Should you change how much you’re spending in retirement when the market goes down?

For nearly anyone about to retire, there is one single question that they absolutely must have answered in order to feel confident about their financial future: How much can I afford to spend each month?

The answer to this question is extremely complex, and there are more than a few ways to arrive at an answer. I’ll do my best at a simple answer in the coming paragraphs, but what I’d like to point out is that arriving at the best answer is often sandwiched somewhere between two deep fears:

1. Spend too much money and run out before you die.
2. Spend too little money and leave more than you intended behind.

The first scenario is obviously a bad one, but the second means you likely missed out on some fun you could have had along the way. Both are failures.

Likely the most common retirement distribution strategy is the 4% rule. Which says, keep your money invested in a 60/40 portfolio (60% stocks – 40% bonds) and you can withdraw 4% of your starting balance each year. For example: If you have a $1 million 401k, you can withdraw $40,000 every year for the rest of your life.

If you assume a conservative rate of return on your investments and a reasonable projection for inflation, this strategy works for as long as you live. Voila.

The problem is, in the real world returns on your investments and inflation aren’t the same every single year. Even if your portfolio averages 6% return, some years it’ll be down 5%, then the next up 12%, then the next up 1%, and so on and so forth. Even if you know for a fact that over your retirement years your portfolio will average a 6% return, it makes an enormous difference when and in what order the up and down years happen. This is called “sequence of return” risk. And simply projecting a more conservative growth and inflation rate aren’t enough to take this risk away.

The seminal study that started the 4% rule was done by Bengen back in 1994, but since then many studies have modeled the 4% rule to fail somewhere between 6-12% of the time. Which means if you start withdrawing 4%, about 1 out of 10 times you go broke sometime in your life. That’s not great.

This has led some advisors to throw out the old, failure prone 4% rule and usher in the new and improved 3% rule.

This lowers the failure rates from 6-12% all the way down to less than 1%…. Which is awesome, but it brings the scenario where someone leaves behind way more money than they intended dashing back into play. In other words, if you follow the 3% rule, a large percentage of the time you’ll look back in your old age and realize you could have spent more money than you did.

Picture an 85 year old widow with more money than they could ever spend, but with health that doesn’t allow them to spend it. Ask almost any one of these people what they would’ve done differently with their money and they’ll tell you some version of the same thing. They wish that they had used it to enjoy their lives; to travel with their spouse, to give to those in need, to visit their grandchildren. And that if only they had less fear of running out they would have.

Enter the guardrails.

Here are the rules:

Begin with a 4% withdrawal rate. Set a high guardrail and a low guardrail based on your account size and if your portfolio balance passes either of these thresholds, you adjust the amount you withdraw.

For example:

If you have a $1 million portfolio, that means a $40,000 withdrawal (4%), or $3,333 per month.

• If your portfolio reaches $1.2 million we increase your distributions by 20% to $4,000 effective immediately.
• If your portfolio reaches $800,000, we decrease your distributions by 20% to $2,667 per month effective immediately.

Of course, in the real world there are a few simple rules that provide added structure to this strategy, and more than a few circumstances that cause a person to deviate from these intentional guardrails.

The most common exception comes when someone simply needs more money each month than the lower guardrail supports – at which time a difficult conversation is had, weighing a list of possible budget cuts with the increased risk of getting to $0 sometime in the future. Not a fun conversation, but better than blindly plummeting towards $0.

The most important rule is that alongside your invested portfolio, you must have a reserve of cash or cash alternatives that cannot go down in value in the event of a major market correction. The goal is somewhere between 2-5 years worth of cash. And although there is an opportunity cost of choosing not to have this money invested, it serves a much greater purpose. It allows us to always follow the first rule in investing.

Rule number one in investing (if there is such a thing) says: never sell an investment at a loss. This would obviously defeat the purpose of investing in the first place and is a ridiculously simple rule. However, in retirement when you need income each month to live, if the market goes down, and everything you have is invested, and down, you simply do not have a choice but to sell at a loss.

Just as an emergency fund of cash insulates you from disaster in your earning years, a cash reserve in retirement insulates you from disaster during distributions.

How does this rule work with the retirement guardrails strategy? The threshold we use to start pulling from cash reserves to create income instead of from your investment account is when you hit your lower guardrail.

This allows us to bridge a very important gap in any investor’s lifetime – investing through a bear market. Having a cash reserve and a structure around how your monthly income will adapt to the world around you sets a path at your feet to remain invested while a bear market lives its short, miserable life.

Have questions about how the Retirement Guardrails strategy works or could be used to fit into your retirement income plans?
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By: David Talley, CFP®