Michael Kitces is a partner and the director of Wealth Management for Pinnacle Advisory Group, co-founder of the XY Planning Network, and publisher of the continuing education blog for financial planners, Nerd’s Eye View. You can follow him on Twitter at @MichaelKitces.
Karen Wallace: Hi, I'm Karen Wallace for Morningstar. No one wants to run out of money while they are in retirement. Often the logic that goes into determining portfolio withdrawal rates in retirement weights this risk rather heavily. The thinking is that it's prudent to keep spending conservative and think of the upside as the icing on the cake. But are we putting too much emphasis on that downside risk? Here to discuss this is Michael Kitces. He is a financial planning expert.
Michael, thanks so much for being here.
Michael Kitces: Thanks, Karen. Good to be here.
Wallace: So, you've recently wrote a blog post where you discussed the upside of sequence risk.
Wallace: Can we sort of unpack that term for those who might not be familiar?
Kitces: So, idea of sequence of return risk is that what your wealth accumulates to over the long run as well as kind of what you've got left in retirement or how long it lasts is driven not just by literally the returns you get. Like, obviously, if you get higher returns, there is more money; if you get lower returns, there's less money. But also, the sequence that the returns come. Because once you are taking distributions in retirement, you run this additional risk that you get great long-term returns, but you get there by having a terrible start and a wonderful finish. Which means if you are taking money out, you could run out during the bad period before the good returns ever show up.
And that phenomenon in the research is coalesced around this idea of taking the--I guess, now famous--4% Rule that says, if you want a safe sustainable number in retirement, you draw out 4% of the initial account balance and you adjust your spending each year for inflation and it lasts for 30 years even though there's a lot of bad sequences in there. If you just withdrew based on average returns, you could actually withdraw about 6% to 6.5%. But we haircut from 6% down to 4% to defend against this risk of what happens if I get my long-term returns, but I get there in a bad sequence along the way. We are going to hold back the spending a little early on just to make sure we don't spend too much too quickly in a bad sequence.
Wallace: So, it's bad returns at a bad time?
Kitces: Yeah, bad returns at a bad time and I'm taking money out and then eventually, the good returns come, but there's so little portfolio left because you got bad returns and you took money out on top that you just literally don't have enough powder left for when the explosive upside returns come and the portfolio doesn't make it to the end. That's this phenomenon that we call sequence of return risk, and it drives you to spend more conservatively than you might just based on return expectations alone because it's not just do we get the returns, but do we get them in, at least, a not horrible sequence.
Wallace: You also made a point in your post that I thought was interesting and that's just sort of the way the math works. The way that wealth compounds is that you can get exponentially more on the upside and there's something like a 10% chance that your portfolio will decline in value.
Kitces: Yeah, this shift towards the 4% rule of, hey, we got to defend against sequence risk, the origin of that as a study done almost 25 years ago by a financial planner and probably not coincidentally former engineer who dug deep into these numbers and actually looked at all the different historical sequences we'd had through--basically all the market history we had available--about 100 years of data and tried to figure out what was the worst sequence we'd ever had, the one worst sequence we'd ever had. And he said, let's take that as our withdrawal rate. The number was about 4.15%; he rounded it to 4.1%; the industry rounded it to 4% and that's where the number came from. It was literally the withdrawal rate that would work in the one worst sequence we'd ever seen in our U.S. market history.
So, it gives you some reasonable comfort. Like, even if we go through another great depression, if it's anything like the last one, the last one was pretty horrible, you would still make it, so some reasonable security. The problem is, if you even just merely get average returns, you are spending 4%, long-term balanced portfolios on average have done about 7% or 8%, and you are going to compound this for 30 years. And so, what we find is, if you actually draw at a 4% safe withdrawal rate, good news, you've made it through every bad market scenario we've ever had in U.S. history. But the flip side is, on average, you more than double your wealth left over. Like, not only do you not risk your retirement nest egg, if you get merely average returns, you double your nest egg.
Like, take all the retirement savings you've been working on for your whole life, double it, don't touch any of it, leave all of it to your kids. Which is usually not the goal we hear from most retirees. I mean, I know some would like to leave a nice legacy for their family and there's nothing wrong with that. But for most retirees that we talk to, the goal is something in the effect of, I would like to spend my money in retirement and enjoy it, which means not don't touch the principal or double the principal and leave it all left over. It's like I want to enjoy my money in retirement. And so, we get this tension now that if the sequence is bad, I need to take 4% so I don't run out. But if the sequence is anything less than bad, I finish with way, way, way more money that I never actually spend and enjoy that I meant to because that's what happens when I dial down on the most conservative possible level.
Wallace: So, there's a risk that by being too conservative with your spending in retirement, you are not maximizing your portfolio, you are not enjoying your wealth?
Kitces: Well, I think, it's more of just you are not maximizing your enjoyment of your wealth. You'll actually do a great job maximizing your portfolio if you let it grow and don't spend it, it's going to go off to the races and compound. And what we find when we actually run the numbers--the origin of the 4% Rule was like the one worst scenario you were just running out of money at the end of 30 years, that's why you had to take only 4%. But if we compare that to the best scenario, because there's kind of equal likelihood of the worst scenario and the best scenario, the worst scenario was you barely make up 30 years, the equally likely best scenario is you leave 9 times your original wealth left over. So, like, you retire with $0.5 million, you leave your kids $4.5 million having not spent it.
And just when we even look at the distribution further, like, there is a 90% chance out of 4% rule you never touch the principal in 30 years. There's an equally likely possibility that--that's the bad scenario, is you merely leave your principal left over. The equally likely good scenario is you leave 6 times your retirement nest egg left over untouched. And so, we get this effect where ratcheting your spending down to that one worst-case scenario--it's a fine defensive strategy. It's built to weather the worst-case scenario. But even bad returns still leave your nest egg over; average returns leave you 2 or 3 times, and you are as likely to still have all your nest egg left over as you are to have 6 times your nest egg left over. And I think a lot of retirees maybe who have heard and read about the 4% Rule just don't realize quite how ratcheted down that actually is and essentially how much upside potential there actually is in spending at that level.
Wallace: Right. What might be a better alternative to the 4% rule if you wanted to sort of maximize your enjoyment of your wealth?
Kitces: So, I think, ultimately, what you come to in recognizing this is it's sort of two different strategies. The first is essentially what I call a ratcheting tool. So, like a ratchet wrench, it turns one way, but it's locked the other way. You can kind of use your retirement spending with a ratcheting rule that says, look, we are going to start out at this number of 4%. If it goes badly, we'll be really happy we started at 4 because it's about the best information we have that it should last. But if things go better or, frankly, just merely not horrible and we start getting ahead, we lift our spending. Like we can set a rule, you know, if my portfolio is more than 50% ahead of where it started, I'm taking a 10% increase in my lifestyle for the rest of my life. And every three years I'm still up 50%, I'm just going to keep ratcheting my lifestyle 10% higher. So, I'm going to enjoy it as I'm getting the upside.
Wallace: So, you give yourself a raise every year.
Kitces: Give yourself a raise and have a plan about how to give yourself a raise so that when to do it and we know what to expect.
The alternative is, you just acknowledge that if you are willing to be a little more flexible in the first place, you can actually spend more. A gentleman named Jon Guyton did a fantastic study on this about 15 years ago, still not widely written about, where he said, well, what if we just make guardrails. Like, instead of starting at 4, let's start at 5. But if things go badly, you are willing to cut back down to 4 or maybe even 3.5. But if things go well, your spending could even go up higher. And what happens if we just put some guardrails in place. So, if things get really bad, we'll cut our spending, knowing most of the time they are not horrible, and we can actually spend more in the first place.
And so, I don't think that approach is for everyone. For some of us, if I came to you and said, hey, the market is having the next great catastrophe, there was nothing anybody could do to avoid it, we're in financial crisis 2.0, you might have to trim your restaurant budget a little, could you do that? For a lot of people, the answer is like, well, yeah. And point of fact, I can't go out with my friends because all of their portfolios are going down, nobody wants to go eat out anyway. So, we are going to potluck for the next two years and have some fun low-cost events with our friends.
A lot of people are comfortable dialing it down a little. Not everyone. For some of us, like, this is my lifestyle and you change my lifestyle, it's going to kind of feel like personal catastrophe to me. So, if that's your experience and your spending pattern, ratchet it down to the lowest level and just wait for the upside. But I think we grossly underestimate how much a little bit of flexibility actually helps. And what Guyton's study found is, if you just put a little bit of flexibility in there, like, I'll take 10% cuts when times are bad and make it up later, the 4% Rule quickly becomes a 5% rule and that's literally a 25% increase in your lifetime spending just by being willing to be a little more flexible.
So, I don't want to preach at everyone you have to be more flexible. Not everybody wants to take the risk of the cuts. But at least understand if you are willing to be more dynamic, the spending number is actually much higher. Like, you don't have to only deal with sequence risk by saying, I'm going to spend the thing that works for the absolute worst sequence ever and just wait for better times to come. If you are willing to be more dynamic to markets that are a little bit more dynamic, the flexibility actually goes a long way.
Wallace: That's really great perspective on this interesting topic.
Kitces: My pleasure. I hope it helps.
Wallace: All right. Thanks. For Morningstar, I'm Karen Wallace.