This simple retirement spending strategy takes on the 4% rule

For nearly two decades, the 4% rule reigned supreme as a benchmark of how much retirees could safely afford to withdraw from their nest eggs initially, with annual increases for inflation, and be reasonably certain they would not outlive their savings over a 30-year retirement.

But leading financial researchers began questioning the validity of the long-standing retirement spending rule of thumb following the market crash of 2007-09, the Great Recession and record low interest rates that have persisted since. William P. Bengen, a fee-only planner and president of Bengen Financial Services, published his initial research on the 4% withdrawal rule in the Journal of Financial Planning in 1994, and based it on a $1 million portfolio split 50/50 between stocks and bonds.

“Future investment returns are likely to be low for some time to come, and this means that retirees will want to be conservative in their approach to spending from their savings,” said R. Evan Inglis, senior vice president of Nuveen Asset Management and a fellow of the Society of Actuaries. When asked by friends and family how much they could afford to spend in retirement, Mr. Inglis recommended just 3% of their assets each year, above any Social Security, pension, annuity or employment, with no adjustment for inflation.

Because Mr. Inglis’ recommended 3% withdrawal rate does not provide for annual inflation adjustments and bases the withdrawal amount on the portfolio’s balance each year, it is safer than the well-known 4% rule. Not only are initial spending limits lower, but they could decline when portfolio values drop. His approach assumes an investor has 40% to 70% of their portfolio in equities and the rest in fixed income.

But seeking to refine his static rule of thumb, Mr. Inglis reasoned that older retirees should be able to spend a bit more because of their shorter remaining life expectancies. As a result, Mr. Inglis developed his “feel free” spending rule, which he detailed in his winning entry to the Society of Actuaries’ latest essay contest.

“To determine a safe percentage of savings to spend, just divide your age by 20 (for couples, use the younger spouse’s age),” Mr. Inglis wrote. “For someone who is 70 years old, it is safe to spend 3.5% (70/20) of their savings,” he explained. “I call this the ‘feel free’ spending level because one can feel free to spend at this level with little worry about significantly depleting one’s savings.”

“The objective of this rule is to ensure that money lasts a lifetime — not to enable the highest level of spending,” he explained. But, he conceded, most people want to — and do — spend more when they are in their early retirement years.

So for the other end of the spectrum, Mr. Inglis created what he calls the “no more” level of spending that he defines as dividing your age by 10. In the case of a 70-year-old, that would result in a 7% withdrawal rate (70/10).

“If one regularly spends a percentage of that savings that is close to their age divided by 10, then their available spending will almost certainly drop significantly over the years, especially after inflation is considered,” he wrote. “Except for special circumstances, like a large medical expense or one-time help for the kids, one should not plan to spend at that level,” he cautioned.

In between the “feel free” and “no more” spending levels, Mr. Inglis offers a practical solution: “Anyone who wants to spend more than the feel-free spending level may want to consider buying an annuity to provide some of their income,” he wrote.

For example, a single 65-year-old man with $750,000 in savings, a $20,000 annual Social Security benefit and a desired spending level of $50,000 per year may want to use a small portion of his savings to buy an annuity. That’s because his $30,000 of annual spending over and above his Social Security benefit represents 4% of his portfolio ($30,000/$750,000), which is higher than his “feel free” rate of 3.25% (65/20).

Mr. Inglis calculated that individual should spend $140,000 of his nest egg to purchase annuity income of $10,370 per year. The combination of his $20,000 Social Security benefit and $10,370 annuity income leaves $19,630 of annual income that he can draw from his reduced nest egg to satisfy his desired spending level of $50,000 per year. That $19,630 falls within his “feel free” withdrawal rate of 3.25 from his remaining portfolio. ($19,630/$610,000 = 3.22%)

Assume that same individual had a $1 million nest egg and a desired spending level of $70,000. With the same $20,000 of Social Security benefits, he would need to spend $425,000 to buy an immediate annuity that would generate $31,481 in annual income. That would leave him with $18,519 to withdraw from his remaining $575,000 nest egg to satisfy his annual spending needs. That still would be within his “feel free” withdrawal rate ($18,519/$575,000 = 3.22%)

“Divide-your-age-by-20 is a great concept for advisers to use with their clients; it is a very simple approach for the everyday person,” he said. “But advisers can augment that rule of thumb with more in-depth analysis that might allow clients to spend a bit more.”

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Mary Beth Franklin is a contributing editor to InvestmentNews and a certified financial planner.