Retirement Spending: How Much Can You Afford?

Key Points

  • How much can you spend each year in retirement? One guideline is the "4% rule"—where you withdraw 4% of your portfolio in the first year of retirement, then increase that first-year dollar amount enough to account for inflation each subsequent year.
  • The 4% rule is a simple rule of thumb, but needs adjustment to fit current market conditions and your situation.
  • To determine retirement spending that you're comfortable with, consider your time horizon, asset allocation and confidence level—then stay flexible.

You've worked hard to save for retirement. Now you're ready to turn your savings into a paycheck. But how much can you afford to spend in the first year of retirement?

If you spend too much, you may need to reduce your spending—or be left with a shortfall later in retirement. But if you spend too little, you may not enjoy the retirement you envisioned.

One widely known and frequently used rule of thumb for retirement spending is known as the 4% rule. It's a reasonable place to start. But we think that you should take a more sophisticated and personalized approach when thinking about your baseline spending in retirement.

Begin with the 4% rule

The 4% rule was first proposed in 1994 as a "safe withdrawal rate" from a retirement portfolio. It works like this:

  • Withdraw 4% of your portfolio in the first year of retirement,
  • Then increase the dollar amount that you withdraw each subsequent year to keep up with inflation. 

If you do this, you will have a very high probability of not outliving your money over a 30-year retirement. This sounds great, and it's a good place to start. However, it may not fit your situation.

What you should know about the 4% rule

There are a few caveats about the 4% rule to be aware of, including:

  • It applies to a specific portfolio composition. The rule applies to a portfolio that's 50% stocks and 50% bonds. Your portfolio composition may differ significantly. We generally suggest that you reduce your exposure to stocks as you transition through retirement. So, if you’re in the later stages of retirement, you may not have a 50/50 mix of stocks and bonds.
     
  • 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 will 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. You may be comfortable with a lower level of confidence, say a nine out of 10 (or 90%) chance of never ending with a negative balance in retirement. This would increase the amount you could spend per year.
     
  • It assumes a 30-year retirement. Depending on your age, a 30-year time horizon may not be possible. The remaining life expectancy, on average, for a 65-year-old male in the U.S. today is just over 19 years, and just under 22 for a 65-year-old female. For a couple both aged 65, on average at least one member of the couple will enjoy a 25-year retirement, to nearly age 90, according to estimates from the Social Security Administration. If you are already retired or older than 65, your planning time horizon may be different. The 4% rule, in other words, won't apply.
     
  • It's a rigid rule. This caveat is the most important. The 4% rule assumes that you settle on an initial dollar amount to spend from your portfolio, then you increase that dollar amount every year—give yourself a “pay raise,” in other words, every subsequent year to keep up with inflation. But it assumes that you never go back and look at the value of your portfolio, how it’s performed, and that you never have years where you spend more—or less. This isn’t how most retirees spend, generally, in retirement. The 4% is a fine place to start at the beginning of a 30-year retirement. But we believe that you should revisit your spending rate annually. 

As you can see, the 4% rule won't apply in every situation. However you slice it, the biggest mistake you can make with the 4% rule is thinking it's a rule that you have to follow to the letter. It's a place to start, mostly as a guideline on how much to save for retirement. After that, we suggest a personalized spending rate, based on your situation, investments, and risk tolerance.

Ask yourself these three questions to help determine your personalized spending rate

Instead of following a one-size-fits-all guideline, here are a few questions to address so that you can settle on a more personalized spending rate.

  • 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 agency or your family history.
     
  • How will you invest your portfolio? Stocks in retirement portfolios provide potential for future growth, to 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.
     
  • 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 more than the portfolio started with. 

We think that aiming for a 75% to 90% confidence level is appropriate, and sets a more comfortable spending limit for more people. But weigh the pros of spending more against the cons of ending with a zero portfolio balance. And stay flexible if conditions change.

Putting it all together

Once you've considered your time horizon, how your portfolio is invested, and how confident you want to be that you won't run out of money, you have a few options.

We suggest discussing a comprehensive retirement plan with an advisor, who can help you tailor your personalized withdrawal rate. Then update that plan regularly.

The table below shows our calculations, to give you an estimate of a sustainable spending rate based on your situation. Note that the table shows what you'd withdraw this year only. You would increase the amount by inflation each year thereafter—or re-review your spending plan based on the performance of your portfolio.

Choose a withdrawal rate based on your time horizon, allocation, and confidence level

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 20-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.1Past performance is no guarantee of future results.

What are Schwab's guidelines for sustainable retirement spending?

We assume that investors want the highest reasonable spending rate, but not so high that your retirement savings will run short. In the table above, 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 5.6% and 6.1%. For simplicity, these same suggestions are summarized in the table below as well. 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.

Schwab's suggested allocations and withdrawal rate

Schwabs 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 close to or above the rate indicated by the 50% confidence level (as shown in the first table), we suggest spending less.
  • Review and update your allocations and withdrawal rates annually.
  • Rather than just interest and dividends, a balanced portfolio should also generate capital gains. Using interest and dividends as the first source of income is a fine strategy. However, we suggest also using growth from the portfolio to help support ongoing spending needs. 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 while boosting the amount you can spend. 
  • 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. 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 on some "nice to haves." Major medical issues or family events could also derail your original spending plan.

The takeaway

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.

Average annual returns and standard deviation are as follows:

Average annual returns and standard deviation are as follows:

 

Asset allocations for Schwab model portfolios are as follows:

Asset allocations for Schwab model portfolios are as follows:

 

Next Steps

To discuss how this article might affect your investment decisions:

  • Explore the investment help and guidance Schwab offers
  • Talk to a Schwab Financial Consultant at your local branch to complete a free financial plan and determine your personal spending rate
  • Talk to us about the services that are right for you. Call our investment professionals at 800-435-4000.

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Important Disclosures