The most common financial planning and investment question I get from clients and prospective clients alike is: How much can I spend from my portfolio in retirement? It also might be the most critical question you'll face in your investment career.
Let's first define what this question is asking. Simply put, once you have stopped working and are no longer earning a paycheck, how much can you reasonably expect to withdraw from your investment portfolio over the remainder of your life without running out of money? More specifically, this means determining what amount of yearly income, increased annually by the amount of prior-year inflation (so you preserve your "purchasing power"), you can take from an investment portfolio for 25 to 30 years or more for those individuals and families who are relatively healthy in their early-to-mid 60s.
What do I think?
Is the "4% Rule" Right?
You may have heard the common wisdom that 4% per year, adjusted for inflation, is a “safe” amount to spend from your portfolio in retirement. But the truth is much more complicated. The study that gave birth to the “4% rule” (Begen, 1994) assumed an investor held a portfolio that was 50% in the S&P 500 Index and 50% in intermediate Treasury Bonds. You have probably read my articles discussing why a more diversified stock portfolio can make a huge difference, as can the decision to hold more stocks and fewer bonds. Everything I've researched finds that 4% is "safe" but also excessively conservative. You can spend more if you invest better.
Unfortunately, even when an individual or family has invested better—they've adopted a well-diversified stock portfolio as the core of their retirement plan—the amount they would have been able to spend without running out of money varies a lot depending on when they retired. We can explore this issue further to develop some guidelines for how to proceed in the future.
Bond Heavy Portfolios: Just. Say. No.
First, let’s understand why 50/50 stock and bond portfolios (or "age in bonds" allocations) are not the optimal allocation for retirees and can lead to significantly less potential spending.
Imagine a person retired in 1995—the farthest back we can go with live mutual fund data—and invested in a 50% stock and 50% bond portfolio: 35% Vanguard US Total Stock Index, 15% Vanguard Total Int'l Index, and 50% Vanguard Total Bond Index. If they withdrew $40,000 (4%) from their portfolio every year, increased annually by the inflation rate, they had $3.1M left over in April 2023. Not bad.
But what if that same $1M was invested in the all-stock DFA Equity Balanced Strategy? Net of $40K per year withdrawals, the principal in this portfolio would have ballooned to $8.4M, or almost three times as much! An investor in the DFA Equity Balanced Strategy could have withdrawn $80,000 (8%) annually, adjusted for inflation, and still had $2.8M left over. That’s twice the amount of spending as the 50/50 portfolio with approximately the same legacy value.
And it’s not just starting in good times that reveal the weaknesses of bond-heavy portfolios. The same $1M investor who retired in 2000, on the eve of a -50% decline for the S&P 500, could have spent $65,000 per year annually plus inflation and still had $1.09M left over in 2023 if they invested in the all-stock DFA Equity Balanced Strategy. In the Vanguard 50-50 stock and bond allocation, the investor ran out of money in 2018 at that withdrawal rate. By “playing it safe,” they went broke.
Clearly, bond-heavy portfolios are not optimal for retirement spending, and the conclusions we draw from them don't apply to savvy investors who want to try to maximize their wealth.
The Impact of Retiring Into a Bull or Bear Market
Unfortunately, we can’t only look at the results from 1995 onward and assume that the amount you could have spent over the last 28 years is the amount you’ll be able to spend over the next several decades. Why not? A retirement simulation that starts in 1995 benefits from five straight years of above-average stock returns; between 1995 and 1999, the DFA Equity Balanced Strategy gained +16.9% annually, well above its long-term average of about +10% per year. If you don't get that level of return in the early years, you might spend more than you can afford.
So let’s look at other starting years to determine how much you could have spent and still had more than the $1M you began with by the end of the retirement simulation.
To do this, we will add one additional consideration to our simulation to make it more realistic—we’ll assume the hypothetical retiree has decided to hire a full-time retirement planning advisor who charges the industry average of 1% per year of the portfolio value. For this fee, the retirement planner will manage and rebalance their portfolio (in the DFA Equity Balanced Strategy), facilitate their ongoing withdrawals, and, most importantly, provide continual guidance and counseling to prevent the investor from bailing out of their portfolio at the wrong time. In these scenarios, the investor doesn't have to do a thing but show up for an annual review and cash their portfolio paychecks. From now on, all mentions of income and portfolio values will be net of the advisory fee; the retirement simulations will assume that all annual spending rates are increased by the prior-year inflation rate.
Here is a summary of the amount a hypothetical retiree could have spent depending on the year they retired, without dipping far below their starting portfolio value:
- First, we will return to 1995; our hypothetical retiree could have spent $80,000 per year and still had $1.14M in 2023.
- Retiring in 1997, after a few strong stock market years, the retiree could have spent $65,000 per year and still had $1.14M in 2023.
- With the bad luck of retiring in 2000, on the heels of a 40%+ decline in the S&P 500 over the next three years, the retiree could have spent $55,000 per year and still had $1.09M in 2023.
- 2003 was a much better time to retire, coming immediately after the 2000-2002 bear market; the retiree could have spent $90,000 per year and still had $1.06M in 2023.
- 2008 was the worst time to retire in almost a century, but the retiree with terrible luck still could have spent $45,000 per year and had $960,000 left over in 2023.
- 2009 was an even better time to retire than 2003, and that's saying something. A retiree could have spent $110,000 per year and still had $1.04M left in 2023!
- We saw a stealth bear market in 2011, but it didn't matter much—a retiree could have spent $70,000 per year and still had $1.01M left in 2023.
- Finally, if someone retired ten years ago, in 2013, they could have spent $80,000 per year and had $1.05M left today.
Threading The Retirement-Spending Needle
The obvious takeaway from the retirement simulations is this: The amount you can spend varies greatly depending on whether you see a string of above-average portfolio returns (such as 1995, 2003, or 2009) or below-average returns (such as 2000 or 2008) in your first few years of retirement. If you have good luck, you could spend 8% to 10% of your portfolio; bad luck and you might only be OK with 5% per year, or 1/2 as much. Unfortunately, no one can predict the future. We don't know whether we'll see a soaring bull market or a crushing bear market in the first year or two of your retirement. So how do you settle on a retirement withdrawal rate that maximizes your spending ability but isn't so aggressive that you quickly deplete your savings?
First, we must understand that the bad years I highlighted above—2000 and 2008—are the exception and not the norm. Using index data to stretch the DFA Equity Balanced Strategy (Index) study period back 53 years, I find that we have only seen three extended bear markets: 1973-1974, 2000-2002, and 2008. So if you are betting that you will retire on the eve of a bear market, you're likely to be mistaken. These six years comprise just 11% of all years since 1970 (inception of the DFA Equity Balanced Strategy Index); the other 89% of starting years were much better and allowed for far greater spending. If you're restricting yourself to just a 4% or 4.5% annual withdrawal, you are being extremely cautious. You could wind up with less spending for yourself but a legacy portfolio value after retirement that is 3x or 4x more than you started with.
Next, we should exclude the other side of the distribution as well. Unless you have retired at a time where looking back, a diversified stock portfolio has dropped by -25%, -35%, or even -50% over the prior year or two, it's unlikely that you can bank on the exceptionally good future returns that we saw starting in 2003 or 2009. You are asking for trouble if you have to pull out 8%, 9%, or 10% per year of your portfolio to live on. If you don't run out of money at this rate of withdrawals, it will be because of luck and not realistic portfolio return assumptions.
That leaves us with the middle of the historical distribution to consider. From our examples above, retiring in 1997, you could have spent $65,000 per year; retiring in 2011, you could have spent $70,000. Assuming you hold a well-diversified stock portfolio and you have a year or two of future spending set aside in a money market account, it seems reasonable that you can withdraw 6% or even 7% of your portfolio every year, increased by inflation, without severe risk of running out of money. If you retire today with $1,000,000, you should try to keep your spending to about $60,000 per year.
The Secret To Retirement Planning Success
What I have just said will surprise many people, especially those who have been hanging on the 4% rule for the last few decades. It will likely outrage those people claiming that future investment returns will be even lower and you can now only spend 2-3% per year of your portfolio. I've heard this for over ten years, and, as the example above shows, this guidance has been comically wrong.
Once you know the odds, the secret to retirement planning success is to be flexible. There are no rules that exist that you can implement and follow blindly. With a higher withdrawal rate, you must have more vigilance.
There's always a chance that 2024, or 2025, or whenever you retire, will see a sharp stock market decline immediately, which takes a year or two to recover from. Suppose you are unlucky enough to experience a big portfolio decline on the eve of your retirement. In that case, you have to be realistic and make adjustments to your spending. If you had planned on retiring and spending $60,000 or even $70,000 per year from your $1M portfolio, consider dialing back on that amount, at least temporarily. By how much?
Let's revisit the experience from 2008. You've been able to spend $45,000 per year without significantly dipping into principal (beyond year one) even though your portfolio dropped by 40% in the first 12 months of retirement. Scale your spending back to this level, even temporarily, and see how long it takes to recover. More practically, a year like 2008 should be one where you don't draw funds from your stock portfolio but instead take your income from your two-year emergency reserve. You might then be able to ratchet up your spending the following year to $50,000 or $55,000 if the portfolio has begun to recover. You will have to see how it goes and adapt. Regularly evaluating your situation is where an experienced retirement planning advisor can help you make intelligent decisions and keep you on track.
If you are wondering whether you are on track to retire, or if your current spending rate or future retirement spending projections are realistic, don't hesitate to schedule a few minutes to chat with me here.
Past performance is not a guarantee of future results. Index and mutual fund performance includes reinvestment of dividends and other earnings but does not reflect the deduction of investment advisory fees or additional expenses except where noted. This content is informational and should not be considered an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.