If you are like most people, the focus of your retirement preparations have been savings-related. You may even have a certain dollar amount in mind that you want to have before you feel ready.
But what happens next? When you retire, you need to have a plan for how you will spend your retirement savings. After all, that is the entire point, right? That’s where knowing how you will spend from your retirement savings comes into play — not just how much. What I mean is that your withdrawal strategy in retirement is just as important as your savings strategy leading up to retirement.
I’ll explain some common withdrawal strategies in this article.
1. Different Withdrawal Strategies
There are many different ways to plan your retirement withdrawals. There are pros and cons of each, and no one method is right for everybody. The key is making sure that you have a plan that works for you, and that you aren’t just winging it or making it up as you go.
Here are a few of the most popular strategies:
The 4% Rule
Perhaps the most famous retirement withdrawal strategy is the 4% rule. This strategy is derived from a study published by financial planner Bill Bengen in 1994 (PDF). You can read the study in its entirety, but the key takeaway is that, using historical data, he found that someone who withdrew 4% of their savings in the first year of retirement, and adjusted their withdrawal for inflation each year after, could have sustained a minimum of 30 years in retirement even in the worst case. Soon after, 4% then became known as the maximum safe withdrawal rate.
Although a rule of thumb like this isn’t certain to hold true going forward (in fact, it’s a subject of constant debate) it provides historical context for knowing how much you might be able to safely withdraw from your own savings.
It’s important not to follow the 4% rule blindly. If you decide to use it, do some research to make sure you are comfortable with the assumptions used to create it, and be prepared to modify the rule to fit your situation better.
While a withdrawal rate strategy is easy to implement, it does have some drawbacks. For example, in the historical context in which the 4% rule was developed, a retiree that followed it would have finished retirement with a much larger savings balance than when they started.
While this certainly addresses the concern of running out of money, it also means that the retiree could have enjoyed much more spending throughout retirement.
One way to address the competing goals — enjoying retirement to its fullest without running out of money — is to have a process in place for adjusting your withdrawals over time.
My favorite such strategy is the guardrail method. This strategy allows you to adjust your withdrawal if you reach certain upward and downward limits. Again, you can see the original research here, but the key takeaway is that you follow the same basic withdrawal approach as the 4% rule, with a few additional modifications. The most notable are the “guardrails” which call for you to:
- Increase your planned withdrawal by 10% if your investments grow large enough.
- Decrease your planned withdrawal by 10% if your investments drop off by a significant amount.
I’ve explained this in a deeper and more mathematical way here, if you’re interested in a thorough explanation, but you get the idea. Following a process like this guides you to make smaller changes over time so that you can spend more if your investments grow, without increasing your chances of spending your savings too quickly.
It’s also possible to create a fixed payment stream from your savings that is guaranteed by a third party. If you participate in Social Security or have a pension-based retirement plan, then you already implement this to some degree. The benefits you receive from them are not dependent on stock returns or your savings withdrawal rate.
You can get this same type of arrangement from your retirement savings by using a portion of it to buy an immediate annuity or choose investments with fixed maturity dates.
There are some benefits to doing this for some of your retirement income. Creating an income floor so that you have a certain amount coming in during retirement, regardless of what the markets do, can be very appealing psychologically. If you know you have some guaranteed income, then you may feel more relaxed and confident about your finances. It could even allow you to enjoy retirement more.
The trade-off is that these types of investments usually have much lower returns than the stock market may provide in the long term. Specifically with annuities, you also lose flexibility because you are effectively “buying” the income stream and won’t have an asset you can sell if you needed to.
One reason Social Security planning is so important, even if you have adequate savings, is because it helps maximize your income floor without drawing from savings to do it.
2. Tie Your Investment Plan To Your Withdrawal Plan
Investing during retirement is different from investing for retirement. That’s because when you are saving for retirement, the goal is to accumulate enough money so that you can retire. But once that happens, the goal of your investments becomes supporting your spending needs.
Your investment plan should reflect that reality and be coordinated with your withdrawal plan. Investments that you will withdraw soon need to be held in more stable vehicles, and some may even need to be held in cash.
On the other end, some of your investments will need to continue to grow to support withdrawals many years down the road.
3. Don’t Forget About Taxes
Taxes matter a great deal in retirement! They shouldn’t be an afterthought, and there’s a lot more to proper tax planning than simply waiting until you file and claiming as many deductions as possible.
You should consider how your withdrawal plan and investment strategy affect your tax bill. You can’t avoid taxes entirely, but it pays to be as tax-efficient as possible.