26 June 2022

The Rules of Retirement Spending Are Changing

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The rules that govern retirement spending are changing. No surprise, then, that retirees have lots of new questions.

For decades, conventional wisdom was that retirees who wanted a high degree of certainty their money will last should spend no more than 4% of their savings in the first year of retirement and adjust that amount annually to keep pace with inflation. Research firm Morningstar Inc. MORN -1.68% upended that thinking earlier this month with a recommendation that people spend no more than 3.3% of their savings at the start of their golden years.

That news prompted a litany of questions from readers of The Wall Street Journal. Is Morningstar the only corner of the money management world arguing for a lower withdrawal rate? Is it ever OK to draw down more than 4%? Can I keep my retirement spending the same if I increase my allocation to stocks, or international investments?

The Morningstar math is straightforward. Someone with a $1 million portfolio would have to draw down $33,000 in year one of retirement instead of $40,000 under the 4% rule. Assuming 4% inflation, that same retiree would have to live on $34,320 in year two and $35,690 in year three, regardless of market performance. Morningstar made its adjustment because of lower returns expected from stocks and bonds in the years ahead. If inflation, which is at a 30-year high, remains near today’s level for an extended period, even 3.3% might not be low enough, according to Morningstar.

How you should react to this new guidance is anything but simple. Here are answers to some of the most pressing questions from readers:

Does everyone agree the 4% rule should be revised to 3.3%? 

No. Some have argued it should go even lower. A group of researchers that includes American College of Financial Services professor Wade Pfau concluded in a 2013 study that the initial withdrawal would have to be capped around 2.5% for investors to have a high likelihood of making their money last over a 30-year retirement.

That calculation, based on forecasts of future returns, assumed investors had 50% of savings in stocks and 50% in bonds.

But the man who in 1994 came up with the 4% rule—retired financial planner Bill Bengen—isn’t conceding that 4% is too high. In fact, he said investors can go even higher if they are willing to diversify their bets. That said, he agrees future returns will likely be below average over the coming decade.

And you can in fact withdraw a higher percentage of your balance if you think your life expectancy is likely to be shorter than 30 years (the period typically used to arrive at these calculations). For example, a couple who retires at age 75 and expects to live another 20 years can start by drawing down roughly 5% of savings, said David Blanchett, head of retirement research at PGIM, the investment management group of Prudential Financial Inc.

Can I withdraw more than 4% if I invest a high percentage of my portfolio in stocks? 

It isn’t a good idea, according to Mr. Bengen. The 4% rule is most reliable for portfolios with 50% to 60% in stocks and the rest in bonds.

If you invest less than 50% in stocks, your returns may be insufficient to support a 4% inflation-adjusted withdrawal for 30 years, said Mr. Bengen. With more than 60% in stocks, your portfolio may lose so much during a bear market that it won’t be able to recover.

“It’s good to be in the middle,” said Mr. Bengen.

What if I diversify my portfolio further? 

It might help, according to the father of the 4% rule. Adding international stocks and the stocks of small U.S. companies to a hypothetical portfolio would have earned enough to justify an initial retirement withdrawal of 4.7% during any 30-year stretch of the last 95 years, Mr. Bengen said.

Mr. Bengen recommends holding roughly 11% each in international stocks and U.S. large, midsize, small, and microcap stocks. He also recommends allocating 10% to Treasury bills and 35% to intermediate-term U.S. bonds.

Still, Mr. Bengen warns that today’s high valuations in both stocks and bonds have no parallel since 1926. As a result, he recommends starting with an initial withdrawal rate of 4.4% or 4.5% if you can get by on that amount, versus 4.7%.

How does high inflation affect my spending plans? 

When inflation rises, the risk of portfolio depletion also rises. Consider Judy, who has a $1 million portfolio. She spends 4%, or $40,000, in the first year of retirement. If inflation is 2% in years two and three, her spending would rise to $40,800 and $41,616. But if inflation is 6% instead, her withdrawals will be $42,400 in year two and almost $45,000 in year three.

When inflation rises, investors end up with higher dollar withdrawals for the rest of their lives, putting a greater burden on the portfolio, said Mr. Bengen.

“Inflation is a pretty serious threat for retirees, which is why I’m troubled by what I see now,” he said.

What about annuities? Is that another way I can withdraw more from my savings? 

Yes. So-called “immediate annuities” convert a lump-sum payment into an annual income for life, said Mr. Pfau.

A 65-year-old woman who buys a $100,000 immediate annuity today will receive about 5.6% a year of the amount she invested. In contrast, the yield on a 30-year Treasury bond is about 2%.

The extra income from annuities is the result of the requirement that you surrender your principal to the insurer. Each payment consists not just of interest, but also of a portion of principal, prorated over your remaining life expectancy, plus a portion of the remaining principal of other annuity purchasers who died before recouping their costs.

Insurance companies don’t charge fees on immediate annuities; instead, they invest your money and pocket the difference between what they earn and the income they promise you.

The payments are guaranteed to continue for life. But when you die, they stop—regardless of whether you’ve recovered the amount paid. To protect your principal, you can purchase a death benefit, but you must settle for a lower income.

Another way to expand your guaranteed income is to delay claiming Social Security, said Mr. Pfau. Unlike most annuities, Social Security is adjusted annually for inflation. If you delay claiming from age 62, when people first become eligible, to age 70, you will miss eight years of Social Security benefits. But your benefit at age 70 is about 77% higher.

Once you get past age 80, you will “be in better shape for the rest of your life,” said Mr. Pfau.

The Internal Revenue Service requires me to pull money from retirement accounts starting at age 72. What if that pushes me above my annual withdrawal target? 

Once you are 72, the law requires you to withdraw a set minimum amount annually from your traditional retirement accounts, or face an excise tax on the amount you should have taken.

To determine your required distribution, divide your traditional individual retirement account and 401(k) balances as of the previous Dec. 31 by your life expectancy in the IRS Uniform Lifetime Table. As people age and life expectancy declines, the percentage they are required to withdraw rises. For example, a 72-year-old must withdraw 3.9% of the balance, but for an 80-year-old, the rate is about 5.4%.

The 4% rule can help you determine how much of your required distribution you can spend. If the 4% rule says you should spend less, take your required distribution and pay the taxes due. Then, deposit whatever exceeds the recommendation under the 4% rule into a taxable account, said Mr. Blanchett.

“You have to take your required distribution, but you don’t have to spend it,” he said.

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