Avoid This Major Pitfall of Standard Withdrawal Strategies

You might be missing something if you're focusing only on your initial withdrawal rate...

...on today's episode, we'll cover what you might be missing, and how you can maximize your portfolio withdrawal strategy.


Questions answered:
What is the 4% rule and how does it apply to me?
How should staggered income and expenses alter your withdrawal strategy?

Time stamps
0:00 Intro
2:15 What is the 4% rule?
4:00 Example of staggered income or expenses
9:13 You might be limiting your withdrawals
12:20 Staggered income and expenses
13:15 Example of staggered income and expenses
18:20 Looking at your portfolio differently
19:09 Summary
21:30 Conclusion
22:38 Outro

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Transcript

 If you're basing your portfolio withdrawals only on the 4% rule, then you're probably missing something. And whether it's actually the 4% rule or guidance approach or anything else, by focusing only on your initial withdrawal rate, you're missing the bigger picture. In today's episode, I'm gonna share with you a better approach.

When you retire, one of your biggest concerns is gonna be, where's income coming from? Your paycheck goes away, your portfolio kicks in, and the way that you're gonna start pulling money out of your portfolio is likely based, at least to some extent on some rules, some research that says, here's how much you can sustainably take from your portfolio.

The problem is if you're just looking at that ignoring everything else, you're probably gonna run in some roadblocks and you're probably gonna look back and say, oh my goodness, I made a mistake that was avoidable. That's what I wanna share with you today. How do you factor in other considerations so you can make the most of your portfolio withdrawals in retirement before we hop in.

As always, want to quickly highlight the review of the week though, and thank you for all of you who have left reviews. Really helpful to get the show discovered by more people. And today I wanna highlight a review this Crums from username D dash Merrick. It says, five star review says very. Lots of useful information for getting the most out of your hard-earned retirement savings.

I didn't know what I didn't know before listening in. Dean Meric, thank you for taking the time to leave that review. It helps me, it supports the show. It supports others who are looking for great retirement advice, so thank you very much for doing so. And for those of you who haven't done so already, if you're listening on Apple Podcast or on Spotify or wherever you're listening and allowed to leave reviews, would really appreciate you taking a couple moments to do.

So now let's get on with the show. So the 4% rule, now I'm picking on the 4% rule because it's fairly basic and easy to explain. But the principles I explained, they're gonna be the same whether they're using the 4% rule to govern your portfolio withdrawals. It's the same whether you're using guidance approach or some other approach.

Your analysis is gonna be limited if it's not taken into account Other. Let's look at an example and to start, let's redefine what the 4% rule is. The 4% rule says that historically speaking, if you take a portfolio that's 50% invested in US large companies and 50% invested in intermediate government bonds, what you can do is you can take 4% of your portfolio value, adjust it for inflation, and based upon all historical timeframes, you'd have an extremely high probability of not running out of money for 30 plus.

So in other words, you start retirement, you have your portfolio, you invested a certain way. You say, what percent of this portfolio can I take out? I take that amount out, I adjust it for inflation, and I'm probably gonna be okay for at least 30 years. Now when you look at that, that seems pretty basic. All you need to do is say, my annual withdrawal.

So that first year withdrawal and retirement needs to represent 4% of my total portfolio. Or less, of course, but no more than 4%. If I want to be assured that this is gonna last for 30 plus years, at least based upon historical numbers. So you see that and say, okay, well if I need $40,000 per year, as a very basic example, what I do is I divide that by 4%.

So 40,000 per year needs to represent 4% of my portfolio. So if I take 40,000 divided by 4%, that tells me my portfolio needs to be a million dollars. So a million dollar portfolio can generate that 40,000 per year adjusted for inflation and be fine for 30 plus years based upon the 4% rule. Of course you still need to account for taxes for non portfolio income sources and cost of living adjustments on those and a few other factors.

But in general, that seems pretty basic. The problem is that's not how most people's retirement actually goes. It's not as if you retire or need the same exact amount from your portfolio for every single year. The reality is you're either gonna have staggered income or staggered expenses or both. And so let's look at an example what that might look like.

Let's say, for example, you retire at 65. Well, you're gonna retire at 65, but your social security maybe is gonna start in five years when you turn 70 and maybe social security for your spouse is gonna start in three years. What you look at that and if you start with zero income when you retire. And then your spouse starts their social security in three years, and then you start your social security In five years, what's happening is you have staggered income sources, which means you don't need regular amounts from your portfolio.

I shouldn't say regular. You don't need consistent amounts from your portfolio. What you're actually gonna need is a lot more of those first three years because there's no social security at all to fund anything. Which means your portfolio is on the hook for everything. If you need 50,000 per year, that full 50,000 has to come from your portfolio.

If you need a hundred thousand per year, that whole a hundred thousand needs to come from your portfolio. Well, now, let's assume three years go by and your spouse's social security benefit kicks in, and let's assume that you need that $50,000 per year and their benefit is 20,000 per year. Well, now you don't need 50,000 from your portfolio.

You need 30,000 from your portfolio. That's a lesser amount. Well, then another couple years goes by, you turn 70 and let's assume at age 70 you have 30,000 coming in from social security. Just kinda making these numbers up on the fly. But as you look at that, now all of a sudden between your spouse's 20,000 and your 30,000, you don't need anything from your portfolio.

So that specific example may or may not be relevant to you Exactly, but the principle is if you just look at a portfolio and say, okay, I need this to create 4% per year of income for me to meet my initial withdrawal needs. Those initial withdrawal needs might not be your actual needs in three years or five years, or 10 years, or whatever it might be.

So that's the case of staggered income. Now, it could also be the case where you have staggered expenses. What does staggered expenses mean? Well, let's look at an. Let's assume you retire and you look at your budget, not just for year one of retirement, but you run a basic projection for the first 5, 10, 15 years of retirement.

Not to get things perfect, but just to get a general sense of what's gonna stay and what's gonna go away when it comes to your budget. Well, maybe your budget starts at $85,000 per year for the first five years of retirement, and you might say, well, what would cause it to change? Well, I don't know. Maybe you pay off a mortgage.

You still have property taxes and homeowner's insurance, but if five years into retirement, your mortgage is gone, and let's assume that was 15,000 per year. Well now I'm 70, 85,000 per year. To do everything you wanted to do, you would only need 70,000 per year to do everything you wanted to do, and you're not taking a pay cut.

You're just no longer paying the bank because your mortgage is paid off. So let's assume that happens for another five years, and then your expenses drop to 60,000 per year because maybe after 10 years into retirement, you've settled in a bit. You're not as active, you're not taking as many trips, but you're still living comfortably on 60,000 per year.

So that's not an uncommon scenario at all. Well, let's look at an example of how would that impact your portfolio withdrawal rates. Let's assume, and again, to recap, your expenses are 85,000 per year. For the first five years of retirement, they're 70,000 per year for the next. So from your six to 10, and then there's 60,000 per year from there on out.

Well, let's assume that you have consistent social security income of 40,000 per year, and by consistent, I mean it's starting day one of retirement. It's not like that previous example where it kicked in partway through retirement. So you have 40,000 per year from Social Security and you have $750,000 in your p.

If we assume for simplicity that portfolio value stays constant, then here's what this looks like. The first five years of retirement, you would need to pull out 45,000 per year from your portfolio. Again, your expenses are 85,000 per year. 40,000 is coming from Social Security. The remaining 45,000 needs to come from your portfolio.

Well, if we wanna understand that as a withdrawal rate, we divide 45,000 per year that you're taking out by your portfolio value. So 750,000. That represents a 6% withdrawal. That seems far too high. If you look at that and that's all you looked at, you would say, I can't retire. I am spending far too much in my portfolio.

My portfolio's not gonna last. Well, that's what you might think, but let's continue with this example. After the first five years, so once your mortgage is paid off, now you're only taking 30,000 per year from your portfolio. 40 thousands coming in from Social Security, your living expenses have dropped from 85,000 to 70,000 because the mortgage is paid off.

So now you're taking 30,000 per year, and if we assume your portfolio value is still 750,000, what 30 divided by 750,000 represents a 4% per year withdrawal rate. So now we feel more comfortable. We say, okay, that's actually a long-term sustainable withdrawal rate, but it gets even better. Let's assume five years later after that, so 10 full years into retirement, we're now assuming that you're only spending $60,000 per year.

And if we're assuming that 40,000 is still coming in per year from Social Security, then you only need 20,000 from your portfolio. Well, if you take $20,000 from your portfolio and your portfolio value is still 750,000, that represents a withdrawal rate of only 2.7%. Now, of course, the reality is your portfolio value isn't going to stay constant.

All those years, market forces and withdrawals are gonna skew that value either upwards or downwards based on what's happening. But the problem is when you retire, if you just apply standard withdrawal rates, it's gonna look like you can't. If this is you in this example and you are myopically focused on trying to get that first year withdrawal rate to work, you're gonna say, okay, I need a portfolio that if I take 4% of it, it can meet all my needs.

Well, if you're limiting your withdrawals to 4% of your portfolio value because you're not looking at the big picture, you're not looking how your expenses are gonna change over time. It would tell you that you would need a much larger portfolio. You would need a portfolio value of $1,125,000 in order to support a withdrawal of 45,000 per year and have that only represent 4% of the portfolio.

So if that was wording kind of confusing. Just to summarize, if you live on 85,000 for the first five years of retirement, and of that 85,000, 40,000 is covered by Social security. That $45,000 difference needs to come from your portfolio. If we divide 45,000 by 4%, it tells us we need a 1.125 million portfolio to enable us to retire.

So if we're there sitting looking at our $750,000 portfolio, we're gonna get really discouraged and say, oh my gosh, I'm still a long way off. So you end up putting retirement off for a number of. Well, the problem is, I'd argue you can retire now with $750,000 in your portfolio and maybe even spend more than the numbers that I listed.

Why? It's not because I have a magical solution to enable a sustainable withdrawal rate beyond 6%. No, not at all, but it's because I can project out that that 6% per year withdrawal rate is only temporary. If you needed 6% per year of your portfolio forever, you would probably not be in a good position to retire and have good odds of success with your retirement.

However, that 6% is only temporary. It's only gonna last in this example for five years. Then after the mortgage is paid off, this falls to a more sustainable 4%. Then after that, after a few more years of travel and spending, in our example, once that goes away, it falls to an even lower 2.7%, which based upon all historical time periods, looking at the s and p 500 and intermediate term government bonds.

That would be more than sustainable. So now of course you wanna stress test this. You really wanna make sure your expenses are right, build in some buffer, do much more than I'm doing here in this basic example. But this is just an example to illustrate how if all you're focused on is that withdrawal rate, you're likely missing something.

And that's just looking at staggered income in a vacuum or staggered expenses in a vacuum. If you double down on that and you have both staggered income and staggered expense, So for example, maybe you have different social security benefits or pensions or rental income or whatever it might be, starting at different times, start retirement, and you have different expenses at different times throughout retirement, which most people do.

Then that doubles the complexity. So you may be thinking, well, what's the point of withdrawal rate then if we can't actually apply it to a real world example, well, you can still apply it, but you just have to understand the context in which you're doing so, and that's what I mean by looking at the big.

When you understand your different income sources and your different expenses as a starting point, then you can apply this. Now, that's not to say there's still other things to be considered like tax considerations or your asset allocation or other factors, but here's an example of how I would approach this.

Once you have a clearer understanding of your income and expenses and how those change over time to do this, let's look at that same example. You have the $750,000 portfolio. You're going to have 85,000 per year of living expenses for the first five years of retirement, $70,000 per year of living expenses for the next five years.

So you're six through 10, and then $60,000 per year expenses from years 11 and beyond. Well, if you look at that portfolio value today of 750,000 to start, don't think of it as just one big portfolio. Break it down into different chunks or buckets or tranches or however you want to think of this, for example.

You need 45,000 per year for five years. Well, let's assume a super conservative number of 0% growth and say, how much would I need just sitting in cash? Not that that's most effective, but just to illustrate this, how much do I need sitting in cash that I know I could pull 45,000 per year out of this portfolio regardless of what happens in the stock market?

Well, 45,000 per year times five years, that's 225,000. So if of this $750,000 portfolio, let me mentally earmark 225,000 of it to fully fund my first five years of retirement. And it's gonna go on something very conservative, say, paying nothing in interest rate, at least no real interest rate after inflation's been backed out.

Well, for the next five years, I need 30,000 per. So that 30,000 per year, if I do the same thing, multiply that by five, that's $150,000. So I will need $150,000 starting year five. I know I'm ignoring the impact of inflation here, so that would need to be taken into account. But just to clearly illustrate this, I need $150,000 per year, starting in year six at the very beginning of year six to fund the next five years.

Well, I have five years to get that $150,000, so I don't have to be as conservative with those funds as maybe I'm choosing to be. In this example with years zero through five year funds. So let's assume I could get 5% growth and I need that money in five years. So if I need 150,005 years and I can put a chunk of money into something growing at 5% from now until then, what that actually means is I need to allocate $118,000.

For my six to 10 year income bucket, so after five years of that $118,000 growing at 5% per year, I'd have $150,000 that could then fund years six through 10. So to recap, I need $225,000 sitting in something super conservative that's gonna pay me $45,000 for the first five. All the while I've put $118,000 into something growing at 5% per year.

So when your six rolls around, that can pay me 30,000 per year. So that's back up again. I started with 750,000. Well, really I still have 750,000, but of that, I've earmarked 225,000 to pay for my first five years of expense. I've earmarked 118,000 to pay for the next five years of expenses. That leaves me with $407,000 remaining, and that's what needs to fund years 11 and beyond.

So if we look at that, can we make that work? Well, here's what we know. Again, at that time, 60,000 per year is what I need to live on. 40,000 per year coming in from Social Security. So 20,000 is what I actually. Keep in mind, 10 years have gone by, inflation's gonna happen. So if we want to keep up with inflation, and again, big step back.

I know I'm not fully factoring in inflation to some of these aspects, so don't copy exactly what I'm doing, but just here's the framework that I look at. If I need 20,000 per year, starting in 10 years, and if I assume a 3% per year inflation rate over that next 10, Then what I really need is $27,000 per year, starting after year 10.

So that's what I need. And again, I have $407,000 that hasn't been earmarked yet of my existing $750,000 portfolio. Can that $407,000 today grow to a number that can support $27,000 per year withdrawals starting after 10 years? Let's see if we take that $407,000 in your portfolio, that's still remaining.

And if we assume we can put that into something that's growing by 7% over the next 10 years, then what it's gonna do is grow at about $800,000. So in other words, in 10 years, I'm going to have $800,000 because I've burned through the first bucket of money. I've burned through the second bucket of money, but I still have $800,000, and that then needs to create $27,000 per year for me for the rest of my.

Well, if I divide 27,000 by my $800,000 portfolio value, that represents a 3% per year withdrawal rate, more or less. So as I look at it that way, my portfolio can absolutely do that. That's underneath the sustainable withdrawal rate rules that we're looking at using the 4% rule. So what I've done is I've not looked at my $750,000 portfolio as one big portfolio.

Yes, it's going to be invested together. It might all be in one account or a series of accounts, and it, depending on what the registrations. But by looking at this in a more segmented way, I've said, how much of that needs to fund years one through five, $225,000? How much of that needs to fund years six through 10, $118,000?

And then what's left over to fund years 11 and beyond in based upon what that's projected to grow to, can it fund those? Via a sustainable withdrawal rate and the answers yes. So I hope that makes sense. I know that this is a little bit more technical and there's some aspects of the actual calculation that I'm leaving out when it comes to the inflation adjustment or the tax side, but that is a good framework of how you'd want to look at this.

And to summarize, the reason I'm breaking it up into those different chunks is two. One years, one through five, six through 10, 11 and beyond. That's because of staggered expenses. So I don't need the same exact withdrawal rate from each time period. So it's helpful to think of those in different chunks, but number two, I'm going to invest differently for the funds that are earmarked for the first five years than I am for the funds that are earmarked for 10, 15, 20 years and beyond.

So that first chunk designed to meet the one through five year needs, that should be very conserv. Because I don't want any risk of a terrible market inhibiting my ability to take money for those first five years. Well, chunks six through 10 that could afford to be a little bit more balanced. You have a longer time horizon.

You can afford some fluctuations, but maybe you still don't want the most aggressive allocation. And then years 11 and beyond that could be a more growth oriented portfolio. Because even if the market does fluctuate, and it certainly will fluctuate over 10 years, you have a long enough time horizon for some of those fluctuations to.

You should keep monitoring it. You should adjust this as you go, but that's the framework that you can think through. So the application of this to the standard 4% rule is twofold. Number one, you're probably not gonna have a consistent smooth. Withdrawal rate the entire time, it's likely gonna fluctuate.

And number two, just because the 4% rule is based upon a portfolio that's 50% invested in the US stock market, and 50% invested in intermediate term government bonds, does not mean you should do that with your portfolio as you start to look at the different buckets that your portfolio actually needs to fund.

Going back to being more conservative for the first bucket. More balanced for the second, more growth for the third. In my example, you should come up with the right allocation for your portfolio based upon when you actually need the funds, not based upon this piece of research that's good, but just designed to give you a sense of what's sustainable over long periods of time.

So whether it's the 4% rule or the gut and Clinger approach, don't just revert to those because of the research showing how much that can support over time those were created. Both those pieces of research were created under the assumption that you started with a standard withdrawal amount and that you adjusted it based upon inflation and market forces.

But that's it. The reality is that withdrawal rate is going to be adjusted based upon your income sources and how those change over. In your expenses and how those change over time, and they're not gonna be perfectly constant. So in conclusion, here's the guidance I'd give. Make sure you're taking a holistic approach to everything.

The 4% rule is great research, guidance approach is based on great researchers. Absolutely nothing wrong with that. However, it's not gonna fit perfectly in most people's situations, so you can know that research inside and out. You can know all the rules, but still really mess up your retirement plan if you're not looking at things holistically.

Make sure you're looking at income and expenses and taxes, inflation, ask allocation, all these different variables to understand the relationship between all of them. So when you're understanding what withdrawal rate you should employ in your portfolio, you're doing so under the right assumptions and you're doing so in a way that will maximize your income over the course of your retirement.

So that is it for today's episode. Thank you very much for listening. Thank you for your support of the show. If you'd like more material just like this, you can find this podcast along with other great information on our YouTube channel at Route Financial. So make sure you're subscriber to this podcast on your podcast player.

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