With Christine Benz, Director of Personal Finance at Morningstar, Author of author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and The Morningstar Guide to Mutual Funds
The Big Question: How Much Money To Withdraw From Retirement Savings
We’re fortunate to have Christine Benz, author and Director of Personal Finance at Morningstar, join us to talk about retirement planning, in particular, the question of how much money retirees should annually pull out of their savings if they want to keep pace with inflation and not burn through their retirement funds. Christine acknowledges that this question is key to whether your retirement planning will succeed or fail. The central problem, she adds, is that it’s difficult to impossible to predict what markets will do over a mid-to-long time frame (a year or more), including, of course, during your retirement years. Ideally, markets will lift both stocks and bonds, and if you’re diversified into those two asset classes (as you should be in your investment portfolio) you’ll never have to worry about the value of your savings dwindling outside of your withdrawals from them. Needless to say, it doesn’t always work out like this, and, instead, you could find yourself in a situation like the early 1970s when inflation spiked, bonds predictably got crushed, and stocks also suffered a major and lengthy decline. Should you be so unlucky, you’d have to lower the rate of withdrawals from savings compared to the former scenario.
The Optimal 4% Withdrawal Rate
Steve notes that most people just want to live on the same income they made while they were working and getting a paycheck. Much research has been done on the optimum percentage of one’s portfolio that should be tapped for living expenses, Steve explains, and the resulting consensus was that 4% would allow you to beat inflation and have your portfolio get you through potentially decades of retirement. He allows that a perfectly stable level of withdrawals is difficult given the volatility of markets and changing spending needs, and, therefore, withdrawals too will necessarily fluctuate.
The Steady Paycheck Approach To Retirement
He asks Christine what she thinks of the idea of the “steady paycheck” of fixed withdrawals. She bases her response on the “4% rule” (derived from researchers looking at the worst market conditions retirees might face) and the assumption of a 60% equity/40% bond weighting in their portfolios and a 25-30 year timeline. While conceding that 4% is a good starting point, she argues that there are downsides to treating this as an inviolable rule. For starters, if you stick to a fixed rate of withdrawals, that amount will be subject to the capriciousness of markets—when they’re down, you may have to enforce unpleasant lifestyle changes on yourself. In fact, most financial planners cite this as a reason not to hold to a rigid 4% (or whatever percent) approach. Christine also brings up the need to account for inflation in your expected withdrawals, roughly an extra 3% per year.
Steve casts some further doubt on the 4% rule by explaining how the current very low interest rate environment and high stock prices conspire to suppress the value of bonds. Christine mentions research by colleagues which confirms this analysis, suggesting that core bond funds may not earn more than 2% over the next decade. This alone should induce retirees with significant bond holdings to downgrade withdrawals to 3 or 3.5% per year.
Changing Spending & Income Needs
Aside from the unpredictable market forces, another important factor in retirement calculations is the changing expenses and spending needs that retirees will face over the years. People tend to spend more in early retirement, gradually slow down and then again spend more in their waning years on long-term health care. Steve alludes to a report showing that spending declines by about 1% a year in retirement; an 85-year old in decent health only needs 80% of the income they needed at age 65. Christine refers to some research on this issue which attempts to find out whether these spending declines are a result of retirees wanting to spend less, or if they’re driven by fear of depleting their savings years before their health fails them.
The Importance Of Staying Flexible With Withdrawals
Trying to understand, plan for, and manage the financial risks posed during retirement entails a kind of probability analysis: how likely is this or that event to happen, and how does this affect calculations further down the line. (Steve uses the analogy of a GPS system that factors in road and traffic conditions to provide an approximate time to get from point A to point B.) Christine refers to ample research over the past few years suggesting that it is vital for people to be flexible in their spending and planning. If market conditions change for the worse—and this has adverse effects on your retirement portfolio—you need to be willing to change course. People who are near to retirement should expect an “equity market shock” over the next 5-10 years. If that comes to pass, and the market overall goes south, this can do a lot of damage to your retirement funds. It’s critical to make allowances to protect you in case of a scenario where you need to drastically reduce withdrawals from your savings portfolio in order to weather the storms until markets bounce back.
Disclosure: The opinions expressed are those of the interviewee and not necessarily United Capital. Interviewee is not a representative of United Capital. Investing involves risk and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. Content provided is intended for informational purposes only, is not a recommendation to buy or sell any securities, and should not be considered tax, legal, investment advice. Please contact your tax, legal, financial professional with questions about your specific needs and circumstances. The information contained herein was obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.
Steve Pomeranz: You’ve all heard of Morningstar, I’m sure. You may have heard of my next guest as well, Christine Benz. Christine is Morningstar’s Director of Personal Finance and the author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and The Morningstar Guide to Mutual Funds. Hey, Christine, welcome back.
Christine Benz: Steve, great to be here.
Steve Pomeranz: Hey, the last time I saw you, we were on a panel for the Money Show in Orlando a few years ago. It’s great to talk to you again.
Christine Benz: It’s good to talk to you too, Steve.
Steve Pomeranz: All right, so today I want to talk about one of the most important questions I’m asked constantly by clients and listeners alike. And it comes from those who are entering retirement. They want to know, “When I retire, what is the safest amount of money I can take from my savings or my portfolio so my money won’t run out and I’ll be able to keep pace with inflation?” Why don’t you start the discussion?
Christine Benz: Yeah, it’s a very common question as you said, Steve. It’s one that will really be central to whether your retirement plan succeeds or fails. So, the problem is, we don’t know when we embark upon our retirements, what the market’s going to be during our retirement years. We could hit a period where stocks and bonds perform really well and inflation is benign, or we could hit a terrible convergence like we had in the early 1970s or even the late 1960s where you had high inflation. You had bond yields that went up and that crunched bond prices. And then in 1973, ‘74, you had a terrible stock market crash. So, you could be that unlucky person who embarks on retirement in that time frame or something like that time frame, in which case, you would have to take a much lower withdrawal rate from your portfolio than the person who encountered the good environment. So, the problem is we just don’t know.
Steve Pomeranz: Well, most people when they retire, they want a steady paycheck similar to the one that they were receiving when they were working. And there’s also has been a lot of research, trying to figure out what the correct percentage of the value of the portfolio would be proper. Some years ago, 4% was quoted, after some research was done, to be one that would keep pace with inflation and allow a portfolio to last throughout a lifetime. But as you mentioned, this stable idea is kind of tough because markets change, your spending conditions change, it’s an environment that’s always in flux. So, let’s start simply if I want a steady paycheck, I suppose I can get one. But when you were working too, your paycheck wasn’t necessarily guaranteed either. Some years, perhaps, you had to take less, some years more. How would you go about it?
Christine Benz: Yeah, I still think that the 4% guideline is a reasonable starting point, but it’s important to understand what that means. And some retirees think that that means that they’re going to take 4% of their balances year in and year out of retirement.
And what you can see is that if you’re using that strategy, if you’re just taking that 4%, you are going to be buffeted around a lot by whatever is going on in the market. So when stocks are down that means that, guess what, you can’t go to the movies anymore, you can’t go out to dinner. You might need to radically tighten your belt. That’s why most financial planners say don’t do that. Don’t employ a fixed percentage method because who wants their standard of living really changing a lot from year to year based on what the market is doing. So, the 4% research started with this idea, which you stated Steve, which is that most people want a stable standard of living. So you take 4% of your balance in year one of retirement, and then, you inflation adjust that dollar amount as the years go by to help keep your cost of living stable or to keep your spending stable.
Steve Pomeranz: So, if you have a million dollars, you’re taking out $40,000 let’s say the first year and, no matter the portfolio is worth, you’re taking out $40,000 plus inflation the following year.
Christine Benz: Right, so assuming inflation is, say 3%, then you would give yourself a little nudge up, you’d be at $41,000 and-
Steve Pomeranz: 200.
Christine Benz: Yeah, exactly. So, that’s the basic idea. But it’s important to understand that that 4% research—which has looked back in market history to look at what would the worst market environment that you would encounter, what withdrawal rate would that support—that’s where 4% comes from. It’s important to remember it does assume that you have at least a balanced portfolio, so something like a 60% equity weighting, 40% bond weighting. It also assumes that you’re planning for a 25-or-30-year time horizon.
Steve Pomeranz: Well, some people saying today that, with interest rates so incredibly low and the stock market high, that future returns, at least in the foreseeable future, are going to be lower, and maybe the 4% rule is not going to work anymore, what’s your thought on that?
Christine Benz: Yeah, that’s exactly right. One of my colleagues, David Blanchett, worked on some research with co-researchers, and they looked at this specific thing, that the raw materials for good bond returns just aren’t there because we think of starting yields as a pretty good predictor of what bonds might return over the next decade. Well, look where we are today. We’re lucky to earn 2% on some sort of a core-bond fund. So, their research kind of poked at the 4% rule and said, if you have a sizable allocation to bonds, you may want to tighten your belt a little bit. The fact that bond returns are apt to be low, means that maybe you need to take more like 3% or 3 1/2% to have a pretty good probability of outliving your money.
Steve Pomeranz: [CROSSTALK] Go ahead, I want to just make one point. The other aspect too is that spending changes throughout your lifetime.
When you first retire, there’s a tendency to spend more, and then as you age, you start spending less. Then towards later age, spending picks up again for healthcare related issues. So, spending isn’t really the same across the board either, right?
Christine Benz: That’s right, and it’s such an important point. I mean most of us know if we manage our household budgets that you have some years where you have heavier spending, either due to good reasons, like you’re paying for a wedding, or you’re doing some travel, or you need a new roof and you happen to need a new car in that same year. So our spending needs change. And as you mentioned, that life cycle that’s specific to retirees is that you have what has been called the go-go years, the slow-go years, and the no-go years. And many of us have experienced this with our parents or other loved ones that this is kind of the trajectory that their lives have followed, where they might slow down in their mid-to- late 70’s and then may encounter some expensive health conditions, specifically long-term care needs later in life.
Steve Pomeranz: I saw a report not too long ago that generally speaking, spending declines about 1% a year. Now that’s on average, it doesn’t actually happen in a stairstep kind of way. But age 65 versus age 85, you’re spending is actually being reduced by about 20%. Do you see the same type of data in your work?
Christine Benz: Yeah, there have been some research studies that have looked at specifically this issue. An open question is whether the spending is tailing off because the retiree wanted to spend less or is it possible that the retiree felt some concern that, “look I’m 85 now I could live to be 95, I’m a little worried about prematurely depleting my assets.” So, that’s something to keep an eye on as well. But some of the studies have actually looked at the same couples and attempted to kind of back out that problem and have found that, in fact, spending does generally tail downward over a retiree’s life cycle.
Steve Pomeranz: We look at things in a much more sophisticated way. I think these 4% rules or these rules of thumb, while they’re good to get an initial understanding of how things work, I mean a lifetime, you mentioned before expenses occur, good expenses, bad expenses. You know, we set priorities in our life. Really, no matter how much money you have, you still have to prioritize things. Nobody has infinite amounts of money. So, we look at kind of like a GPS system where we’re doing probability analysis and we’re saying, what are you spending, what are you projected to spend, what is your portfolio projected to earn? And then we actually put in the reality of the situation on a regular basis. And we get this kind of GPS tracking thing going where GPS will tell you, “hey, it’s going to take you 20 minutes to get from point A to point B. Well, that’s a probability analysis, looking at traffic and road conditions and so on. And we do kind of the same thing with our analysis. Isn’t that really a better way of going about this idea of tracking on a real-time basis throughout your lifetime?
Christine Benz: I think it is, and you bring up a really important point, Steve, which is that all of the research that has come out in the past few years has pointed to the value of being willing to look at what’s going on with your portfolio, with the market and being willing to do some course corrections. So, if you encounter that really lousy market—and, frankly, I think that people who are perhaps just embarking on retirement today, need to be prepared that we could have some sort of equity market shock over the next five or ten years—and encountering those lousy marketing environments very early in retirement, that’s the thing that can kill a retirement plan. So, if you can be flexible, if you encounter that lousy environment, take your spending down during those years, that’ll greatly improve the sustainability of your plan.
Steve Pomeranz: My guest Christine Benz, Morningstar’s Director of Personal Finance. Thanks so much for joining us once again, Christine.
Christine Benz: Thank you, Steve.
Steve Pomeranz: And don’t forget to hear this segment again, you can go to our website which is stevepomeranz.com. And why don’t you come to the site, sign up for our weekly update, and ask us some questions, we love that.
Thanks, Christine, we really appreciate it.
Christine Benz: Thank you.