When people are looking to make the transition to retirement, they want to know how much they can spend each year without running out of money. The amount of capital you can safely withdraw from your portfolio each year without running out of money has been called the “Safe Withdrawal Rate.”
There is something called the 4% rule, which has been taken to mean that based on prior market history, in the first year of retirement, your starting withdrawal rate is 4% of your capital (investments). Each year in retirement, this is increased by inflation, and this would last the rest of your life.
As an example, if you were to retire today and your total investments were $1,000,000, your starting withdrawal amount would be $40,000/year (4% of $1,000,000). Every year during retirement, you would increase your annual withdrawal by the current inflation rate.
While this rule can be good to review when you are 40 years old and planning to retire at 60, you can’t base your entire retirement strategy on this rule as it doesn’t apply directly to real life without adjustments.
- What is the 4% rule?
- Common misconceptions.
- 4 Key items when applying the 4% rule in real life.
How did the 4% rule originate?
The 4% rule for retirees is based on an original study by William P Bengen in 1994 and updated in 1998 with the Trinity study (by Phillip Cooley, Carl M. Hubbard and Daniel T. Waltz), which reviewed past historical returns and investment allocations to determine what is a safe withdrawal rate from your investments when you retire.
Based on Bengen’s paper, and later the Trinity Study, the 4% rule or “safe withdrawal rate” was developed as follows:
- Using past market returns, they tested various withdrawal rates and investment allocations to determine a safe withdrawal rate.
- The safe withdrawal rate they determined was 4% as follows:
- When you begin retirement, the starting withdrawal rate is 4% of your capital (investments).
- Each year going forward, this is increased by inflation.
- An allocation of at least 50% to equities was required.
- Your portfolio should last at least 30 years, even in the worst markets in US history.
When speaking with people looking to make the transition to retirement, the four most common misconceptions about the 4% rule are:
- They believe that the 4% withdrawal rate is how much they can spend each year.
- They believe that their investments will not decline in value.
- The type of investments doesn’t really matter.
- You can base your retirement income plan on the 4% rule.
The above points are incorrect:
- The research did not take into consideration the impact of taxes.
- The 4% rule is based on the withdrawals lasting 30 years, and depending on the specific year of retirement, your capital could be almost 0 after 30 years or increased substantially.
- The research indicates that at least 50% of the investments need to be allocated to equities.
- The next section will review real-life planning using the 4% rule.
4 KEY ITEMS WHEN APPLYING THE 4% RULE IN REAL LIFE
When planning in real life, the rule does not take into consideration:
- the effect of taxes,
- retiree’s actual spending patterns,
- plan adjustments,
- and income sequencing.
EFFECT OF TAXES
A key consideration about the 4% rule is it does not take into consideration taxes. For example, if you have worked hard and saved $1,000,000, the 4% rule would indicate you could withdraw $40,000 per year in retirement.
Remember this is before tax withdrawals. As an example, the rule does not take into consideration:
- Different tax rates on withdrawals: If the source of withdrawal is a RRIF, then the entire $40,000 is 100% taxable as income, vs a withdrawal from a non-registered investment, which may include tax preferred income such as return of capital, capital gains and dividend income. If the withdrawal is from a TFSA, none of it would be taxable.
- Other Sources of Income: The rule does not include other sources of income that increase your overall income and taxes, such as CPP, OAS, Pension Plan, Rental income, or HOLDCO income.
- Tax Planning: The rule does not take into consideration the tax planning opportunities that may be available over your lifetime.
Taxes greatly affect your spending in retirement and must be planned for.
- Nine Strategies to Pay Less Tax in Retirement
- Paying your taxes in Retirement
- Tax Efficient Income Withdrawals
REAL-LIFE SPENDING PATTERNS
The 4% rule indicates you increase your spending by inflation each year, which is measured by the consumer price index.
Over the past year, we saw the effect of inflation, and during retirement, you do need your income to increase over time, but everyone has their own specific spending requirements.
Real spending over time does change and is personal. When retirement planning, you may want to view your spending in three different phases. Michael Stein, who wrote “The Prosperous Retirement,” divided retirement into three decades: the GO-GO years, SLOW-GO years, and the NO-GO years.
I have termed these the ATM years, which are the three stages of retirement spending:
Active Years – Stage One
These are your most active years that occur in the first 10-15 years of retirement when you are still healthy, younger, and are able to do the things you wish to do.
Transition Years – Stage Two
These are the years when you begin to transition and slow down, and your spending declines along with some of the activities you used to do. As an example, you may no longer wish to take longer overseas trips, but may continue to visit the southern US in the winter.
Maintenance Years – Stage Three
These are the years you tend to stay close to home, with less activities. Often this is based on age and health. This is the period when you could see extra health care expenses for at home care, and/or a move into a retirement facility.
With real planning, you can structure your spending requirements based on your specific needs and spending patterns, and you can design the strategy to spend more in the active years, and still have a high probability of the income lasting your lifetime.
The 4% rule was developed based on surviving the worst market returns and events in history (i.e., The great depression, WW2, Vietnam war, and the 1973 oil crisis).
Not running out of money in retirement is key, but if you limit it to only withdraw 4%, in many cases, you may be able to spend more.
Also, in the cases where a withdrawal rate above 4% was used, the studies assumed people will spend all their assets down to zero and not make any adjustments.
Most retirees do not want to run out of money but also want to be able to have some flexibility in spending.
To do this, many can make adjustments to their retirement income and cash-flow strategy.
When developing a retirement plan, you must build in some contingency and have the ability to adjust your spending as required. Examples of some ways to adjust your spending if your portfolio experiences negative returns are:
- Most retirees have both essential and discretionary expenses – and discretionary expenses are those that can be adjusted for a period. An example today would be holding off buying a new car for a year or so until interest rates perhaps decline and/or the investment market recovers.
- Clients during the 2008-2009 global financial crises were able to adjust their spending by putting off major purchases or home renovations during that period.
- Some clients have a contingency plan to downsize and/or sell a vacation property if required during the maintenance years.
A key factor is the ongoing updates to review your income plan to test the current spending and what your maximum sustainable spending might be.
With an ongoing process you can determine when problems may occur, often decades ahead of time, and adjust as required. During the past few months, we have updated plans for several clients to see if adjustments are required.
INCOME SEQUENCING – ORDER OF WITHDRAWAL
The 4% rule is based on withdrawing income from your investment assets, and many retirees have other sources of income such as:
- Canada Pension Plan (CPP)
- Old Age Security (OAS)
- Pension Plans
- Rental Income
- Part-time work
Each of the above sources of income can have different start dates and income amounts. For example, you can delay both OAS and CPP to age 70 and obtain an increased lifetime guaranteed income.
By reviewing various order of withdrawal strategies, you will be able to determine a strategy that can maximize your after-tax income over time, and you can have various withdrawal rates as you age.
HOW IS THE 4% RULE USED IN REAL FINANCIAL PLANNING
After developing a customized retirement spending plan the 4% rule, which is actually a review of “safe withdrawal rates”, is one of the diagnostic tests that can be used to evaluate the sustainability of a plan.
The 4% rule can’t be used in isolation. Similarly, when you go for a physical, your doctor just doesn’t check your blood work and say you are ok. It is just one of the holistic tools used in a comprehensive approach.
The retirement income and cash-flow planning process should review your withdrawal rates over time taking into consideration:
- the effect of taxes,
- actual spending patterns,
- other sources of income,
- and different income sequencing patterns.
Annual updates and reviews will act as a retirement guardrail to make sure your strategy is still on track, and you can adapt and adjust as required.
For more information, you can refer to Preserving Wealth: The Next Generation – The definitive guide to protecting, investing, and transferring wealth by Jack Lumsden, MBA, CFP®
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This material is provided for general information and is subject to change without notice. Every effort has been made to compile this material from reliable sources; however, no warranty can be made as to its accuracy or completeness. Before acting on any of the above, please make sure to see me for individual financial advice based on your personal circumstances. The information provided is for illustrative purposes only. Commissions, trailing commissions, management fees and expenses may all be associated with mutual fund investments. Mutual funds are not guaranteed, their values change frequently, and past performance may not be repeated. Please read the Fund Facts and consult your Assante Advisor before investing.
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