Retirees: are you spending too much?

The 4 per cent guideline can put you in the right ballpark, but the best spending policies factor in time horizon, asset allocation, and market fluctuations.

Christine Benz 20 November, 2019 | 1:12AM

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How much can you spend in retirement without outliving your money? It's one of the most fundamental questions confronting anyone who has retired--or is getting ready to.

Setting a sustainable withdrawal rate--or spending rate, as I prefer--is such an important part of retirement planning, pre-retirees and retirees who need guidance should seek the help of a financial adviser for this part of the planning process.

And at a bare minimum, anyone embarking on retirement should understand the basics of spending rates: how to calculate them, how to make sure their spending passes the sniff test of sustainability given their time horizon and asset allocation, and why it can be valuable to adjust spending rates over time.

Here are the key steps to take.

Step 1: Determine your current spending rate
To determine your own spending rate, simply tally up your expenses--either real or projected--in a given year. Subtract from that amount any nonportfolio income that you're receiving in retirement: pension, rental, or annuity income, to name a few key examples. The amount that you're left over with is the amount of income you'll need to draw from your portfolio. Divide that dollar amount by your total portfolio value to arrive at your spending rate.

Say, for example, a retiree has $60,000 in annual income needs, $28,000 of which is coming from the pension and the remainder of which--$32,000--she will need to draw from her portfolio. If she has an $800,000 portfolio, her $32,000 annual portfolio spending is precisely 4 per cent. But if she needs to draw $50,000 from her portfolio, her spending rate is 6.25 per cent.

Step 2: Run a basic sustainability test
One of the best starting points for testing the viability of your current spending rate is the 4 per cent guideline. The notion that 4 per cent is generally a safe withdrawal rate was originally advanced by American financial planner William Bengen; it has subsequently been refined--but generally corroborated--by several academic studies, including the so-called Trinity study.

Before retirees take the 4 per cent guideline and run with it, however, it's important to understand the assumptions that underpinned it.

First, the research assumed that retirees would wish to maintain a consistent standard of living, drawing a steady stream of income--in dollars and cents--from their portfolios each year. Thus, the 4 per cent guideline assumes that the retiree spends 4 per cent of his or her initial balance in year one of retirement, then subsequently nudges the amount up in subsequent years to keep pace with inflation. In reality, most retirees spend more in some years and less in others. Research from Morningstar Investment Management's head of retirement research David Blanchett also indicates that retirees tend to spend more early in retirement and less later on, save for escalating healthcare costs toward the end of life.

Additionally, the 4 per cent guideline assumes a 60 per cent equity/40 per cent bond asset allocation and a 30-year time horizon, and that the 4 per cent, whether it comes from income and dividend distributions or from selling securities, is the total withdrawal.

Step 3: Factor in your own situation
Because not every retiree's profile matches the assumptions Bengen used in his research, not every retiree should take the 4 per cent guideline and run with it.

Just as calculators can help accumulators gauge the adequacy of their savings rates, so can online calculators help you see if your withdrawal rate is sustainable. Tools like T. Rowe Price's Retirement Income Calculator allow you to harness your own variables to address the viability of your plan. Whether you're tweaking the 4 per cent guideline or using an online tool, be sure to take the following factors into account.

Time Horizon: Retirees with time horizons of longer than 30 years should plan to take well less than 4 per cent of their portfolios in year one of retirement. On the flip side, older retirees--those 75 or older, for example--might consider taking a higher withdrawal rate. Blanchett has suggested that retirees consider their life expectancies when determining their spending rates.

Asset Allocation: A retiree's asset allocation should also be in the mix when calibrating sustainable spending rates. The 4 per cent guideline, as noted above, is centered around a 60 per cent equity/40 per cent bond mix. But investors who want to employ a portfolio that includes more bonds and cash should be more conservative in their spending rates, as Blanchett has discussed.

Step 4: Be ready to course-correct based on market conditions
Retirees greatly reduce their portfolios' sustainability potential when they encounter a lousy market early on in their retirements and don't take steps to reduce their spending. That's because if they overspend during those lean years, they leave less of their portfolios in place to recover when the market does. Sequence-of-return risk can be mitigated, at least in part, by having enough liquid assets to spend from early on in retirement so that the more volatile assets that have slumped (usually stocks) can recover.

Because sequencing risk poses such a threat, much of the recent research on sustainable withdrawal rates supports the idea of tying in withdrawal rates with portfolio performance. The retiree takes less out in down-market years and can potentially take more out in years when the market performs well, as it has recently.

About Author

Christine Benz

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.