I recently wrote an article about how you should think about allocating your investment portfolio during your working years to maximise the amount you save by the time you reach retirement. That article, entitled “Personal portfolio allocation”, can be found on the EMC website here. This article discusses how you should think about managing the distributions from your retirement (and other) savings vehicles after you stop working, as well as how you should invest your savings during the drawdown period.
Once you retire, you might receive income from individual tax-deferred / -advantaged retirement accounts, from state-provided plans like Social Security in the US or the State Pension in the UK, or some combination of both. Based on my research, the average American between ages 65 and 74 has a bit over $600,000 in total savings, of which around two-thirds ($426,000) is in retirement plans (source here). In the UK according to NimbleFins, people aged 65 and over have on average £389,200 ($490,392 equivalent) in savings in the form of private pension plans (£275,600) and net non-retirement savings (£113,600). For the record, the median levels of retirement savings are significantly lower in both countries. In fact, between 40% and 50% of Americans have no savings for retirement when they reach retirement age, while the similar figure in the UK appears to be in the 20% to 25% area. To be fully reliant on state pension plans at retirement is obviously not where you want to be, although it is clearly more widespread than most of us realise.
This article focuses on people who have saved privately for their retirement during their working years, building a pool of savings that they can tap into once they retire to complement income from state-sponsored retirement schemes or defined benefit plans. Naturally, you will want to stretch your private savings as long as possible without compromising your life style too severely. Decisions involving your retirement savings are very personal and are also highly dependent on your risk tolerance. Let me start by discussing four drivers that might help you think about your post-retirement savings, including determining the amount of withdrawals from your private savings once you retire:
Your expenses, or so called “burn rate”,
Your income, including not only savings plans and other investments, but also earned income,
The rate of assumed inflation, and
How long you will live.
Sizing your expected expenses
Sizing the amount of monthly or annual withdrawals from your savings during retirement first requires you to have a good handle on your expenses, including things like:
The cost of running your home (utilities, property taxes, insurance, mortgage interest, etc.), not forgetting one-off large maintenance expenses or home improvements,
The cost of insurance, especially medical, auto and homeowners insurance,
The cost of travel / going on holidays,
Transportation costs especially if you own or rent a car,
Medical, dental and eyecare expenses not covered by insurance or state health care,
Dependent- (children or parents) related expenses and / or pet care,
Food, dining out, petrol, clothes, and so on.
I find it slightly intimidating even thinking about these outflows because there are so many.
Once you have a handle on this figure, my recommendation would be to add 10% more just to cover unexpected contingencies.
What about post-retirement income?
Any income received during retirement would offset some or all of these expenses. This could for example come from defined-benefit pension plans (which hardly exist anymore), legacy annuities (ditto) or state-provided retirement plans like Social Security or other state-sponsored pension plans. Moreover, it is increasingly common today for retirees to continue to generate some income after they leave full-time employment by having part-time jobs or becoming self-employed (consultancy, Board positions, etc.). Naturally, any ancillary income should be considered as an offset to expenses.
There are other sources of available wealth that can be tapped including physical assets, especially one’s home, although I have not factored these in because they tend to be one-off transactions. For example, you can release equity in your home by selling it and downsizing, or by entering into a reverse mortgage.
Inflation adjustments
Inflation must also be taken into consideration once you have retired, since your expenses are probably going to increase by at least the rate of inflation. When you are doing your back-of-the-envelope calculations, I suggest that you increase your estimated expenses each year by 3%/annum to factor in inflation. Depending on the return you earn on your savings, periodic drawdowns which increase by the inflation rate are likely to speed the drain on your savings.
How long will I live?
The last and most difficult component of determining your drawdowns in retirement is to estimate how long you will live. Or in other words, for how many years after your retirement will you need to tap into your depleting savings? In the US once people reach age 65, the average man will live 17 more years (to age 82) and the average woman will live 20 more years (to age 85) according to Statista.com. Life expectancy in the UK and most of Europe is slightly longer. Even so, most “back of the envelope” retirement analyses use 30 years, because as unlikely as living to age 95 might be (assuming you retire at age 65), it is untenable to run out of money before you die.
These four things – your expected expenses, your expected income, the inflation rate and the time you expect to live – are necessary to see how comfortable you might be once you retire. Once you determine the net amount you need each month to live over the next (assumed) 30 years, you can then consider how to use your retirement and other savings to close the gap, making sure in the process that you do not exhaust your savings.
Funding your retirement
As you think about funding your retirement, two alternative approaches are:
Calculate your monthly or annual expenses post-retirement, and assume that any expenses not covered from private or public pension plans will be covered by drawing on your savings, or
Use a “rule of thumb” to determine how much you can withdraw during your retirement, and then size your expenses (meaning adjust your lifestyle) accordingly.
The overriding objective is to ensure you can live the rest of your life comfortably without the risk of running out of money.
A “rule of thumb” for drawing down your savings during retirement
Financial planners have developed simplistic “rules of thumbs” to help people determine how much they should withdraw from their retirement and savings portfolios each year.
The Bengen 4.5% rule (“SAFEMAX” rate)
In the early 1990s, a US financial planner named William Bengen (Wikipedia article here) did a series of calculations using historical data, which led him to conclude that an appropriate drawdown rate would be 4%/annum. The annual withdrawal would be adjusted each year for inflation, assumed at the time by Mr Bengen to be 2%/annum. As far as longevity, he assumed that a person would live 30 years after they retire. Mr Bengen later revised the so-called SAFEMAX rate to 4.5%/annum in an article published in 2012 in Financial Advisor entitled “How Much Is Enough”? Importantly, he performed a very thorough empirical analysis and “back tested” his SAFEMAX percentage over various historical time periods using actual return data for various asset classes (see Ibbotson date, available here on Stern School NYU website).
Looking back through time at rolling 30-year periods, Mr Bengen found that In only one instance – starting in 1969 – did the individual’s savings get depleted before 30 years. It is important to recognise why this happened on this one occasion because it could happen again. What made this one 30-year period starting in 1969 “fail” the test was a combination of poorly performing financial market conditions early in the periodcoupled with unusually high inflation during the mid/late 1970s. The message seems clear to me – if you get off to a bad start due to either higher-than-expected inflation or worse-than-expected market returns, adjust your withdrawal schedule (or burn rate) early on so as to re-establish a viable amount of savings. I should also note that Mr Bengen used a conservative portfolio mix of 53% stocks and 47% intermediate US Treasuries in his study, which will be relevant in the discussion further below.
Dave Ramsey suggests a (ridiculous) alternative
The 4.5% “rule of thumb” withdrawal rate came to the forefront during a rant recently from Dave Ramsey on The Ramsey Show, during which he suggested that the appropriate withdrawal rate should be 7%/annum to 8%/annum rather than 4.5%/annum. I have included the 9-minute clip on Twitter in case you wish to listen to it, although let me say that this chap is not my “cup of tea.” I disagree with Mr Ramsey, because neither history nor rationality support his basic assumptions, which include i) historical inflation of 4%/annum (too high), and ii) a historical rate of return on one’s portfolio of 12%/annum (way too high). Neither figure aligns with historical reality. Moreover, inflation and investment returns do not simply move each year in a straight line based on historical averages, but instead vacillate from year to year, sometimes wildly.
Historical returns
For the record, the table below summarises the Ibbotson data. It is abundantly clear that regardless of the portfolio mix, a 12% average return over long periods of time is simply not possible.
Focusing on the middle 72-year period, inflation has averaged 3.5%/annum between 1950 and 2022, and a 70/15/15 stock/bond/cash portfolio has generated a blended return of 9.1%/annum. Based on the difference, this suggests on the surface that a 5.6% withdrawal rate might work, although I would even consider that a stretch because the analysis does not consider cycles during which either returns on financial assets can be unusually low for a period of time or inflation can be unusually high. As you might surmise from Mr Bengen’s work, poor performance early in a period is much worse than poor performance later in a period, since returns are compounded.
My recommendations (and I am NOT a financial planner and this is not advice)
The question then is how much should you withdraw from your retirement savings each year to ensure that you do not run out of money before you die? Naturally, this is theoretical, and you can never really be 100% confident on a plan ex ante. But it is simple math really, in that you need to size your expense and withdrawals by making some assumptions:
A rate of inflation over time for your expenses,
An appropriate asset mix, and
Returns on assets that are embedded in historical precedent and are ideally backtested.
It is the second point that is most important to me, because I realise that I have a more aggressive view on portfolio mix than many people. My mantra is twofold, and these are not easily reconcilable as they often pull in opposite directions.
You do not want to be forced to sell underwater investments in a down market, but at the same time,
You need to establish a portfolio mix that maximises the return of your portfolio over a several decade period.
For example, if you believe that the appropriate savings withdrawal rate is 5%/annum, then you might keep 15% or so of your portfolio in cash (i.e. in UST bills, short-dated CDs, or other cash equivalents), with the balance aggressively invested in stocks and bonds, but skewed towards stocks. For example, an appropriate portfolio mix might be 10%-15% in cash/cash equivalents, 15%-20% in longer-dated US Treasuries and corporate bonds (across the credit spectrum but skewed towards investment grade corporates) and no less than 70% in equities. Personally, I would keep less cash, but this reflects my personal risk profile, and it might be very different from yours. In my opinion, most financial planners and wealth managers seem to be much too conservative as far as portfolio mix once a person retires. Although this reduces risk and provides (arguably) more current income, it strips the portfolio of much of its upside. When you might live another 20 to 30 years, underperformance due to an overly low-risk approach can be debilitating to your portfolio, speeding its demise.