You’ve worked hard to save for retirement, and now you’re ready to turn your savings into a paycheck. But how much can you afford to spend? If you spend too much, you risk being left with a shortfall later in retirement. But if you spend too little, you may not enjoy the retirement you envisioned.
One frequently used rule of thumb for retirement spending is known as the 4% rule. It’s relatively simple: You add up all of your investments, and withdraw 4% of that total during your first year of retirement. In subsequent years, you adjust the dollar amount you withdraw to account for inflation. By following this formula, we believe you should have a very high probability of not outliving your money during a 30-year retirement.
For example, let’s say your portfolio at retirement totals $1 million. You would withdraw $40,000 in your first year of retirement. If the cost of living rose 1.93% that year, you would give yourself a 2% raise the following year, withdrawing $40,772, and so on for the next 30 years.
The 4% rule assumes you withdraw the same amount from your portfolio every year, adjusted for inflation
Source: Schwab Center for Financial Research. Assumes an initial portfolio value of $1 million. Withdrawals increase annually by 2%. For illustration only.
While the 4% rule is a reasonable place to start, it doesn’t fit every investor’s situation. A few caveats:
- It’s a rigid rule. The 4% rule assumes you increase your spending every year by the rate of inflation—not on how your portfolio performed, which can be a challenge for some investors. It also assumes you never have years where you spend more, or less, than the inflation increase. This isn’t how most people spend in retirement. Expenses may change from one year to the next, and the amount you spend may change throughout retirement.
- It applies to a specific portfolio composition. The rule applies to a hypothetical portfolio that’s 50% stocks and 50% bonds. Your actual portfolio composition may differ significantly and you may change your investments over time during your retirement. We generally suggest that you diversify your portfolio across a wide range of asset classes and types of stocks and bonds, and that you reduce your exposure to stocks as you transition through retirement.
- It uses historical market returns. Analysis by Charles Schwab Investment Advisory, Inc. projects that market returns for stocks and bonds over the next decade are likely to be below historical averages. Using historical market returns to calculate a sustainable withdrawal rate could result in a withdrawal rate that is too aggressive.
- It assumes a 30-year retirement. Depending on your age, a 30-year retirement may not be likely. According to Social Security Administration (SSA) estimates, the average remaining life expectancy of people turning 65 today is well under 30 years. If you’re already retired or older than 65, your planning time horizon may be different. The 4% rule, in other words, may not suit your particular situation.
- It includes a very high level of confidence that your portfolio will last for a 30-year period. The rule uses a very high confidence level (effectively 100%) that the portfolio is designed to last for a 30-year time period. In other words, it assumes that in nearly every scenario the hypothetical portfolio would not end with a negative balance. This may sound great in theory, but it means that you have to spend less in retirement to achieve that level of safety. By staying flexible in retirement and revisiting your spending rate annually, we don’t believe you need to target such a high confidence level.
Beyond the 4% rule
However you slice it, the biggest mistake you can make with the 4% rule is thinking you have to follow it to the letter. It’s a basic guideline for how much to save for retirement, but after that, we suggest adopting a personalized spending rate, based on your situation, investments, and risk tolerance.
How do you determine your personalized spending rate? Start by asking yourself these questions:
- How long do you want to plan for? Obviously you don’t know exactly how long you’ll live, and it’s not a question that many people want to ponder too deeply. But to get a general idea, you should consider carefully your health and life expectancy, using data from the Social Security Administration and your family history. This online calculator can also assist you in determining your planning horizon.
- How will you invest your portfolio? Stocks in retirement portfolios provide potential for future growth, to help support spending needs later in retirement. Cash and bonds, on the other hand, can add stability and can be used to fund spending needs early in retirement. Each investment serves its own role, so a good mix of all three—stocks, bonds and cash—is important.
We found that asset allocation had a relatively small impact on your first-year sustainable withdrawal amount, unless you had a very conservative allocation and long retirement period. However, asset allocation did have a significant impact on the portfolio’s ending asset balance. In other words, a more aggressive asset allocation had the potential to grow more over time, but the downside is that the “bad” years were worse than with a more conservative allocation.
Asset allocation can have a big impact on a portfolio’s ending balance
Source: Schwab Center for Financial Research. Assumes a constant asset allocation, a 75% confidence level, and withdrawals growing by a constant 1.93%. Assumes a starting balance of $1 million. Confidence level is defined as the number of times the portfolio ended with a balance greater than zero. See disclosures for additional disclosures on allocations and capital market estimates.
- How confident do you want to be that your money will last? Think of a confidence level as the percentage of times in which the hypothetical portfolio did not run out of money, based on a variety of assumptions regarding future market performance. For example, a 90% confidence level means that, after running 1,000 simulations using different returns for stocks and bonds, 900 of the hypothetical portfolios were left with money at the end of the designated time period—anywhere from zero dollars to an amount more than the portfolio started with.
We think aiming for a 75% to 90% confidence level is appropriate, and sets a more comfortable spending limit for more people. Targeting a 90% confidence level means you will be spending less in retirement, with the trade-off that you are less likely to run out of money. If you regularly revisit your plan and are flexible if conditions change, 75% provides a reasonable confidence level between overspending and underspending.
- Will you make changes if conditions change? This is the most important issue, and one that trumps all of the issues above. The 4% rule, as we mentioned, is a rigid guideline, that assumes you won’t change spending, change your investments, or make adjustments as conditions change. You aren’t a math formula, and neither is your retirement spending. If you make simple changes during a down market, like lowering your spending on a vacation or for expenses you don’t need, you can increase the likelihood that your money will last.
Putting it all together
After you’ve answered the above questions, you have a few options.
The table below shows our calculations, to give you an estimate of a sustainable spending rate. Note that the table shows what you’d withdraw from your portfolio this year only. You would increase the amount by inflation each year thereafter—or ideally, re-review your spending plan based on the performance of your portfolio. (We suggest discussing a comprehensive retirement plan with an advisor, who can help you tailor your personalized withdrawal rate. Then update that plan regularly.)
We assume that investors want the highest reasonable spending rate, but not so high that your retirement savings will run short. In the table below, we’ve highlighted the maximum and minimum suggested first-year sustainable withdrawal rates based on different time horizons. We have also matched those time horizons with the suggested asset allocation mix for that time period. For example, if you are planning on needing retirement withdrawals for 20 years, we suggest a moderately conservative asset allocation and a withdrawal rate between 5.4% and 5.9%. For simplicity, these same suggestions are summarized in the table below as well.
Choose a withdrawal rate based on your time horizon, allocation, and confidence level
Source: Schwab Center for Financial Research, using Charles Schwab Investment Advisory’s (CSIA) 2016 10-year long-term return estimates and volatility for large-cap stocks, mid/small-cap stocks, international stocks, bonds and cash investments. CSIA updates its return estimates annually, and withdrawal rates are updated accordingly. See the disclosures below for a summary of the Conservative, Moderately Conservative, Moderate, and Moderately Aggressive asset allocations. Past performance is no guarantee of future results.
Again, these spending rates assume that you will follow that spending rule throughout the rest of your retirement and not make future changes in your spending plan. In reality, we suggest you review your spending rate at least annually.
Schwab’s suggested allocations and withdrawal rate
Source: Schwab Center for Financial Research. Initial withdrawal rates are based on scenario analysis using CSIA’s 2016 20-year long-term return estimates. They are updated annually, based on interest rates and other factors, and withdrawal rates are updated accordingly.1
Here are some additional items to keep in mind:
- If you are regularly spending above the rate indicated by the 75% confidence level (as shown in the first table), we suggest spending less.
- If you’re subject to required minimum distributions consider those as part of your withdrawal amount.
- Be sure to factor Social Security, a pension, annuity income, or other non-portfolio income, in determining your annual spending. This analysis estimates the amount you can withdraw from your investable portfolio in the first year of retirement. For example, if you need $50,000 annually but receive $10,000 from Social Security, you don’t need to withdraw the whole $50,000 from your portfolio—just the $40,000 difference.
- Rather than just interest and dividends, a balanced portfolio should also generate capital gains. We suggest all sources of portfolio income to support spending. Investing primarily for interest and dividends may inadvertently skew your portfolio away from your desired asset allocation, and may not deliver the combination of stability and growth required to help your portfolio last.
- We suggest that most investors allocate enough to cash investments and short-term bonds or bond funds to support two to four years of withdrawals. This approach—often called “bucketing”—provides a cushion to support spending and help weather market downturns.
Stay flexible—nothing ever goes exactly as planned
Our analysis—as well as the original 4% rule—assumes that you increase your spending amount by the rate of inflation each year regardless of market performance. However, life isn’t so predictable. Remember, stay flexible, and evaluate your plan annually or if significant life events occur.
If the market does poorly, you may not be comfortable increasing your spending at all. If the market does well, you may be more inclined to spend more on some “nice to haves.”
The transition from saving to spending from your portfolio can be difficult. There will never be a single “right” answer to how much you can spend from your portfolio in retirement. What’s important is to have a plan and a general guideline for spending—and then adjust as necessary. The goal, after all, isn’t to worry about complicated calculations about spending. It’s to enjoy your retirement.