Spending Strategies in Retirement

by Mitchell J. Smilowitz, CPA

For most of our working lives, we focus on saving enough money to live independently and comfortably in retirement. Then we retire – often without thinking about how we will spend the money so that it lasts our lifetime. This article describes two sustainable spending strategies that allow you to meet your retirement income needs.

The 4% Rule

The 4% Rule has the advantage of simplicity. While there are many variations of the 4% Rule, the basic idea is to limit annual spending to 4% of your total savings (both retirement and other savings), excluding Social Security, when you begin retirement. This number increases annually by the rate of inflation. According to projections generated by Morningstar, adopting this model results in a 95% probability that your savings will last 25 years.

Here’s an example:

  • Assume you have $750,000 in savings ($50,000 in bank accounts; $200,000 in an after-tax brokerage account; and $500,000 in your JRB account).
  • You can plan to withdraw $30,000 each year (4% of $750,000 = $30,000).
  • Assume an inflation rate of 3%. In year two of retirement, you take $30,900 (3% of $30,000 = $900).
  • The amount you withdraw continues to increase each year by the rate of inflation.
  • This example does not include your Social Security benefits. Visit the Social Security website to estimate your Social Security income.

There are several consequences of the 4% rule to consider.

  • The 4% Rule addresses how much you can sustainably spend from your savings on an annual basis, not how much you need. You’ll have to prepare a budget to determine if you will have sufficient income, with Social Security, to cover your expenses.
  • According to Morningstar, the 4% Rule requires that you maintain a portfolio of 50% stocks and 50% bonds.
  • The 4% Rule assumes your savings will decline over the course of your retirement.
  • Once you reach 70½ the Required Minimum Distribution from your retirement account may exceed the amount you plan to withdraw. You can invest the difference in an after-tax account.
  • A significant downturn in the equity markets, especially early in your retirement, may decrease the probability that your savings will last 25 years.

A variation of the 4% Rule, the percent-of-portfolio method, allows you to preserve capital. It calls for limiting annual spending to 4% of your portfolio regardless of inflation. When your portfolio increases in value, you can spend more; when your portfolio decreases, you spend less. This approach can result in large year-to-year fluctuations in income.

Time Segmentation Strategy

The Time Segmentation Strategy combines a conservative, fixed income investment portfolio to pay for 5-10 years of expenses with a more aggressive portfolio for the remainder of your savings.

The strategy works best if you replenish the conservative portion of the portfolio annually. But it is flexible. If your equities decline in one year, you can decide not to replenish the conservative portion of your portfolio. You can make up for the lost transfer to your short-term portfolio when the market goes back up. This allows you to avoid selling equities during a down market while maintaining a more aggressive growth portfolio.

Consider this example based on the same assumptions we used in the discussion of the 4% Rule.

  • The first row of the table shows that you have $750,000 in savings when you retire.
      • You establish a conservative portfolio of $210,000 ($30,000 annual spending x 7 years) invested in stable value, money market or other low risk investment vehicles. (To simplify the math, the gains from these conservative investments are not included in the example.)
      • The remaining $540,000 is invested in equities. The aggressiveness of this portfolio can vary based on your comfort with risk.
  • At the end of Year 1 of retirement:
      • Your conservative portfolio is $180,000 ($210,000 - $30,000 spent in Year 1).
      • Your equity portfolio increases by 6%, or $32,400 to $572,400.
      • You transfer $30,000 from your equity investments to replenish your conservative portfolio.
      • This reduces your equity account to $542,400.
      • Your year-end total balance in your portfolio is $752,400.
  • In Year 2 of retirement:
      • On December 31 or Year 2, your conservative portfolio is again at $180,000.
      • Equity investments decline 5%, or $27,120, to $515,280.
      • Not wanting to sell your equity investments when the market is down, you decide not to replenish your Annual Spending Fund.
      • Your year-end total balance is $695,280.
  • In Year 3:
      • Your conservative portfolio is now $150,000 ($180,000 - $30,000).
      • Your equity portfolio increases 7% and is worth $551,350.
      • With the rebound in equities, you decide to fully replenish your conservative portfolio by transferring $60,000 from your equity investments.
      • Your conservative portfolio has $210,000 and your equity account holds $491,350.
      • Your year-end total balance is $701,350.
  • In Year 4:
      • Your conservative portfolio is back to $210,000 on January 1 of your 4th year in retirement.
      • You begin the year with $491,350 in your equity portfolio.
      • During the year you spend $30,000 from your conservative portfolio.
      • Your equity portfolio earns 4% and the value of the portfolio increases to $511,004.
      • Your year-end total balance is $691,004 and you transfer $30,000 into your conservative portfolio.

As you can see, the time segmentation method allows you to enjoy the benefits of the higher long-term returns stocks have historically offered while basing your annual spending on less volatile investments.

The 4% Rule and Time Segmentation Strategy are two approaches for spending your retirement savings. Crafting a spending strategy to meet your specific needs is a major part of living in retirement. Please contact the JRB at 888-JRB-FREE (572-3733) or staff@jrbcj.org to work with you on a sustainable spending strategy.