Executive Summary
The conventional method for evaluating safe withdrawal rates assumes that retirees maintain a stable standard of living through retirement in real (inflation-adjusted) dollars. While there’s nothing unsound about this assumption – at least so long as it reflects a particular retiree’s goals – it is worth considering how accurate this assumption is relative to actually observed retirement spending behavior of the “typical” retiree.
Because, as it turns out from a growing base of research, constant real spending is not particularly realistic for most retirees. Instead, various studies are finding that real spending actually declines throughout retirement, by as much as 1% to 2% per year. And compounded throughout retirement, this discrepancy between standard industry assumptions and actual retiree behavior may be underestimating the safe withdrawal rate.
In this guest post, Derek Tharp – our new Research Associate at Kitces.com, and a Ph.D. candidate in the financial planning program at Kansas State University – analyzes safe withdrawal rates assuming decreasing spending in retirement, finding that the discrepancy between standard industry assumptions and actual retiree behavior may be underestimating the safe withdrawal rate by 0.32% to 0.75% – turning the so-called “4% rule” into something closer to a “4.5% rule” (with subsequently reduced real spending) instead.
While some may argue that “overstating” spending assumptions is good for the sake of being conservative in making retirement projections (certainly it is worse to run out of money that it is to have some extra!), assuming constant real spending is not the only (nor necessarily the best!) way to incorporate a margin of safety. Further, an appropriate safety margin will vary by retiree, depending on their risk tolerance and spending flexibility. If advisors truly wish to give advice that is customized to an individual’s goals and values (as most say they do!), then the safety margins utilized should reflect an individual retiree’s situation, too.
Obviously, the best way to capture an individual’s unique circumstances is simply to create a customized financial plan — which isn’t a radical idea for most advisors — but it is still important to understand what is actually customizable within a plan and what remaining assumptions may be biasing the results. And for advisors who prefer to apply and adapt the safe withdrawal rate to individual retiree circumstances, it’s still crucial to build on the right baseline assumptions – recognizing that the 4% rule may be predicated on retirement spending that simply doesn’t reflect reality!
Assumptions Of Conventional Safe Withdrawal Rate Research
The conventional approach to safe withdrawal rate research, starting all the way back with Bill Bengen’s original 1994 “4% rule” study in the Journal of Financial Planning, assumes that retirees maintain a stable standard of living throughout retirement – which means receiving a consistent stream of cash flow that increases annually with inflation to maintain purchasing power. And the results of that spending pattern are then tested against various historical sequences of returns to determine what initial spending rate is a "safe" starting point.
The logic behind this approach is fairly straightforward. Earlier approaches to securing retirement income tended to focus simply on generating a consistent nominal stream of cash flow throughout retirement, but given the risks of inflation (especially as life expectancies and the retirement time horizon increased), the need for nominally increasing cash flow throughout retirement became more apparent. And exploring both the consequences of inflation and the sequence of inflation (when paired with the sequence of returns), was a key insight of the original Bengen study (along with the impact of sequence of returns).
Of course, retirement researchers need to pick something that can serve as a reasonable baseline for conducting and comparing various withdrawal rate analyses. Assuming constant inflation-adjusted spending (constant real spending) was a logical choice and has continued to function as the baseline retirement spending assumption for nearly every safe withdrawal rate study since.
Observed Spending Behavior Of Retirees
In the decades since Bill Bengen’s original “4% rule” research set a stable-standard-of-living baseline, we’ve gained further insight into the actual spending behavior of individuals in retirement.
And what researchers have found is that both the composition of spending and the level of spending vary throughout retirement – with both tending to change in some predictable ways. As it turns out, on average, most retirees actually experience decreasing rates of real spending throughout retirement.
Utilizing consumption data from the Consumer Expenditure Survey, one study from the Center for Retirement Research (CRR) at Boston College found that real retirement spending decreases by about 1% per year throughout retirement. A follow-up study from David Blanchett at Morningstar utilized data from the Rand Health and Retirement Study (HRS) to find that real spending actually increased slightly in the first few years of retirement, but then began decreasing at an increasing rate through the remainder of the first half of retirement (bottoming out at an annual change of about -2.0%), before beginning to decrease at a decreasing rate for the remainder of retirement (ending at an annual change in real spending of roughly -0.5%). This U-shaped real spending pattern found by Blanchett was dubbed the “retirement spending smile”.
Although the CRR and Blanchett studies both found decreases in real (inflation-adjusted) spending, the decreases were small enough that nominal spending would likely at least be stable, or even slightly increasing, throughout the retirement years. In other words, retirees appear to maintain a stable nominal standard of living, or increase it slightly over time… but the increases are small enough that, on average, they don’t even keep pace with inflation, causing a decrease in purchasing power (and thus real-dollar spending) over time.
Nonetheless, the fundamental point is that an assumption of constant real spending – where the retiree increases their spending for the full amount of inflation each year – would project materially higher lifetime spending than what is borne out in the available real-world data.
Safe Withdrawal Rates Under More Realistic Spending Assumptions
So what would safe withdrawal rates look like utilizing more realistic spending assumptions?
To analyze this question, we can compare a baseline assumption of constant real spending throughout a 30-year retirement time horizon (i.e., the conventional safe withdrawal rate model), to alternative spending patterns in retirement that properly recognize how real spending tends to decrease over time. In this case, we look at four potential decreasing spending patterns: (1) a 1% annual real reduction for 30-years, (2) a 1% annual real reduction for the first and third decades and a 2% annual real reduction for the second, (3) a 10% real reduction after each decade of retirement, and (4) a 20% real reduction in the second decade of retirement and a 10% real reduction in the third.
Notably, these analyses do not delve into how the composition of retirement spending might be changing throughout retirement (e.g., whether discretionary spending might decline at a faster rate, while health care might inflate at a higher rate), and instead, just look at total spending. With these assumptions, scenarios (1) and (3) are consistent with CRR’s findings of straight-line decreases in total retirement spending over time, while (2) and (4) are consistent with Blanchett’s “retirement spending smile”.
Not surprisingly, lower cumulative spending in retirement results in an increase in the safe withdrawal rate, and the greater the assumed (cumulative) spending cuts, the larger the initial withdrawal rate can be.
(Note: These analyses assume a 60/40 portfolio that is annually rebalanced – where the equities are large-cap U.S. stocks and the fixed-income allocation is Treasury Bills – given the limited benefits of longer-term bonds with interest rate risk from a safe withdrawal rate perspective.)
Overall, the results reveal that reduced spending scenarios result in a safe withdrawal rate increase of at least 0.32%, and as much as 0.75%.
Notably, on a relative basis, this is an initial spending increase of only 8% to 18% (from initial spending of $4,008 per $100,000 of retirement assets up to $4,390-$4,830 per $100,000 of assets) despite the fact that retirement spending is ultimately cut by as much as 30% to 40% in later years. The reason the safe withdrawal rate increase is so modest relative to the total spending decrease over 30 years is in part because spending cuts are assumed to occur gradually over time. And because sequence of return risk is concentrated at the beginning of retirement, it still materially constrains spending. After all, it doesn’t matter if spending is assumed to decrease later in retirement if a combination of bad market returns and high spending in early retirement has already fatally depleted the portfolio by the time the spending slows down.
Nonetheless, in real spending terms, an initial retirement spending increase of 8% to 18% is not trivial, particularly in a world where many retirees have a strong preference for spending more in the “Go-Go” years of early retirement!
Spending Assumptions For Future Safe Withdrawal Rate Research
While the research on safe withdrawal rates to date has certainly provided important insights into retirement planning, it is worth considering what default assumptions are best going forward. The simplicity of the current default assumption certainly has some appeal to it, but in light of growing evidence that it provides an inaccurate depiction of typical retiree consumption behavior, it is worth considering what should be used as the “default” going forward.
Unfortunately, as noted earlier, researchers analyzing retirement spending patterns still aren't in agreement about exactly what the “typical” path of decreasing spending is. Additionally, there’s still debate in the financial planning community about whether or how the spending patterns for the typical mass affluent or high-net-worth retiree might be different than the “average American”.
Nonetheless, it appears likely that at least some kind of reduced-spending-over-time assumption is more accurate than the existing baseline of constant real-dollar spending. Most financial planning software – not to mention more robust Monte Carlo models built by researchers – could easily substitute “inflation-adjusted” spending with “inflation-adjusted minus 1% per year”.
Of course, that’s not to say that research should be confined to the default – if anything, increasing diversity of spending patterns analyzed will help us better understand the varying implications of different withdrawal patterns – but given the non-trivial differences in withdrawal rates under more "typical" retiree spending behavior, some reduced-spending assumption seems prudent as a future baseline for evaluating retirement strategies (e.g., various shapes of equity glidepaths).
More fundamentally, it’s important to recognize that with a baseline assumption of at least some spending reduction over time in retirement, the 4% rule may realistically be closer to a 4.5% rule.
Constant Real Spending As Precautionary Planning?
Some may argue that analyses based on constant real spending are preferable, given that they are inherently more conservative. After all, if retirees actually do decrease their spending throughout retirement, then they will just have an extra cushion with more assets later!
While there may be some comfort in building in a precautionary margin of safety when analyzing a retiree’s situation, similar to utilizing conservative life expectancy assumptions, there is still such thing as being “too” conservative and potentially constraining a retiree’s lifestyle unnecessarily. Further, when utilizing more sophisticated software that can account for various levels of taxation, variable income streams, future inflows and outflows of assets, and other time-based planning considerations, building in a margin of safety by assuming an inaccurate retirement spending "path" could lead to making suboptimal decisions (e.g., an unnecessarily high “path” of retirement spending could unwittingly distort the optimal tax-efficient spend-down strategy across multiple types of retirement accounts).
In addition, it’s important to recognize that there are other ways of handling the uncertainty of retirement projections, short of just making arbitrary (and potentially unrealistically conservative) retirement spending assumptions. For instance, a sensitivity analysis can help to identify which particular risks could be most impactful in order to better monitor them. Additionally, the process of monitoring a financial plan on an ongoing basis provides the opportunity to make mid-course adjustments long before any “severe” adverse scenario occurs. More generally, “safety margins” can be applied with many assumptions beyond just spending, including life expectancy, legacy capital, and return/inflation assumptions.
Furthermore, it’s not necessarily the case that some arbitrary margin of safety is equally appropriate for different retirees. Depending on a retiree’s tolerance or capacity for risk, they may be willing to accept different safety margins for planning purposes. Particularly for retirees who are especially flexible with their retirement spending in the first place, and therefore may be more willing to make mid-course adjustments, if needed.
Ultimately, the best way for any planner to accurately account for a retiree’s unique circumstances and preferences is to simply to create a customized financial plan for that retiree! In fact, even “rule-of-thumb” based approaches like the safe withdrawal rate have significant room to adapt to individual retiree circumstances. Nonetheless, to the extent that the safe withdrawal rate approach will be used, it’s still crucial to consider whether it is appropriate given the baseline assumptions and recognize that given the emerging data on real-world retirement spending, the 4% rule might be better viewed as a 4.5% rule (with declining real spending) instead.
So what do you think? Is it more realistic to assume declining spending throughout retirement? Is it time for a new “default” assumption in SWR research? Should we be concerned about being too conservative in estimating SWRs? Please share your thoughts in the comments below!
