retirement.

Inflation Is Also Difficult to Foresee

So, another reason that this is such a tricky problem is that inflation is really difficult to foresee. We had a period of very benign inflation for a couple of decades, really, leading up to this recent bout of inflation, and it’s just hard to foretell what specific economic conditions will give rise to inflation. So, in the case of this recent bout of inflation, for example, I think it’s a great case in point where it was very difficult to have predicted certainly a global pandemic that would have given rise to the supply chain disruptions that we saw and the pent-up demand that we saw coming out of the pandemic. Certainly, the Ukraine invasion was a contributor as well. All of these things fired up inflation over the past year-and-a-half. So, it can be difficult to guess what inflation might be like over our in-retirement time horizon.

Even Setting a Retirement Date Is Hard!

Another issue is that people have a tough time determining when they will actually retire and predicting when they will actually retire. So, this is some research that was done by a group of think tanks that looked at when retirees thought they might retire as well as when the same people actually did retire. And I love this slide because it depicts that we tend to be not great judges of this. So, not only do we have a hard time figuring out what market conditions will be like over our time horizon or what inflation might be like, we also have a hard time figuring out when we might actually retire. In general, when you look at this data, you see that people tend to retire a bit earlier than they predicted that they would.

So, we had a lot of folks in the preretirement zone saying that they thought they would work until 65 to 69 or even 70 to 74. And what we see when we look at this data is that people tended to not be able to work as long as they thought. They tended to retire earlier. And there may be a variety of reasons that can cause someone to need to leave the workforce earlier than they expected. It can be the individual’s own health situation, it can be spousal health considerations, parental health considerations. It may be that the job is physically difficult to do, and that might necessitate a retirement. We also know that ageism is a thing for older workers, that older workers may have every intention of continuing to stay employed but may be forced out of the workforce for whatever reason earlier than they expected. So, this is another wild card—that we may not be able to even successfully guess when we’ll retire. It’s not entirely within our control.

The Wild Cards Are Stacking Up

So, the wild cards are starting to stack up, which is why the safe withdrawal rate problem is such a difficult one. We have volatile stock and bond returns, certainly very difficult to predict. Inflation also difficult to predict. Our retirement dates—we may not be great gauges of, judges of. And our own spending patterns may be a bit variable, and they may be a bit lumpy. So, the convention when we do retirement spending research is sort of assuming that the retiree will take a fixed real withdrawal throughout his or her time horizon, where you’re taking X amount in year one of retirement and then just inflation-adjusting that dollar amount thereafter. The fact is, when we look at retirees’ actual spending patterns, we see more variability, and we do see spending high in the early years of retirement and then trending down in the middle/later years, and then perhaps trending up later in life in keeping with uncovered long-term-care or out-of-pocket healthcare expenses.

Another wild card, obviously, in all of this is our life expectancy, that most of us do not have a clear window into how long we might live. And that really makes planning difficult because we’re planning for an uncertain time horizon. In contrast with other goals that we might have, other financial goals, whether it’s college for our kids or a home purchase within five years, we don’t know the duration of our retirements, and that’s another complicating factor, and that’s the hardest one obviously to solve.

Must-Know Number One: Pay Attention to Starting Conditions

So, I’ve talked a lot about what we don’t know and why this is so difficult. Now, I’d like to get into what we do actually know about safe withdrawal rates, and one of them I hinted to earlier on, which is that starting conditions at the outset of our retirement can give us a little bit of a clue as to how the market might behave, at least over the first 10 years of our retirement. And this is another slide I love because it depicts two different sequences of returns. So, on the left hand side of the slide is the actual sequence of returns that a retiree cutting out of work in the early 1970s would have had. And I mentioned earlier on it was a bad market environment, so bad equity returns, bad bond returns due to rising interest rates and high inflation for a good part of that period. So, someone with a $500,000 portfolio using a 5% withdrawal rate over that specific very difficult time horizon early on in retirement would have spent through his or her portfolio within 20 years. And that’s what we think of as a retirement fail. Because typically when you embark on retirement, if you’re, say, in your mid-60s, you want to be sure that your portfolio lasts 25 or 30 years at a minimum. So, to have spent through your funds within 20 years is a retirement failure. It’s not something that we’d want to emulate, obviously.

The right-hand side of the screen shows the sequence of returns exactly flipped, where the great returns we had for a good part of the 1980s and in the early 1990s, occurred at the beginning of that 20-year time horizon. So, assuming the same $500,000 portfolio, the same 50% stock, 50% bond mix, the same 5% withdrawal rate, that person at the end of that 20-year period would have not only met his or her distribution needs, so the person would have taken the cash flows from the portfolio and spent those, but the portfolio would have also grown very nicely during that time horizon. And again, luck of the draw. We’re assuming a much more fortuitous sequence of events where you have a good bond market, a good stock market, fairly low inflation, all of those factors redound to the benefit of being able to take more from the plan.

Gauging Withdrawal Conditions

This goes back to that slide I already showed you—that the right withdrawal rate really depends on the specific time period and the specific confluence of market events in play during that drawdown period. So, if we’re thinking about our own retirements, I think it’s helpful to put a little bit of a dashboard together, where we’re looking at some of these key variables and making some assessments about whether we think things might work in our favor or things might work against us. So, the ideal conditions for starting withdrawals would be that you’d come into retirement with low equity valuations, so stocks are cheap, and during your retirement, you’re able to sell them off to meet your cash flow needs and you’re able to sell them at ever higher prices. So, low equity valuations would be a good thing to come into retirement with. Decent cash and bond yields are another huge plus. That’s something that retirees did not have in the previous decade. It’s looking a lot more favorable, thanks to rising interest rates, that people will have that safe footing in safe securities with a higher yield. And finally, low inflation is another big plus. If you can come into retirement with the sense that inflation is pretty low and there are no clear catalysts for it going higher, that definitely is beneficial to the plan, and it can help improve starting safe withdrawal amounts.

So, the flip side is also true. Poor conditions for starting portfolio withdrawals would be that stocks are expensive at the outset of retirement, that cash and bond yields are very, very low and that inflation is high. And the reason high inflation early on in retirement—and I’ll hit on this a little later on—the reason why that’s such a negative is that high inflation reduces the purchasing power of our portfolio cash flows. So, even if we are able to get a higher yield from our portfolio, if we’re having to haircut those yields by inflation, that cuts into our actual spending. So, high inflation is certainly a negative as we think about starting conditions for retirement withdrawals.

2022: A Harbinger of Better Things?

The good news for people who are thinking about retirement right now or perhaps for those who have just retired is that 2022, even though it was a painful market in many respects, does foretell better things for new retirees. So, we had stock prices fall. We had bond prices fall at the same time, largely because of rising interest rates. Just a handful of categories managed to perform well last year—commodities and that yellow line in my slide is the one that did manage to buck the trends—but if you had a fairly vanilla portfolio, you probably saw losses in your portfolio last year. It wasn’t a comfortable year. It wasn’t an easy year. But the good news is the fact that we have depressed stock prices and certainly, bond yields coming up due to depressed bond prices, that conspires to make market conditions more attractive for new retirees today.

Equity Valuations Are Improving

This is a look at our price/fair value graph that our analysts put together based on their bottom-up research for the individual companies that they cover. And I’ll just explain what we’re looking at here in case you’re not familiar with this graph, and this is part of the Morningstar Investor website. This is an aggregated price/fair value for all of the companies in our global coverage universe. When our analysts are tasked with covering individual companies, we ask them to come up with what they think is a fair value for that company based on their own discounted cash flow analysis. So, to use a simple example, if a company is trading at $80 and our analyst thinks it should be worth $100, the price/fair value would be 0.8. On the other hand, if the share price were $120 and the analyst thinks it should be worth $100, well, then, the price/fair value would be 1.2. So, this is the aggregated price/fair values for all of the companies in that global coverage universe, and what you can see is that this bounces around a little bit, that there are various points in time where the market looks expensive to our analysts. So, for a good part of 2021, for example, you can see that our analysts thought, again, based on that bottom-up research, that stocks were looking frothy. But then, when the market sold off in 2022, you can see that the analysts thought that stocks looked a lot more reasonable at that time.

So, when we look at price/fair values for that global coverage universe today, you can see that the typical company is trading at about a 10% discount to fair value. That’s a better condition for starting retirement withdrawals than would have been the case even a year ago or a year-and-a-half ago when valuations were higher.

Undervaluation Across the Morningstar Style Box

The good news is that we see this undervaluation across the style box. It’s not just concentrated in a single area, although you can see on this slide that our analysts are finding the cheapest stocks in the small-cap rung of the style box. But generally speaking, this is broadly dispersed under valuation, that even large company stocks, whether value or growth, look inexpensive to our analyst team. So, that’s a good news story.

And Across the Globe

Another good news story, and this is one that we’ve been beating the drum on a little bit for the past few years, is that the undervaluation does appear to be not just in the U.S. but across the globe. In fact, there are other major markets where our analysts’ price/fair values are a little bit more attractive than in the U.S. than in North America today. So, that’s good food for thought. If you haven’t rebalanced your portfolio or haven’t been wanting to give much attention to any international holdings in your portfolio, this suggests that you might consider doing so simply because of relatively attractive valuations in non-U.S. stocks.

Bond Yields Are Also Looking Much Better

Another factor that bodes well for new retirees, and I hit on this earlier, is just the fact that we’ve seen yields come very far in a very short period of time. So, these are 10-year bond yields across geographies, and you can see that most major geographies have moved higher in terms of their yields. U.S. has led the way, but other countries have certainly been raising interest rates to combat inflation as well. Even Japan, which is that bottom line there, it has been raising interest rates very recently, which is a relatively new phenomenon for Japan. All of this redounds to the benefit of bondholders. If we have higher yields on offer, when we’re embarking on retirement, that portends well for the starting safe withdrawal rate. So, this is a good news story in many respects, even though we had a difficult market environment for 2022 for bonds, that it sets bond investors up with better conditions than they would have had a-year-and-half ago because we know that there’s a very tight relationship between bond yields, starting bond yields, and subsequent bond returns over the next decade.

Outlook for Stocks, Bonds Have Improved

This is a slide that is a compilation of the various capital markets’ forecasts that I try to put together at the beginning of every year, and sometimes within periods of market disruption, I’ll gather the capital markets forecast from various firms, including our team at Morningstar Investment Management, as well as other firms outside of Morningstar—BlackRock, Vanguard, and so on. In my latest rundown of capital markets forecasts, what I found were much better equity return prospects and certainly, fixed-income return prospects than was the case when I did the same exercise at the beginning of 2022. Back in 2022, most firms were expecting bond returns to be in the 2% range. Equity return expectations were also much lower. So, this is just another reinforcement that the starting conditions for retirees embarking on retirement today look a lot better than they did even a couple of years ago.

One thing I would point out on this slide is that the capital markets forecast for both developed-markets equities and emerging-markets equities look a lot better than is the case for U.S. equities. This has been a consistent theme in these capital markets forecasts. It really hasn’t changed. Even though we did have a selloff in the U.S. equity market in 2022, global markets generally sold off as well. So, the valuation advantage for non-U.S. stocks is still there despite 2022. Again, if you haven’t rebalanced, might be a consideration to do so whether you’re retiring or many years from retirement.

Better Expected Stock/Bond Returns Lift Starting Safe Withdrawal Rate

The good news is when we have better market conditions, better expected stock and bond returns, that lifts what is a safe starting withdrawal amount.

So, when we did our research on starting safe withdrawal amounts in the 2020-2021 period, our conclusion was that a 3.3% starting safe withdrawal rate had a 90% probability of success with a balanced portfolio over a 30-year time horizon. When we revisited the research last year, so at Sept. 30, 2022, we came up with a better number, a 3.8% starting safe withdrawal rate, in large part because market conditions have improved along the lines of what I just discussed.

Before we go any further, I just want to underscore the assumptions that we use in coming up with these calculations. So first of all, we’re using a fixed real withdrawal system. So, we’re assuming, to use my base case, we’re assuming that someone is withdrawing 3.8% from that portfolio in year one of retirement and then they’re inflation-adjusting that dollar amount thereafter. So, to use that 3.8% number with a $1 million portfolio, that would mean $38,000 in year one of retirement and then assuming a 3% inflation rate, you get to take $39,000 and change in year two. So, the idea is that the retiree wants more or less a paycheck equivalent, kind of a fixed level of real spending throughout the retirement time horizon. That may or may not be what the retiree wants but that’s the base case that we used, and that’s very much the convention when we talk about starting safe withdrawal rates. We used a balanced portfolio, and again, we used a 90% success rate. We targeted a 90% chance of not running out of funds over the time horizon.

So, this is a good news story that starting safe withdrawal rates are higher. But the bad news story, and I think I have to address it, is the fact that investors saw their portfolios decline last year. So, 3.8%, yes, it’s a higher number, but your portfolio balance very likely is down a little bit. So, it may be roughly the same, maybe even a little bit less than would have been the case with that 3.3% on a higher portfolio balance.

Must-Know Number Two: Maintain a Balanced Portfolio

So, lesson one is to pay attention to starting market conditions because they can be very important in determining how much you can safely take out. Lesson two is to maintain balance in your portfolio. So, these are various asset allocations, various combinations of stocks and bonds and cash, that someone might have used during their retirement drawdown period. And what you can see is that a 100% stock portfolio did in fact support the highest withdrawal rate in market history. So, if we look at 30-year time horizons over market history, if you had that 100% equity portfolio and you hit it exactly right, you could have taken a 6.5% withdrawal over that time horizon, starting withdrawal over that time horizon.

The problem with that all-equity portfolio is that if you hit it exactly wrong and you picked a terrible time to retire with that equity-only portfolio, the safe withdrawal amount would have been meaningfully lower. In fact, it would be fully half of the highest safe withdrawal amount. So, this research that looks at historical data and was compiled by my colleague John Rekenthaler very much points to the value of having a balanced allocation. So, you can see that the portfolios that have at least some fixed-income assets in them tended to deliver a pleasing safe withdrawal amount, neither terribly low nor terribly high. And of course, high is good, but the idea is that you would like to try to improve the odds and to ensure that you can take out the most from your portfolio as is possible. The historical research points to the value of balance.

Higher Yields Point Toward Value of Balance

And indeed, when we look at our own research, which takes a forward-looking view of what would be safe withdrawal amounts, we come to a similar conclusion. So, over those very short time horizons, so for older retirees, for example, we can see that actually based on our research, based on our Monte Carlo simulations, they’re actually better off with more-conservative-tilted portfolios, so portfolios that have as little as 30% or even 20% in equities. Whereas people who are retiring with more typical time horizons, so people retiring with 25- or 30-year time horizons are better off with portfolios that are balanced in nature. The 60/40, the 50/50, even the 40/60 portfolio tends to support the highest safe withdrawal amount. And the reason is that even though the expected return on stocks is much better, and that cuts across stocks of all types, what we see is that the variability of bond returns is much more predictable, much more reliable, and that’s what we’re seeing in the right-hand column here, where we’re looking at the expected standard deviation of returns for each of these asset classes.

Stock Returns Are Higher, but More Variable

You can see that, yes, equity returns—expected returns—are better, but the variability of their returns, the volatility of their returns is also much higher. On the other hand, bonds and cash, you have a lot more certainty of the return that you might earn, in part because of that tight correlation between starting yields and subsequent returns that I talked about earlier, that we just know that with higher yields, bond investors have a much better shot of earning a safe return than is the case with investors who roll the dice with very equity-heavy portfolios.

Bucket Approach Provides Balance

This is just a quick look at the Bucket approach, which I think very much reinforces the value of having balance into the portfolio that you bring into retirement. Many of you have probably heard me talk about this Bucket strategy before. I always take pains to credit Harold Evensky for his work in this area, where years ago, he and I were talking, and I asked him what he did with his clients, and he said, “Well, I just used this cash bucket that I bolt on to the long-term total return portfolio, and that gives my clients a lot of peace of mind with what might be going on with the longer-term components of the portfolio.”

So, in a simple Bucket setup, we’re setting aside one or two years’ worth of portfolio withdrawals in cash investments. We’re not taking any risks with this portion of the portfolio. We are subject to inflation risk, but we’re not overallocating to it. So, we’re just holding a couple of years’ worth of portfolio withdrawals. And then, with the rest of the portfolio, we’re just stepping out a little bit on the risk spectrum. So, with Bucket 2, we have a high-quality fixed-income portfolio mainly, and I would stairstep that portion of the portfolio from very conservative, high-quality short-term bond funds to holdings that are a little bit more aggressive. So, there I would consider holding intermediate-term bonds, a component of Treasury Inflation-Protected Securities. But the idea here, the core idea here is that with Bucket 1, your cash bucket, and Bucket 2, which is your high-quality fixed-income piece, you could have Armageddon with the stock market. You could have very terrible performance with your stock portfolio, and you would still have that 10-year runway of fairly safe returning assets that you could spend through if you needed to.

In many other market environments, you may actually want to be pulling from appreciated equity holdings. In fact, that was my guidance to retirees in that period from 2019 through 2021 was that their best source of cash flows was hiding in plain sight in their appreciated equity holdings. But in some market environments like 2022, the Bucket system can really come in handy because you have those cash flow reserves sitting there for you. You don’t have to disrupt fixed income, and you certainly don’t have to disrupt equities. So, that’s the basic Bucket structure. Inherently, it’s a balanced sort of approach. And many retirees who run through this exercise with their own portfolios where they’re looking at their anticipated portfolio withdrawals and then dropping X amount into each of the buckets, frequently, retirees will come up with more or less balanced portfolios after going through this exercise.

Sample In-Retirement Bucket Portfolios

This is just a sample in-retirement Bucket portfolio, a very plain-vanilla one composed of exchange-traded funds. So, we’re assuming that retirees are spending $60,000 from a $1.5 million portfolio. So, they’re using a 4% withdrawal rate, a little higher than we would suggest might be sustainable. But for the sake of this illustration, they’re taking out $60,000 a year. So, you can see that they’ve organized the portfolio in the way that I’ve just discussed where they have a couple of years of portfolio withdrawals in that cash bucket, Bucket 1, another eight years, or $480,000 worth of portfolio withdrawals, in that high-quality diversified fixed-income portfolio, and then Bucket 3 is the growth portfolio for years 11 and beyond. For them, that’s the bulk of their portfolio. They have a globally diversified portfolio. They have a little bit of emphasis on dividend growth stocks, which came through 2022 with flying colors. If you’re more minimalist, if you’re kind of a Boglehead three-fund portfolio person, you might reasonably just have a total market index, total international index, and total bond market, even though you’ll miss out of a little bit of nuance, you would have the basic core constituents of a Bucket strategy, but you’d also want to have that cash reserve set aside to meet your spending needs for the first couple of years of retirement.

But Buckets 1 and 2 Carry a Substantial Opportunity Cost

The key thing to note on the Bucket strategy is that there is an opportunity cost. In fact, I think of Bucket 1, that cash bucket, is a little bit of a luxury good and the size of that cash bucket really depends on how well-situated your plan is. If you feel like your plan is in terrific shape, you’re not worried about your spending, you’re not worried about outliving your resources, you could reasonably hold a little bit more in Bucket 1. But for many other folks, I think they want to be careful to not overallocate to Bucket 1, mainly because, on an inflation-adjusted basis, you’re probably in the red with this portion of the portfolio.

So, there are some ways to skinny down that Bucket 1. One would be a series of steps that would be advocated by Wade Pfau. He’s a leading retirement researcher. One would be to hold some sort of reverse mortgage that you could tap in a pinch, kind of a standby reverse mortgage. If you have some sort of a permanent life insurance policy that has cash value, you could potentially tap those cash reserves on an as-needed basis. And you could potentially use some sort of a short-term annuity product to fill that role as well.

Alternatively, another idea to avoid the opportunity cost, to avoid that big drag of Bucket 1 would be, if you came into retirement and encountered a really bad market environment, that you could spend through that Bucket 1, spend through potentially part of Bucket 2, and then just not fully replenish those buckets once they were depleted. That’s sort of the reverse glide path idea that some retirement researchers including Michael Kitces have talked about.

Another idea, another way to tweak that basic Bucket system that I’ve talked about is for retirees to potentially shrink down Buckets 1 and 2 a little bit. So, Bucket 1 might just cover you for one year’s worth of portfolio withdrawals and Bucket 2 might just hold enough high-quality bonds to tide you through, say, five years’ worth of portfolio withdrawals. So, you can certainly make some adjustments to those allocations to the safer buckets in an effort to reduce the opportunity cost of having too much in safe assets.

Must-Know Number Three: Protect Against Inflation

Another key conclusion in the research on retirement spending is that it’s really important to be mindful about inflation and to take steps to protect against inflation in the plan. This is a quote that I pulled from a conversation that Jeff Ptak and I had with Wade Pfau—I mentioned Wade just a few minutes ago—where he pointed out that inflation tends to build upon itself, and that can be a real negative for people embarking on retirement. So, he says, if there’s a 10% inflation rate in the first year of retirement and then it gets back to normal afterward, every future year of spending has been impacted by that first-year inflation rate. I think that’s such a thought-provoking point, especially right now. The idea is that even if the inflation rate gets back to normal, retiree spending will still be at that elevated level, even though that spending will be inflating at perhaps a smaller rate going forward. So, that’s just one of several reasons why inflation can be a big deal in retirement. If it occurs early on in retirement, it builds upon itself as we just outlined in that Wade Pfau quote.

Why Inflation Can Be a Big Deal in Retirement

Another issue is that older adults tend to spend more on certain categories, where when we look over history, they may be inflating more quickly than the general inflation rate, and the main one there is healthcare, that we know that older adults do spend more on healthcare than the general population, and we also know when we look back on historical inflation, healthcare inflation has to historically run higher than the general inflation rate. So, that’s another risk factor for older adults from the standpoint of inflation.

Another factor is that retirees, because they’re withdrawing a portion of their portfolios to pay for their ongoing living expenses, don’t have the luxury that working folks have of getting those cost-of-living adjustments automatically in their paychecks. They may see some cost-of-living increase, especially if they’re receiving Social Security. But for the portion of their portfolios that they’re relying on to supply their living expenses, well, they’re not getting any sort of automatic inflation increased there. That’s why it’s really important to make sure that that portfolio is at least somewhat insulated against cost-of-living increases.

Another issue in the mix is that inflation is the natural enemy of anything that has a fixed payout. Whether it’s a bond that you might buy and hold to maturity or a CD or some sort of a fixed annuity that you’ve purchased, that if inflation runs high as you are taking income from that product, you will find that high inflation will gobble up more of it. It’s just the nature of anything with a fixed payout that you want to be very careful and mindful of inflation. And then, finally, inherently, more conservative portfolios that lean more toward bonds and cash as is generally typical of older adults means that they have lower return potential and that means that inflation takes a bigger bite out of the return. So, this is just a series of reasons why it’s worth thinking hard about how your total plan is protected against inflation.

Inflation Protection: A Harder Problem

The tricky part is that actually insulating that portfolio and plan is a little bit more difficult. So, at the portfolio level, you’d want to think about a few key categories. Treasury Inflation-Protected Securities, and I tend to like shorter-term Treasury Inflation-Protected Securities, I Bonds, the breakout sexy category of 2022, is another category to consider bringing into your retirement portfolio. The idea is that you have explicit inflation protection for the safe portion of your portfolio with these types of products. How much inflation protection I think does depend on the individual, but when I look at the recommendations from my colleagues in Morningstar Investment Management, they typically recommend TIPS and I Bond allocations in the range of 25% to 30% of the fixed-income portfolio. So, I think that’s a good starting point as you’re thinking about how much to allocate to them.

Stocks are by no means a direct inflation hedge, and we certainly saw that on stark display last year when we saw stocks go down even as inflation went up. But over very long periods of time, if we have a sufficiently long time horizon, we know that stocks really more than any other major asset category have the best long run shot at beating inflation, which again gets back to the value of balance—of having safe securities in your portfolio but also having growth-oriented securities in your portfolio to help beat back inflation. So, those are things to consider at the portfolio level.

At the plan level, there are a couple of strategies to consider. One is delaying Social Security, and the key reason is that—and many of you heard that you receive an enhanced return for delaying—this is especially valuable if you think you’ll have a longer-than-average life expectancy or if you are making Social Security claiming decisions on behalf of a younger spouse. So, you receive an enhanced return for delaying, but you also receive the inflation adjustments that you would have received if you are already taking Social Security payments prior to your eventual claiming date. So, your higher enhanced return is also inflation-adjusted along the way.

And then, it’s also valuable to think about inflation as you calculate your portfolio spending plan, as you figure out how much to take out of your portfolio. If you have reason to believe that inflation will be high in especially the early years of your retirement, it makes sense to be a little bit more conservative in terms of your starting withdrawals. On the other hand, if you believe that inflation will be very, very low for whatever reason, you could potentially take a little bit more from that portfolio in terms of your starting withdrawal.

Must-Know Number Four: Factor in Lifestyle Considerations

Lifestyle considerations are the next key takeaway as we think about the conclusions that we can use to inform starting safe withdrawal rates. So, this is what’s been called the retirement spending smile. This is a piece of research that my former colleague David Blanchett produced that examined the trajectory of actual retirement spending over people’s retirement time horizons. And what the research concluded is that in contrast with that base case that I mentioned we use when we’re thinking about starting safe withdrawal rates, when we look at actual retiree spending, we see that spending starts higher and that often coincides with people’s good health years, where there’s pent-up demand perhaps to do travel, and then we see that spending tend to decline in the middle to late retirement years, and then it often elevates later in retirement, often in keeping with uninsured healthcare expenses, uninsured long-term-care expenses, higher prescription drug costs, and so on. This is, I think, in a lot of ways a statement that that base case that we use is a little bit of a straw man because it doesn’t depict how retirees actually spend. I mentioned much of the research assumes that fixed real expenditure pattern, but we see when we look at the data, when we look at David Blanchett’s data, we see that decline throughout the middle to later years of retirement.

Takeaways for Spending Rates

How do we take this research and marry it with our research on safe withdrawal rates? One conclusion that you can come away with is that when we model in that lower spending in the middle to later years of retirement, that pattern that many older adult households exhibit, when we model that in, that translates into retiree spending increasing about a percentage point less than the inflation rate per year. So, I mentioned in our base case we’re assuming the full inflation rate. What we see when we look at actual retiree spending is that their own spending actually increases by a bit less. So, if we model that in, what we can see is that that translates into a higher safe withdrawal amount.

I want to direct your attention to the far right-hand column there. That looks at starting safe withdrawals for people who are assuming that they will take a percentage point less than the actual inflation rate as the years go by in their retirement. And you can see that that translates into a higher starting safe withdrawal rate because the bargain is that you will take a little bit less than the inflation rate as the years go by. That’s one reason why, if you think about the spending smile, that argues for a higher safe withdrawal than would be the case if you assumed that someone is taking that fixed real withdrawal over the whole retirement time horizon. But before retirees take this and run with it, they just need to be comfortable with their end of the bargain. So, yes, it suggests that withdrawals early on in retirement in those pent-up demand years can be higher, but it does necessitate lower spending as retirement unfolds. It’s also important to think about someone’s own health situation, and specifically the plan for long-term care and whether there is a plan for long-term care. If there is not a plan for long-term care and the older adult could see a significant spike up in spending later in life to cover those uninsured long-term-care costs, that argues for being a little bit more conservative with those starting safe withdrawal amounts.

Must-Know Number Five: Consider a Variable Strategy

The final point I want to touch on is the value of being variable. The strategy that I just outlined is a simple twist on a basic fixed real withdrawal system, but there are a variety of other systems that you can explore, and these are various systems that we explored in our research at Morningstar on safe withdrawal rates. The variable systems vary a bit, but most of them do try to ensure that the retiree doesn’t take so much in down-market environments, and some of them try to give you a little bit of a raise to compensate you in periods when market performance has been very, very good.

We examined a variety of different flexible strategies. You could use a simple fixed percentage each year. In fact, I sometimes encounter retirees who tell me that they’re taking just 3% or 4% of their portfolio each year regardless of what their portfolio’s value is. The big trade-off, of course, with a strategy like that is that your cash flow is buffeted around a lot by whatever is going on with your portfolio. So, my view is that such a strategy would tend to be best for people who have a lot of nonportfolio income sources, so where they have a pension or where Social Security is meeting most of their income needs, and they’re just using their portfolio for extras. Such a strategy would only be appropriate in those situations.

There are refinements to that basic fixed percentage strategy, which we explored in our paper. One would be to use an RMD-type method, a required minimum distribution type method. The basic idea is that you are looking at your portfolio’s balance per year, but you’re adjusting your withdrawals based on life expectancy. And those are really the two key variables that you’d want to bear in mind if you’re making any sort of adjustment to your withdrawal rates.

We examined a pure required minimum distribution system in our research. We also looked at the guardrails system, which was developed by financial planner Jonathan Guyton and computer scientist William Klinger. The guardrails is a system that in our 2022 research and in our 2021 research showed itself to be a really good system in terms of delivering the highest lifetime withdrawals, especially for equity-heavy portfolios.

You can also just make simple tweaks to a fixed real withdrawal system. One system that I like for people who are looking for simplicity is simply to forgo the inflation adjustment in the year following a year in which the portfolio has lost value. So, coming out of a 2022, for example, if you’re going for a strategy like this, the trade-off would be that in 2023, you would not be able to take an inflation adjustment based on what happened in the market last year. That illustrates the potential trade-off of that strategy. But it’s certainly a simple system, and in many market environments, where we see portfolios going down, especially equity portfolios going down, that’s because we’re in some sort of a recessionary environment when inflation is pretty mild. In other market environments, that may not be the case.

Variable Methods Entail Trade-Offs

Just a quick look at some of the trade-offs that these variable strategies might entail. This is a look at safe withdrawal rates. So, that’s what we’re seeing on the vertical axis, and then the horizontal axis is the standard deviation of these various withdrawal systems. So, you can see at the far right that is a system of taking required minimum distributions that, because it is so tethered to portfolio balance, means that you have to be willing to put up with a lot of volatility in your cash flows. Again, might be appropriate for people with a lot of nonportfolio sources of income but might not be appropriate for folks who are taking most of their cash flow needs from their portfolio.

The guardrails is that goldish yellow dot. You can see that it shows well in terms of lifting portfolio withdrawals, lifting starting safe withdrawal amounts, and also is a little lower on the standard deviation scale than that RMD system. And then, clustered over there on the left hand side of the screen would be more-modest adjustments. So, we have the fixed real withdrawal system and a couple of other related systems on the left hand side of the slide. You can see that those systems do help elevate starting withdrawals a little bit, so the system of forgoing inflation, for example, or taking a 10% reduction after the portfolio has had a loss, those elevate starting withdrawals a little bit, and they do so without incurring substantial volatility in terms of the retiree’s cash flows.

Lifetime Withdrawals Are Higher for Some

This slide illustrates the lifetime withdrawals for the various systems. You can see that the RMD system, the required minimum distribution style system, which we talked about how volatile it is in terms of cash flows, actually delivered the highest lifetime withdrawal, and that’s because an RMD-type system gets you spending your portfolio. You’re spending more in good years, and that tends to ensure that you consume your portfolio over your time horizon. Other systems—the fixed real withdrawal system, for example—you can see led to the lowest lifetime withdrawal amount along with the system of taking the inflation haircut. So, you can see that there are some trade-offs with these various systems.

But Paydays Can Be More Volatile

This slide illustrates the volatility of paydays, which we talked about, that some of the systems lead you to a very stable sort of paycheck equivalent, whereas others would have more volatility in their cash flows. And again, I think it comes down to how much of your cash flow needs are coming from nonportfolio sources. If a lot of your cash flow needs are coming from nonportfolio sources, you’re probably more comfortable exploring some of these more dynamic and variable systems.

And Ending Balances Can Be Lower

Finally, I wanted to touch on how ending balances fit into all of this, how residual balances at the end of that 30-year time horizon that we modeled in might change depending on the system. What you can see is that that fixed real system that has become a convention in retirement planning circles tends to lead to very heavy residual balances in a lot of instances, and that’s especially true with portfolios with large allocations to equities. On the other hand, an RMD-style system, for example, gets you to consume more of your portfolio and all but ensures that there’s less of that portfolio in place at the end of that 30-year time horizon. So, again, this is a very personal consideration whether you want to leave assets for heirs or charity or whatever the case might be, or whether your goal is to maximize your own consumption. It really comes down to your own vision for your retirement plan. But this is another one of the trade-offs that we think it’s important to think about and explore before settling on your own withdrawal rate system.

My hope is that today’s presentation has provided you with food for thought and given you more confidence in your own retirement spending plan. Thanks for joining us today. I’m Christine Benz for Morningstar.