The 5 Years Before You Retire: Retirement Planning When You Need It the Most | Chapter 3: Income in Retirement
Updated: Sep 11
If there’s one question we answer for our clients, it’s “How much can I spend in retirement?” It’s actually a really easy question to answer. The answer is always …it depends 🙂
Of the factors that get to an actual answer tailored to a specific household, there are two very important factors that are unknown: how long you will live, and what financial markets will do until then. We can get an idea of your life expectancy with a simple health questionnaire (and otherwise plan on you living beyond average), and we can use some historical data and current market analysis to run projections for what markets could do. But our job is to have a plan for how your income will need to change based on changes to markets, your health, your spending goals and priorities, etc.
There are some very simple (real) answers to the question above, and Birken first explores the common (and commonly misunderstood) 4% rule. Let me first say what the 4% is not. The 4% rule is not that you take 4% of your portfolio each year in retirement. It’s true if you do this, you will never run out of money, but that’s true for any percentage. For example, let’s say you plan to spend 50% of your portfolio annually. Here’s what that could look like.
Year 1 $2,000,000 start — spend 50% which is $1,000,000
Year 2 $1,000,000 start — spend 50% which is $500,000
Year 3 $500,000 start — spend 50% which is $250,000
Year 4 $250,000 start — spend 50% which is $125,000
The first few years might be really fun, but by year 10 you are spending a whopping $2,000 per year. 50% is drastic just to make a point. Instead, spending 4% would keep your income much more stable, but would result in you underspending throughout your retirement likely to the tune of millions of dollars that could have otherwise been enjoyed (spent, given, etc.). Unless you obtain more enjoyment from seeing a large number on a piece of paper rather than enjoying it with your loved ones (at which point a counselor or therapist might be needed), or if your main goal is to leave as much as possible to your beneficiaries (and there’s an argument to instead give it to them sooner which would be better for them), simply taking your portfolio total at the end of each year and planning to spend 4% is not a good plan.
The actual, popular 4% rule, is explained well by Birken, “If a retiree were to withdraw 4% of her assets in the first year and increase that withdrawal by a small amount each year to account for inclination, then the savings would last for thirty years.” The caveat that Birken’s is aware of, is that this method will allow your income to last for 30 years — probably. Without knowing what markets (more specifically what parts of which markets you’re invested in) will do over the next 30 years, we can just go based on probability not certainty. Here’s what that could look like, using the same starting point from above.
Year 1 $2,000,000 start — spend 4% which is $80,000
Let’s say your portfolio also drops by 10%, and inflation is 3%
Year 2 $1,728,000 start — spend the first year’s $80,000 increased by 3% inflation, which is $82,400
Let me explain the math on year 2. If you remove $80,000 from the $2m, you have $1,920,000 left. If that drops by 10% (which is $192,000, you’re left with $1,728,000. The 4% rule is that the actual percentage calculation only starts at the beginning of your retirement. After that, you are increasing annual income by inflation regardless of annual performance. In a given year your distributions may be above or below 4%, and that doesn't factor into decisions. In the example above, your year two distribution is 4.7%. Towards the end of retirement it may be closer to 10% - it depends entirely on how your investments perform.
Although using this income rule does have a dynamic plan for how you will react to varying levels of inflation, this plan does not have any instructions for how to judge if/when you need to deviate. You are riding with your inflation increased income until you are gone or run out of money. The math is fairly easy (though not quite so easy as just 4% each year), and Birken looks with some favor on the 4% rule, rightly understood.
That said, this is not an income plan we would recommend or implement for a client for the following reasons.
This does not offer any guidance on how to adjust if markets are above or below average. Chances are high that you will end up overspending or underspending, neither are ideal.
This does not tell you how to adjust spending for years with lumpy income needs. Whether it’s a vacation budget you want for the first 10 years of retirement while you’re still able to travel, or other large one-time expenses such as home remodels, there is no direction for how to adjust for this.
It does not consider other income sources, such as Social Security or pensions and the options around how to optimize those. Delaying Social Security would mean forgoing that income for many years, likely resulting in not enough income at first and potentially too much later on.
This chapter in particular is one we’d like to explore more (and admittedly will have stronger convictions on) than others. For this reason, we’ll spend a few more weeks discussing these retirement income options.
So if the 4% rule, misunderstood or rightly understood, are not frameworks we would recommend for answering, “How much can I spend?”, then how does Brockmann Financial answer that question?
I’m glad you asked 🙂
Let us know
Have you heard of the 4% rule before? In which of the two ways above did you understand this rule to function?
Until next time, happy reading!
