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Beyond 4%: The Argument For Flexible Spending Rules In Retirement

Michael Kitces recently conducted a study of the 4% rule to see if it holds true for longer time horizons. The William Bengen study that the 4% rule is based on didn’t test the 4% withdrawal rate on retirement periods of longer than 33 years. Yet many FIRE retirees may be in retirement for 40-50 years. We need to address flexible spending rules in retirement.

Does that make the 4% rule too risky? Or, perhaps it’s too conservative?  These are the questions that Kitces’ study set out to answer. And it revealed some fascinating data that everyone who plans to retire early should pay attention to.

Overall, Kitces found that the 4% rule is inadequate for FIRE retirees. Rather than a hard-fast application of the 4% rule, he recommends that early retirees set flexible spending rules in retirement.

Below, we’ve summarized some of the study’s key findings.

Flexibile Spending Rules In Retirement: Why the 4% Rule Is Inadequate For FIRE Retirees

For those who aren’t familiar with the 4% rule, the fundamental logic is that you should not exhaust your retirement account during retirement if you confine annual withdrawals to 4% or less of your total account value.

The most common example given is that if you retire with a $1 million portfolio, you would be able to safely withdraw $40,000 in Year 1. Then in Year 2, you would adjust your 4% withdrawal rate for inflation. And you would continue to adjust for inflation in subsequent years.

Over an “average” retirement period, the 4% rule has been proven again and again to work. But Michael Kitces found that the 4% rule is inadequate when considering flexible spending rules in retirement periods of 35+ years. Here’s why.

1. It Doesn’t Adequately Account For The Downside Risk Of Long Retirements

The longer an investment spends in the market, the more risk it is exposed to. The 4% rule was specifically based on a 30-year time horizon. But when a portfolio needs to last an extra 10-20 years, that extra risk exposure needs to be accounted for.

Bengen himself theorized that the safe withdrawal rate is actually 5% for those with a 20-year time horizon and only 3.5% for those with a 45-year time horizon.

Kitces study confirmed Bengen’s hunch. Testing a 3.5% withdrawal rate against a $1 million portfolio and a 50-year time horizon, there was, in fact, one scenario where the account depleted itself–in the 48th year.

Now, this is no doubt a “doomsday” scenario. And, as we’ll see below, longer retirements actually have a greater chance of creating huge accounts than depleted accounts.

But, however unlikely it may be, the “sky is falling” scenario must be accounted for in any conservative retirement plan.

Dive deeper: Podcast Episode 113R |Making Your Retirement Plan Bullet Proof | Tanja Hester

2. It Doesn’t Adequately Account For The Huge Upside Potential Of Long Retirements

Kitces’ study confirmed the necessity for a 3.5% withdrawal rate in order to protect FIRE retirees from the one devastating scenario. But what was surprising about the study was how unlikely that one scenario was.

Instead, retirees with 40-50 time horizons are much more likely to end up with larger retirement balances than the typical 30-year retiree.

For example, if you retired with $1 million and withdrew funds annually at a 3.5% rate, there’s a 90% chance that you would end up with $3 million at the end. And there’s a 50% chance that you’d finish with more than $9.3 million.

Again, this is assuming a 50-year retirement.

This kind of growth goes completely against the whole idea of the 4% rule. The 4% rule is meant to keep you from cutting into your principal (i.e. running out of money), not accumulate huge account balances.

If there’s a 90% chance of finishing with three times as much money as when you retired, that begs the question “Well then, couldn’t I just have retired earlier?” Or “Couldn’t I withdraw 5%  or 6% throughout my retirement instead?”

But no, you couldn’t do either of those things because of that one “doomsday” scenario where the account ends up depleted.

Are you beginning to see the potential inadequacies with the 4% (or 3.5%) rule for FIRE retirees?

3. It Doesn’t Adequately Account For Income Generated In Retirement 

When the 4% rule was created, it was intended for traditional retirees who wanted to know how much money they’d need to save in order to survive their non-working years.

But many FIRE followers are retiring in their 20s, 30s, and 40s. This means that there’s a good chance they could still generate income during their “retirement” years.

That income could come from starting a business that lines up with their passion or picking up a part-time job. But it’s a little naive to assume that a 27, 31, or 39-year old FIRE retiree will never generate another penny of income again.

Dive deeper: What Does Retirement Really Mean?

But, again, there’s no way of accounting for this in the 4% rule. Check out how much less you’d actually have to save before retiring if you knew you were going to make a bit of money in retirement…even small annual amounts.

  • Generating $10,000 of income a year in retirement for the next 40 years reduces the required savings to FIRE by $250,000.
  • Generating $20,000 of income a year in retirement for the next 40 years reduces the requires savings to FIRE by $500,000!

And that’s assuming a 4% withdrawal rate (or 25x multiplier). If you chose a 3.5% withdrawal rate, as is suggested for retirement periods of 35+ years, making money in retirement looks even better. In that case:

  • $10,000 of income a year would reduce your required savings by $280,000.
  • $20,000 of income a year would reduce your required savings by $560,000.

In short, the FIRE lifestyle throws a ton of variables at the hard-fast 4% (or 3.5%) rule that it’s just not equipped to handle.

So what can you do if you intend to retire early? Kitces has a suggestion: set flexible spending rules in retirement instead.

Setting Flexible Spending Rules In Retirement

Instead of having a “set it and forget it” mindset towards your FIRE retirement withdrawal rate, Kitces recommends setting flexible spending rules in retirement instead.

He gives three examples of flexible spending rules that could work well for FIRE retirees.

1. Increase Your Withdrawal Rate As Your Portfolio Grows

We like this method because it allows for increases in flexible spending in retirement but it would never call for a spending cut. Kitces gives two ideas for how to apply this rule.

Flexible Spending Rules In Retirement: Increase Spending by 10% Every Time Your Account Reaches a 50% Buffer.

This is one of the simplest flexible spending rules in retirement. And it doesn’t require you to change your withdrawal rate on an annual basis. Instead, you would wait to make any changes at all until your account had grown at least 50% from its starting value.

So if your $1 million starting portfolio grew to $1.5 million, you would increase your spending by 10%. If you had been spending $35,000 a year (3.5% withdrawal rate), that would mean increasing your annual spending to $38,500.

Kitces recommends re-checking every three years. If you still have a 50% buffer, you can give yourself another 10% spending bump.

Flexible Spending Rules In Retirement: Reset Your 3.5% Withdrawal Rate Each Time You Hit a New Portfolio High Mark

With this rule, if your $1 million grew to $1.2 million, you’d increase your annual spending from $35,000 to $42,000

It’s important to note that with this rule, you’d never withdraw less than $35,000 per year, even if your portfolio fell below $1 million. The $35,000 is a floor that doesn’t change. But the “ceiling” can grow if your portfolio does well (and there’s a really great chance that it will).

2. Stay Within A Safe Spending Range

Another way to look at flexible spending rules in retirement is to do away with a specific withdrawal percentage altogether. Instead, you may choose a percentage range that you stay within.

Kitces gives the example of 3% to 5%. If you chose that as your range, you’d be good to go as long as your spending stayed within that channel.

If you’re spending drops below 3% of your portfolio value,  you get a 10% raise. And if you’re spending rises above 5%, then you’d have to take a pay cut of 5%.

Using this strategy, you could begin with a 4% withdrawal rate instead of 3.5% if you wanted. So, beginning with a $1 million starting balance, you could withdraw $40,000 in Year 1 as opposed to $35,000.

But if your portfolio fell below $800,000, you’d have to take a 5% pay cut. On the flip side, if your portfolio grew to 1.35 million, you’d get a 10% raise.

3. Separate Your Required Spending From Your Discretionary Spending

This approach could make it possible for you to retire even sooner. With this strategy, you retire as soon as your portfolio balance is large enough to take care of your bare necessities.

But if your portfolio grows beyond its starting point (and it most likely will) or if you add income (and there’s a good chance you may), then you can increase your spending on the “wanna haves” like more travel, out-to-eat, and entertainment.

You may be surprised at how quickly you could retire if you were only planning to save enough to cover your basic needs in retirement. But you’d need to be ok with living a limited lifestyle in years that your portfolio was not performing well.

Flexible Spending Rules In Retirement: Bottom Line

The FIRE movement is all about freedom and independence. It seems only fitting that FIRE retirees should have more freedom and flexibility in retirement spending as well.

Michael Kitces makes a compelling case for why early retirees may want to ditch the traditional usage of the 4% rule and choose flexible spending rules in retirement instead. You can check out his full article here.

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Beyond 4%: The Argument For Flexible Spending Rules In Retirement
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