Ready For Retirement
Planning for Large Costs in Retirement | Beyond the 4% Rule
Listener Sherry asks a good question: How do large, one-off expenses (like a new roof, new car, etc.) fit in the 4% Rule?
James explains the concept of the 4% Rule and its limitations while demonstrating how it can be an effective guideline in planning and forecasting retirement success.
He addresses the importance of anticipating one-off expenses and, depending on your portfolio withdrawal rate, using sinking funds to get a reality check on where you stand.
Questions answered:
Are one-off expenses covered in the 4% Rule?
Who should be concerned with creating sinking funds for one-off expenses?
Timestamps:
0:00 - Sherry’s question
3:19 - Shortcomings of the 4% Rule
5:30 - Look at income and outcome
6:58 - Portfolio withdrawal rate
10:51 - Example of no margin
13:02 - Sinking funds
16:57 - New reality check
18:49 - Consider the duration of expenses
20:17 - The wrap-up
Create Your Custom Strategy ⬇️
Listener Sherry asks a good question: How do large, one-off expenses (like a new roof, new car, etc.) fit in the 4% Rule?
James explains the concept of the 4% Rule and its limitations while demonstrating how it can be an effective guideline in planning and forecasting retirement success.
He addresses the importance of anticipating one-off expenses and, depending on your portfolio withdrawal rate, using sinking funds to get a reality check on where you stand.
Questions answered:
Are one-off expenses covered in the 4% Rule?
Who should be concerned with creating sinking funds for one-off expenses?
Timestamps:
0:00 - Sherry’s question
3:19 - Shortcomings of the 4% Rule
5:30 - Look at income and outcome
6:58 - Portfolio withdrawal rate
10:51 - Example of no margin
13:02 - Sinking funds
16:57 - New reality check
18:49 - Consider the duration of expenses
20:17 - The wrap-up
Create Your Custom Strategy ⬇️
The 4% rule has long been a cornerstone of retirement planning, specifically helping to address the question of how much can I expect to spend for my portfolio each year while still being reasonably assured that that money is going to last for maybe the next 30 years or so to support me throughout retirement. But what are we supposed to do when we have a big unexpected expense in our retirement? Maybe we have our perfectly planned budget, but then we need to repair the roof, or then the car breaks down, or then there's some major expense. How do we reconcile that with this 4% rule? That helps us understand how much we can take out each year. That's exactly what we're going to discuss on today's episode of Ready for Retirement.
Speaker 1:This is another episode of Ready for Retirement. I'm your host, james Canole, and I'm here to teach you how to get the most out of life with your money. And now on to the episode. Today's question comes from a listener named Sherry. Sherry submits this question. She says Hi, james, I really appreciate your show and the way you break financial concepts down into easily digestible nuggets.
Speaker 1:My question is how to think about large expenditures in retirement. What happens when a large expense comes up, like a new roof, septic system or car purchase. Does this count as part of that year's 4% withdrawal or do you create some kind of sinking fund for such items ahead of time? If our withdrawal is $125,000 per year, a $25,000 new roof is a substantial piece of the budget. Thank you for your guidance on how to wrap our heads around this important piece of the retirement puzzle, sherry. Well, sherry, thank you for that question.
Speaker 1:I think this is something that's really important for a lot of people to understand, because retirement cannot be perfectly boiled down to a 4% rule or a specific amount of income that you can expect to cover all expenses in retirement. As we go through this, I'm going to give some simple ways that you can look at this. There's not necessarily a perfect way to do so, but at least some frameworks for how can you think about planning for this in retirement. But I will say this what do we do as financial planners at Root, financial financial planners in general, we try to use software, and I know we're not going to use software in this episode, so I'm just saying this as a starting point that ideally, you're running this through some type of a program, because what that can do for you is when you look at your retirement, it's not as if your expenses stay the exact same every single year throughout retirement and your income sources stay the exact same every single year throughout retirement. Those vary. The implications of that is your withdrawal rates, the amount you're taking from your portfolio, will also probably vary year to year, so don't expect that it's going to be exactly 4% every single year, or 3% every single year, or 5% every single year. I've yet to see a retiree who spent the same exact percentage of their portfolio every year, and it's because there's so many variables that impact this income sources, expenses, portfolio value, things like having to pay for a new roof, a new car, things of that nature.
Speaker 1:So what's the best way to do this? Well, the best way to do this is, of course, to model it through software, because the software can help you model out. What if you do purchase a new car every so often? What if there is a new home repair or roof that's needed every so often? What if there's a period of time that you're supporting children or grandchildren? What if there's a larger vacation every so often? What if there's big long-term care expenses down the road? So I'm starting with this because that's absolutely the best way to do it. Not the software is going to be perfect, because, of course, the future is unpredictable, but software at least says.
Speaker 1:If these assumptions, if these inputs are true, here's what you might expect your withdrawal rate to look like. That being said, this would be a pretty lame episode if I just said, sherry, go get some software and called it a day. So what I want to do now is give you a framework that you can use to think about this, and the first thing they'll say is this start by understanding the shortcomings of the 4% rule or any retirement I don't want to call them theories, because they're not theories but any type of retirement strategies like that. Why do I say there's a shortcoming? So the research is true.
Speaker 1:Bill Bangan created this 4% rule framework where he said look, if you have a portfolio that's half intermediate term US bonds and half large cap US stocks, over all historical time periods, looking backwards, there's not been a 30-year time period that you would have run out of money if you started your portfolio withdrawals at 4% or less. So that's true. Why do I say it's limited? If that's true, well, it's limited because that's not how the normal person actually spends money. The normal person isn't looking at their portfolio and saying, okay, you tell me how much I can spend. The normal person is saying I'm looking at my expenses what do I need for groceries, what do I need to pay utilities, what do I need to travel Like I want to travel or do the things that I want to do. So the normal person isn't looking at some theory or some white paper to say, okay, my portfolio can generate exactly X number of dollars per year. They're starting with their real life, they're starting with their monthly budget, and then the portfolio comes in to supplement what you might have coming in from other income sources, like social security or a pension.
Speaker 1:So, as we start today, one of the main points I want to get across on today's episode is don't try to peg your actual spending to a rule like the 4% rule that's entirely focused just on your portfolio, and I don't mean this to be dismissive of this rule. I think this is wonderful research that helps us to understand that there is a limit to how much our portfolio can generate in income. There is an upper threshold after which, if we keep spending too high a percentage of our portfolio, there's a very good chance that we spend down our portfolio and run out of money. So we need to understand the role that this rule plays in our portfolio and in our overall financial plan. But this is more of a guideline to say look, if you're consistently spending more than this, you might be in trouble, but if we can consistently keep our withdrawals to less than this, we probably have a good chance of staying on track. So where should you start?
Speaker 1:Knowing this to be true or knowing this all to be the case, I suggest that you start by looking at your expenses so understand what your expenses are. Is it $4,000 per month that you need to spend in retirement? Is it $8,000 per month? Is it $15,000 per month? Start there. Once you know what your expenses are, the next thing you need to do is you need to understand how much of those expenses is my portfolio responsible for and how much of those expenses. How many of those expenses will be covered by income sources through retirement, like social security, pension, rental income, whatever the case might be.
Speaker 1:Let's look at an example. Let's say you want to live on $6,000 per month throughout retirement and let's assume that you're married and you and a spouse have $4,500 per month coming in from social security, whether you're married or not, whether those are the actual income numbers or not. Just focus on the framework here. Focus on the formula. But let's assume that you have $4,500 per month coming in. That means there's a shortfall, in your case of $1,500 per month, which comes out to $18,000 per year. What does that tell us? Well, you want to spend $6,000 per month. $4,500 is coming from social security. $1,500 or $18,000 per year that's what's actually coming from your portfolio.
Speaker 1:What you need to know is what does that represent as a withdrawal rate? If you only have $20,000 in your portfolio and you're taking $18,000 out, you're going to have not a formula for success. If you have several million dollars in your portfolio and you're taking $18,000 out, you could do that forever. So look at the dollar amount that you're taking from your portfolio and then understand what does that represent as a withdrawal rate of the larger portfolio. So, as we're doing this, I'm going to make the math simple for me. As we're going through this, I'm going to assume that you have exactly $1 million in your portfolio. Well, if you are taking $18,000 out of a $1 million portfolio, you are taking exactly 1.8% as an annual withdrawal rate from your portfolio. So what does this start to tell us? How is this at all even helping us? To address Sherry's question of what do we do about those one-off expenses Well, if you're looking at this and you're only spending 1.8% of your portfolio, and assuming you're invested in a halfway decent retirement portfolio, there's a very high likelihood that not only is that going to be totally sustainable over the course of your retirement, but your portfolio is probably just going to continue growing.
Speaker 1:Now, that's not to say there won't be down years in the market. There absolutely will be down years in the market. There will absolutely be down years in your portfolio, but on the whole, your portfolio is probably going to continue growing to the point where it's worth a lot more money at the end of your lifetime than it is even when you began retirement, if you're only spending 1.8% per year. So what does that mean? Well, if 4% is that upper threshold and I want to be very careful when I say that, because I don't think that it actually is the upper threshold In fact, even in Bill Bagan's white paper, it wasn't necessarily the upper threshold. It was the upper threshold if you started retirement at the worst time in history and you had a series of really bad market events in front of you.
Speaker 1:There are other ways. I actually like to approach this. I think other ways seem to make a lot more sense for retirees. But let's just call 4%, for the sake of argument here, the upper threshold. Well, if 4% rule is what you could spend and you're only spending 1.8%, let's assume this is Sherry's example. Now I'm just making these numbers up.
Speaker 1:But to answer Sherry's question, sherry, what that would mean to me is you probably don't need to be too overly concerned about those one-off expenses because you're living on less than half of what your portfolio could generate. In other words, there's a lot of margin that's already built in. So if you're worried about oh my goodness, every so often my car is going to break down or their roof has to be repaired and that's a pretty significant cost or you know what we want to help our children or grandchildren with some financial support, whatever the actual expense might be If you have a lot of margin, like you might in this example, I'm less concerned about that because as long as you can say, okay, keep those extra expenses to about 2.2, next year you're going to spend another $50,000 to remodel the entire front yard and the following year you're going to spend another $50,000 to take the entire family on an extended vacation. I'm obviously being extreme here, but if those one-off expenses are significant I would be worried. But if these one-off expenses truly are one-off, where every so often, every handful of years or so, you're spending several thousand dollars, you have to compare it to what is your normal withdrawal. If your normal withdrawal is already at 4% kind of an issue, but if your normal withdrawal is 1%, 2%, 3%, what that's telling you is you have some margin and you're probably in a good position to occasionally take that extra amount and do something with it, even without running the risk of spending too much money from your portfolio.
Speaker 1:So I know that's not an exact formula to answer Sherry's question, because the truth of the matter is there's not an exact formula One. We don't know exactly how much of a withdrawal rate our portfolio could withstand throughout retirement, because we don't know what the market's going to do, we don't know what inflation is going to do, we don't know what our actual spending is going to look like. But we use this as a starting point to say if you have some margin, understand what that margin looks like, and then you'll have a relative sense of what could we support every so often, before we have to start worrying about are we going to run out of money because we're spending too much of our portfolio down? Let's now look at this from the standpoint of what? If you don't have that margin? Let's assume that you do have that same million dollar portfolio, but you're spending $3,300 every single month through retirement on just core monthly living expenses. Why do I say $3,300 a month? Because on an annual basis, that comes out to just under $40,000 per year, so you're spending $40,000 per year. You have a million dollar portfolio. If you just look at the 4% rule, it seems like you're fine. You just keep spending that 4% and you can adjust that for inflation and, assuming you have about 30 years in retirement, you're probably going to be okay.
Speaker 1:But then the unexpected expense comes up. Aka. Then life happens. There's a roof, there's a car, there's a major medical bill, there's something that comes up that requires an extra amount of withdrawal from your portfolio. What do you do then?
Speaker 1:Well, let's start with what you don't do. You don't just say, oh well, this was unexpected, so I'm just going to take a big withdrawal from my portfolio, or oh, I wasn't planning for this to happen. Therefore, withdrawal from my portfolio, or oh, I wasn't planning for this to happen. Therefore, I can just pull more money from my portfolio and it's not going to impact my actual plan. That could not be farther from the truth, but this is, for some reason, a perception that a lot of us have. We'll somehow justify this to ourselves and say, oh, this wasn't a planned expense. I wasn't intending to have a major medical bill or for the roof to break or to have to buy a new car so early. So therefore, I'm just going to take it from my portfolio and almost act as if there's no implications for that.
Speaker 1:Well, there certainly are implications for it, and you have to remember your portfolio does not care if this was a planned expense or a totally unplanned, unexpected, freak accident that caused you to have to take money from your portfolio. Your portfolio can only support a given level of income before you start to run the risk of earning out of money. So, when you look at it from that standpoint, your portfolio doesn't care. Your portfolio does not care the nature of your expense, whether you're giving money to charity or you lost it all gambling. A withdrawal is a withdrawal is a withdrawal. It's counting against what your portfolio can support and, at the end of the day, that's all we need to understand. I know this sounds simple, but I can't tell you how many people I've talked to of thinking, oh, because this was unexpected or because this was something that was a little bit tragic, can't we take more from our portfolio? I'll have to tell them yes, you can, but there are absolutely consequences for that as well. So, if that's you, if you're thinking, wow, I am kind of already at the upper threshold. I'm spending close to 4% per year of my portfolio and I know there's probably going to be some unintended expenses or unexpected expenses, what should I do? Well, in this case, I would do something like what Sherry suggested.
Speaker 1:Sherry talked about using sinking funds. Now, for those of you who are unfamiliar with what a sinking fund is, a sinking fund says look, let's use travel, for example. Let's assume you know you're going to spend $6,000 one time, every single year for travel. A sinking fund says look, instead of just waiting for month 12 to come around and then writing a $6,000 check and trying to figure out how do you pay for this, what you should be doing is, every single month, setting $500 aside into a separate account. So after one month, there's 500. After two months there's a thousand. After six months there's 3000. After 12 months, you have $6,000 in that account and you have the money already there. That's the concept of a sinking fund. You're preparing along the way for these expenses that you know will come up.
Speaker 1:So let's look at a quick example. Let's assume that you're spending $3,000 a month from your portfolio and you have that million dollars as an example we've been using. Well, $3,000 per month is $36,000 per year. So if that's all you were spending, you're at a 3.6% withdrawal rate. So it seems pretty reasonable. It seems like something that can absolutely be expected to last you for a long period of time, assuming you're, of course, invested the right way. But let's assume that's just for the basic core expenses and you're not setting any money aside for any other goals that you have.
Speaker 1:Let's assume that you also want to take one big trip every year and that's going to cost exactly $12,000. Well, $12,000, you should really be setting up a sinking fund, which is $1,000 per month, to plan for that travel once a year. And then let's assume that every 10 years you want to have $36,000 set aside for a new car. Well, what that means is you should put $3,600 aside every year and do that for 10 years. And, to break it down even further, on a monthly basis you should be putting aside $300 per month, because that comes up to $3,600 per year. So new car every 10 years, of course ignoring any benefit of getting an interest rate on this money. I'm just breaking down the numbers. Real simple, no interest here. But if you wanted to do that every 10 years, that's 300 per month that you want to set aside.
Speaker 1:And then home repair. And granted, this one's a difficult one because you might spend next to nothing one year in home repairs. In the following year maybe you spend $30,000 because you have tons of things that you need to redo or fix. So start with an estimate of what might you need on an annual basis, and let's assume that's $15,000 per year. Now, depending on your home, that could be a totally extreme amount or that could be completely insufficient, depending upon where you live and the cost of your property. But let's use that as a starting point because again makes math easy. Fifteen thousand dollars per year means you need to be putting aside one thousand two hundred and fifty dollars per month.
Speaker 1:So now let's look at that again. We know you're spending three thousand dollars per month in this hypothetical example, on your core monthly expenses, which is thirty six thousand dollars per year, of your total portfolio value, which comes out to a withdrawal rate of 3.6 percent. Well, seems good. But let's now add in car savings, annual vacation, home repair. So let's assume you're going to take that sinking fund approach where, instead of just paying for these things as they come, you're going to actually understand what are those things cost on a monthly basis by setting aside the money now. Well, once you do that, you'll start to see pretty immediately that, instead of spending $3,000 per month, like you thought, you're actually spending $5,550 per month. Not all that's actually being spent today, but you're starting to establish those sinking funds that you can spend money on those larger expenses down the road. At $5,550 per month, that's $66,600 per year, which is just under a 6.7% withdrawal rate, which has significantly different implications than does the 4% rule. So this is where the concept of a sinking fund Sherry to your point can be incredibly helpful, because if you're looking at your spending and saying, oh, I'm only spending $3,000 per month on my million dollar portfolio, I'm under the 4% rule. I'm good.
Speaker 1:Well, you might be, but if you're not planning for those one-off expenses and, by the way, there's tons of these this can be anything from saving for a new car, like we talked about. This can be vacations. This can be property taxes, if they're paid semi-annually or however they're paid. This could be things like Christmas gifts, birthday gifts. This could be things like home repair. This could be things like long-term care expenses, medical expenses all these things that aren't as simple as, say, a cell phone bill, where you know exactly what you're going to be paying each month, or even gas for your car, where you don't know the exact amount, but you have a pretty good range of what that's going to look like every month.
Speaker 1:It's these one-off expenses that make it really hard. But translating those one-off expenses into a monthly amount that you need to be saving, and then trying to save that to a sinking fund, all of a sudden, what that does is it gives you a much more realistic picture of how much are you actually spending. Because if you look at this and say, oh, my goodness, I'm actually spending 6.7% of my portfolio, go back to what I said before, your portfolio doesn't care. If you weren't planning on those expenses and they caught you, your portfolio can only support up to a certain threshold before you run the risk of spending that portfolio completely down. And if you're sitting there and saying, wow, I'm spending 6.7% of my portfolio value in all these expenses I have, I'm probably going to have them for the foreseeable future. So, in other words, it's not just a temporary thing because at a big expense this year, this is an ongoing thing. I'm going to be spending this on an ongoing basis.
Speaker 1:That's probably a sign that you need to make a change. Does that mean you need to work longer so can't retire when you want to? Does this mean that you need to cut spending? Does this mean that you need to make some other change? It probably does. Now, one thing you want to look at is, like I just mentioned a minute ago is this spending regular or will that drop at some point? I've done other podcasts and videos where there's been plenty of clients I've worked with where their initial spending in retirement was six, seven, 8% per year of their portfolio value and they didn't think they could retire.
Speaker 1:But when we looked at the numbers, we said, well, look at this here. Some of these expenses are going to go away. Look at this you have your mortgage and your mortgage payment is happening now, but in two and a half years that's paid off and as soon as it is, your monthly expenses go way down. Or look, you're paying out of pocket for your healthcare costs right now because you're retired before age 65. But once Medicare kicks in, that line item will go down. Or look, you're supporting your child and you're still paying for some of their continuing education or college expenses, but in a few years that will go away.
Speaker 1:So, when you can start to look at your expenses, it's not 100% always the case that if you're over a certain withdrawal rate, you are not going to be able to retire. But what you really want to know is is this a withdrawal rate that's going to be sustainable for the indefinite future? And if you're starting to realize, when these big expenses are factored in, that yes, this is going to be an unsustainable withdrawal rate, that's the time where you might need to make some changes. But on the flip side, as we talked about, if you're looking at your actual spending and you're consistently spending less than your portfolio could actually support, you may not need to be as concerned about those one-off expenses because you've got some margin built in. You have some room to increase your spending when that unexpected expense happens because you're not spending the full amount that your portfolio might be able to support on an annual basis.
Speaker 1:So as we start to wrap up, sherry, I want to thank you for that question because this is one of those things where I think we believe there's a perfect answer of how do we address this, how do we account for this. In some ways, it's very difficult and just admitting that, as a place to start of, we're not going to have a perfect sense of exactly what our expenses will be throughout the course of retirement. But when we can start to break that down of what are our core expenses and what are those one-off expenses we might need to expect, we can start to see how does that translate into the withdrawal rate that we're going to be taking or expecting from our portfolio? So, sherry, thank you for your question. Thank you to all of you who are tuning in and listening. If you are enjoying this podcast at all, always appreciate it when you leave those reviews on Apple podcasts and Spotify really does help more people to find our show. If you're listening on the podcast, you can also check out the YouTube channel, where we do this podcast and we have other weekly videos as well, hoping to help everyone get the most out of life with their money and create a better, more secure retirement. So that is it for this week. Thank you, as always, for listening and I'll see you next time.
Speaker 1:Hey everyone, it's me again. For the disclaimer, please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartnerscom and click start here, where you can schedule a call with one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.