"Every summer we can rent a cottage in the Isle of Wight ... if it's not too dear ... We shall scrimp and save..." — "When I'm Sixty Four," as performed by The Beatles
More financial advisors are suggesting that it has become necessary to rethink one of the primary rules of thumb in retirement allocation calculations — that we should spend no more than 4 percent of our nest egg annually.
Let's consider the financial dynamics of the 4 percent rule. If your retirement accounts total $1.5 million, that means that you should withdraw no more than $60,000 in the first year of retirement. Factoring in inflation, in the second year you might need to spend a little over 4 percent of your nest egg to ensure the same standard of living. Simply stated, few of us can afford to spend through our nest egg too quickly.
So what has changed to render the 4 percent rule less valid? The most obvious answer is that we're living longer and thus, our retirement accounts must serve us for more years. Also, the high cost of medical care for retirees has become a wild card, one that no financial planner or retiree can predict. Currently, though, estimates are that retirees will spend, on average, some $400,000 in medical expenses after age 65.
There's another theme, however, that is becoming more pervasive in the financial planning industry: investment returns are likely to be lower over the next 10 years than they have been over the previous decade. Stock market valuations are significantly higher than what they were nine years ago when the stock market bottomed out in March of 2009, and the economy isn’t growing nearly as fast as it once did.
This combination of retirees living longer and an expectation of lower returns has caused many advisors to suggest that clients utilize a 3 percent rule as a new guideline for retirement spending. Granted, this doesn't sound like much. But our fictional retiree ($1.5 million at retirement) who is spending 3 instead of 4 percent of his nest egg the first year in retirement would see a 25 percent drop in annual spending, from $60,000 to $45,000. That's a huge lifestyle adjustment. Consider also that once you spend that $45,000, the next year you are spending 3 percent of a smaller nest egg, unless of course your investment growth outpaces your withdrawal.
Most folks possess an intuitive retirement spending barometer. In years when returns are poor, retirees may back off on that European river cruise, and in banner years, they may splurge on a Hawaiian vacation. This flex spending approach may work for some. Of course, this means that the stability of your portfolio value and the predictability of your portfolio income becomes that much more important.
Margaret R. McDowell, ChFC, AIF, author of the syndicated economic column “Arbor Outlook,” is the founder of Arbor Wealth Management, LLC, (850-608-6121 — www.arborwealth.net), a “fee-only” registered investment advisory firm located near Sandestin.