If we told you there was a way to retire in style without having to worry about money, would you be interested?
This is appealing, right?
It’s not out of the question.
This blog provides an excellent viewpoint on how to use spending flexibility to accelerate retirement planning, whether or not you aspire to retire early.
The 4% rule, which advocates withdrawing 4% of your portfolio each year and then increasing it by the rate of inflation, is a commonly used guideline for retirement spending.
Consider the following: you have €2,000,000 in savings at retirement, and annual inflation is 5%. In the first year, €80,000 would be set aside [4% * €2,000,000], then €84,000 in the second, €88,200 in the third, and so on. This method’s widespread use may be attributed to two factors: its ease of use and the peace of mind it gives you that your savings won’t shrink over time.
But imagine if you had greater leeway.
Putting up Barriers
Spending can be increased to as high as 5.5% from 4% by following a simple technique of lowering spending when in a bad market.
On December 31 of each year, you look at the MSCI World Index to determine if it is within a certain percentage of its all-time high. You’d either be within one of three distinct spending conditions, or “guardrails,” depending on that figure:
- If the MSCI World Index is within 10% of its highs, you should spend all of your spare cash during the next 12 months.
- The MSCI World Index should be more than 10% and less than 20% below its highs before you spend half of your discretionary income.
- If the MSCI World Index drops more than 20% from its high point, you should spend all of your spare income during the next year.
Your retirement discretionary budget should include ‘nice-to-have’ items like travel and entertainment but not necessities like food and shelter. Maybe a trip, a nice dinner, or a night at the theatre. The rest is obligatory funding.
Illustration utilising a €2,000,000 portfolio
According to the 4% rule, you would spend €80,000 a year (after adjusting for inflation) if you had a €2 million portfolio and your expected required spending was 100%. This is the standard recommendation.
But imagine if half of your money went towards “nice to haves.”
You can spend up to 2.75 percent of your portfolio each year on necessary expenses (after adjusting for inflation) and the other 50 percent based on the ‘guardrails’ above (keep in mind that we do not adjust our discretionary spending for inflation).
To keep up with inflation, you would spend €55,000 annually for the rest of your retirement. This is mandatory spending, and it remains the same regardless of the state of the market.
However, the markets would affect your discretionary expenditure. For instance:
- If the MSCI World Index is within 10% of its highs, you may be able to afford to spend an extra €55,000 over the next 12 months.
- You may spend an extra €27,500 over the following year if the MSCI World Index is more than 10% off its highs but less than 20% off its highs.
- If the MSCI World Index drops more than 20% from its high point within the next year, you should expect to spend an extra €0.
Your retirement discretionary spending won’t increase with time. The aforementioned amounts can be added to your necessary spending (which has moved with inflation) by checking the MSCI World Index on December 31 of either year 1 or year 30 of your retirement.
In essence, here’s how much you’d spend in your first year of retirement given the aforementioned three market scenarios:
- The average in the market is €110,000 (€55,000 mandatory and €55,000 optional).
- To be exact: €82,500 [€55,000 mandatory + €27,500 optional].
- In a downturn, you should set up €55,500 (€55,000 mandatory + €0 optional).
As you can see, ‘guardrails’ allow you to spend more than the 4% rule (€80,000) would allow throughout a typical market and a correction.
The likelihood that you will not exhaust your financial resources
Of course, not all retirees will feel secure with a 50% discretionary spending allowance. The table below illustrates the effects of varying retirement spending discretion and withdrawal rates over the course of 30 years. A diversified stock and bond portfolio is used.
To begin, estimate what share of your retirement budget will go towards luxuries. Go down that column until you find the proportion you’re comfortable with about the likelihood of not running out of money. Your withdrawal rate is the result.
If you desired an 88% chance of not running out of money over 30 years and could only spend 10% of your discretionary income, you would choose a withdrawal rate of 5%. A higher withdrawal rate of 5.25 percent would provide you with a 100 percent chance of surviving your 30-year retirement if 40 percent of your expenditure was discretionary. Naturally, this is predicated on simulated historical data starting in 1926 and adhering to the aforementioned constraints.
To what end do guardrails serve?
If you withdraw more money than you need to during a significant downturn, that money will never come back.
Most people think of the Great Depression when asked about the worst time to retire in contemporary history. Even though it was a horrible period, 1972 was the worst retirement year in modern history. After the market crash of 1973–1974, in which prices dropped by 50%, a decade of high inflation ensued. Safeguards have been effective at all times and in all places we have observed. There’s no way to know for sure that guardrails will prevent every possible accident, but they’re our best bet given what we know and can do at the moment.
Think about it.
- Sunday, December 31, 2023, dawn
- You’ve saved two million euros for your golden years.
- On January 1, 2024, to celebrate your upcoming 60th birthday, you intend to withdraw €200,000 from this account. For the year 2024, this would leave you with €1,800,000.
- However, when the market opens, 20% of your portfolio is lost, and you complete the year 2023 with €1,600,000 instead of €2,000,000.
- You withdraw €200,000 as planned on the first trading day of 2024, leaving €1,400,000.
- Your investment portfolio will recover and grow by 25% by 2024. This makes up for the 20% drop at the conclusion of the prior year. The overall return for the past year is 0%.
- By 2024’s end, what will you have accomplished
The correct amount is €1,750,000 (or $2.15 million). Obviously, this is €50,000 less than the €1,800,000 you anticipated having before spending your vacation fund.
In other words, sequence of return risk’ wiped out that €50,000 in the blink of an eye. Due to your withdrawal, the €200,000 (and you) will miss out on the 25% recovery that was due to occur in 2024.
Guardrails serve this purpose. In the event that the market closes the year at least 10% below its highs (and you wind up sticking to your guardrails), you will reduce your withdrawals for the next year. The benefit of having withdrawal limits is that you can take out more money during prosperous times, compensating for the times when you had to be more frugal.
Constantly, we face trade-offs.
Guardrails help in two ways (which are essentially the same but phrased differently):
- In retirement, you have more financial freedom.
- It’s possible to reduce retirement savings.
Guardrails can be useful if you’re ready to make the choices that come with installing them. Either (a) you take on greater risk or (b) you spend less money at least some of the time in retirement if you wish to spend more.
If you want to spend more throughout retirement, you need to be adaptable, regardless of whether you have 30 or 60 years to do so.