After you retire, you need to decide how much you can spend each year, which investments to take the money from, and when to rebalance your investments. Collectively, this is called your “withdrawal plan”.
The Default - the 4% Rule Withdrawal Strategy
Since the “4% Rule” is so well known, you might consider the withdrawal plan the 4% rule uses to be the “default”.
Your initial retirement spending is 4% of your portfolio balance when you retire
Each year you raise your sending to match inflation
Each year you rebalance back to 50% stocks / 50% bonds and take out your spending for the year
There’s a lot to like about this strategy. It is easy to understand and follow. You don’t have to worry about cutting your spending, since the plan doesn’t ever do that. You only check your portfolio once per year to take out your spending and rebalance, so you can ignore most of the market’s noisy ups-and-downs.
There are downsides, too, however. First, your spending is based on your portfolio balance on a single day. If your portfolio drops 20% right before you retire, the strategy says you need to spend 20% less for life. Second, since your spending adjusts only with inflation, you won’t spend more even if your portfolio has doubled since you retired. Conversely, since you don’t make spending cuts, your spending needs to be relatively conservative just in case markets crash right after you retire. Third, you rebalance mechanically each year. In a long stock market crash, you’ll sell some of your safer bonds for stock which might have a lot further to fall.
The 4% rule is a fantastic planning tool, but we wanted a strategy that addressed these shortcomings.
Our Withdrawal Strategy
Our strategy is:
- Spend 3% of the previous peak balance of our portfolio, adjusted for inflation.
- Cut spending to 4.5% of our current portfolio, if it would otherwise be higher.
- Sell bonds to fund spending.
- Rebalance only from stocks to bonds, and only when stock prices are high.
What effects do these changes have?
Setting our spending based on our previous peak balance means our planned spending is more consistent - a person who retires just before a crash can spend the same amount as they would if they retire during the crash instead. When you’re nearing retirement, it feels a lot better not to watch your lifetime spending jumping up and down with the market.
This design also allows for raises in retirement. Each time the market hits new highs, our “previous peak” goes up and our allowed spending does, too. If our portfolio doubles in retirement, our spending target will, too.
During a crash, we still allow raises to match inflation, but also allow for some spending cuts. If our target spending is more than 4.5% of the current balance, we will trim spending to that limit. So, if our overall portfolio drops by more than one third, we have to trim spending. Since we keep about 66% of our money in stock, stock prices must drop by more than 50% before we would make any cuts.
If you follow the 4% strategy and your portfolio drops one third in a crash just after you retire, you will be taking out 6% of the current balance. Our strategy causes less strain on our portfolio during situations like this.
Finally, by rebalancing only from stocks to bonds, we hold onto our bonds during a long crash. Since we have about 33% in bonds and spend about 3% per year, we know we have about 11 years of spending in bonds while we wait for a crash recovery.
Rebalancing every year, like the 4% strategy does, has two effects. When stock prices are high, you sell some stock to “lock in” gains, increasing portfolio safety. When stock prices drop, you sell some bonds and buy stock to take advantage of low prices, increasing long term returns. Before retirement, both of these benefits are valuable. In retirement, don’t need maximum gains anymore. By rebalancing only by selling stock for bonds, we’re keeping just the “increase safety” effect and maximizing safety in long, deep market crashes.
So, to recap, setting spending based on our previous peak provides more predictability before retirement and allows for raises during retirement if the portfolio has grown. Accepting spending cuts during significant crashes reduces portfolio stress. Rebalancing only by selling stock at high prices increases portfolio safety, losing some long term growth that we no longer need to maximize.
We chose 3% rather than 4% as our basic spending target for a few reasons.
Most importantly, setting spending at the previous peak means we’re emulating the worst-case scenarios for the 4% rule, when you retire at a high and promptly hit a crash. We always set our spending based on the last high, so we use a slightly lower spending rate to make up for the reduced safety. That said, our willingness to make spending cuts will also increase safety quite a bit in the worst years.
More personally, we retired early and will have a very long retirement. Our portfolio must keep up with inflation for a very long time. We also want a higher chance of long term spending increases in retirement, and spending less to start means more of our money can compound to support longer term increases. Finally, we worked longer than we’d planned to, so we can afford a lower spending target.
I had originally planned for us to spend 3.5% of our previous peak and cut down to 4.75% if needed. I suspect our strategy at 3.5% / 4.75% is as safe as the 4% rule, but I haven’t dug up historical return data to formally test it.
The 4% rule is a great planning tool, but it’s really just a starting point. Your retirement is personal, and your withdrawal strategy can be, too. If you want to get into this topic in depth, check out the book Living Off Your Money by Michael McClung. The book is an excellent, in-depth analysis of a number of strategies and provides a nice comparative analysis of them. If you want to maximize safety and are willing to be very flexible about your spending, check out the Bogleheads Variable Percentage Withdrawal (VPW) Strategy, which many Bogleheads swear by.