I frequently describe retirement as the time of your life when you have both the time and resources to live the life you want to live. I like this description because it captures the optimism of this period. We all understand that we are closer to the end than the beginning, so it is only fair that we enjoy ourselves more.
The catch is we are more on our own in retirement than at any other time in our lives. We are more reliant on our resources and likely have less access to outside sources, such as working. None of us are Monty Brewster (Brewster’s Millions) – if we spend our savings there isn’t a bigger pile of money waiting for us. That is why retirement income planning is so essential, since problems early in retirement may have severe repercussions for your retirement dreams.
Retirement Risk #3: Excess Withdrawal
Part of the planning process is understanding the risks we face in retirement and developing strategies to adjust when these risks become a reality. Most of these risks we have little control over; we cannot control the investment markets, interest rates, or government actions, for example. But other risks are more controllable. Excess Withdrawal Risk is one risk where, in most situations, we have the control.
A couple of definitions are required before we discuss EWR (if I don’t abbreviate Excess Withdrawal Risk now, my fingers are going to get tired out before I finish writing!). First, what do we mean when we say “withdrawal”?
In this post, we are talking about the money you take from your savings each week/month/year once you retire [NOTE: We are using the terms “savings” and “investments” interchangeably here. For our purposes, there is no difference if the money is in a bank account, a brokerage account, or some other asset.] This is the money you use beyond what you receive from Social Security, pensions, etc. For most of us, this means there could be a substantial difference between spending and withdrawal amounts. However, EWR is not the same as overspending, although overspending can lead to unsustainable withdrawals. Overspending can happen even if your only income is Social Security.
What is a Sustainable Withdrawal Rate?
Before we discuss what is “excessive,” lets define what is “sustainable.” A lot of time and energy has been invested by many people to determine what a sustainable withdrawal rate looks like, and there is no absolute answer. The reason the answer is fuzzy is that there are several variables, and not all of them are known ahead of time. In 1994 William Bengen published what is now known as the 4% Rule. Looking back nearly 70 years of US investment market returns, Bengen concluded that if someone withdraws roughly 4% of their account value each year, they would never have run out of money in retirement. (This is an over-simplification of his conclusions but is accurate enough for this post.) Since his paper was initially published, additional studies have reached similar conclusions. As a result, 4% is generally considered a “sustainable” withdrawal rate.
Ultimately, market returns will heavily influence what rate you can use. If your savings earn a much higher rate than what you are taking out, then you will have more money available. Unfortunately, there is no way to know this ahead of time, so we tend to use the 4% rule as at least a starting point in the conversation.
Think of EWR as the other part of the equation that Longevity Risk is concerned with: Where Longevity is living longer than planned, Excessive Withdrawal is using your assets faster than expected.
Dangers of Overspending
How does someone get to a point where they are overdrawing from their savings? There are two ways: overspending or over assuming. When we say, “overspending,” we do not only mean people are recklessly spending. it also includes people who need to draw excessively from their savings to pay for their needs. For those spending out of necessity, and this may be unpleasant to hear, you are only putting off the inevitable. If spending is not reduced now, it will have to be later when assets are depleted, and only social security is left. You may be better off making the hard choices today while you still have some savings, thus some flexibility. Ignoring the problem will not make it go away.
Making Investment Assumptions
The complaint about the 4% rule is it assumes some of the worst investing conditions we had seen in the 20th century. When looking at some of the better conditions, limiting your withdrawals to 4% could result in you leaving significant more money to your heirs than when you started retirement. As a result, many people draw out more than the 4%, assuming that they will not have to deal with horrendous investment market conditions. This is where over-assuming will appear.
I will exaggerate to illustrate this point: If you assume your savings earn 100% every year once you retire, then you could take out 50% of your money at the beginning of each year without running out of money; the growth would replace what you took. However, if you took out 50% and earned 0%, you would be broke in two years. So clearly relying on an overly optimistic return has risks.
Investment market returns matter. The greater return you earn on your savings, the higher the withdrawal rate you can use in retirement. Over a 20- or 30-year period, higher returns will generally come from investing more in stocks and less in cash. In exchange for these higher returns, however, comes greater volatility. In a random 12-month period, stocks could up 30% or down 30%. What I have found necessary to being able to take on more investment volatility in retirement is having the flexibility to reduce distributions when stock returns are lower.
How to Be Flexible
There are a couple of things you can do that may provide greater flexibility. First, have outside sources of income. Every dollar you get from somewhere else is one less dollar you have to take from your savings. The most obvious, and the one nearly all of us will have, is Social Security. While a discussion of the “how-to” could last hours, there are a variety of strategies available to increase your monthly benefit. Though not many of us have access to them anymore, pensions can be a reasonably stable source too. Having a job, even part-time, will allow you to lessen the draw on your savings.
An Overlooked Opinion
The other thing to consider is making sure you are using all your assets, including your home’s equity.
The largest single asset for many Americans is their home, yet few consider it when planning their retirement income. Reverse mortgages, though not for everyone, could allow for a greater distribution from your investment accounts. There is not enough space here for a discussion about them, but it is imperative to understand reverse mortgages, like any financial tool, before using it in your plan.
Committing to a Plan
My final suggestion is to use a Withdrawal Policy Statement (WPS). A WPS spells out when and how much you will adjust your withdrawals in reaction to your savings value. Typically, it is only a page or two, but it puts in writing what you will do when your account value goes up or down. It includes a beginning value, distribution amount and an annual increase rate (for inflation). The next section of the WPS establishes when distributions will be increased or decreased due to investment returns.
For example, a WPS could say:
The adjustments are saying if the account value moves 20%, then an adjustment is made to the distribution.
If it goes up 20%, then the distribution drops to 3.2%, and you get a raise. However, if the value drops 20% (distribution rate is 4.8%), then the payout is reduced.
Now you have a plan on one page of what to do when your investments go up or down. You do not need to panic and guess what the right move is if things go down, and you don’t have to feel as if you’re missing out, when things are going up.
The Value of Planning Ahead
Your journey in retirement should be enjoyable, with minimal stress. Engaging in the Retirement Income Planning process allows you to address those stressors when you have the time to make choices. Creating a sustainable income in retirement can be a concern, but with diligent planning, you can reduce that concern.
Are you ready to start planning for your ideal retirement? Reach out for a free consultation here: https://afmgplanning.com/schedule-your-appointment/
Kevin focuses on helping people with retirement income planning. He is concerned that too many people become overwhelmed as they shift from building their retirement savings to using their retirement savings to support their desired lifestyle. By engaging in a robust planning process, he aims to lessen the financial fears we all have after we end our careers. Learn more about Kevin