Published February 23, 2022
All of these rules of thumb exist for one purpose—to help you figure out if you have enough money to stop working.
All of these rules of thumb exist for one purpose—to help you figure out if you have enough money to stop working.
When it comes to retirement planning, there is no shortage of tips, tricks and “top 5” lists meant to help you decide whether you’re ready. But which ones have a grain of truth and which can you safely ignore? In this episode, Andrew Busa and Diana Linn talk through popular retirement planning advice to help you prioritize what’s really important, including:
Deciding when to retire is one of the most important decisions you can make. Listen now to let Andrew and Diana help you make sure you make it right.
Hi, this is Andrew Busa, Manager of Financial Planning at Adviser Investments and we’re here with another The Adviser You Can Talk To Podcast. And today I’m joined by my colleague, Diana Linn, account executive and financial planner.
Hey Andrew. Thanks for having me.
Absolutely. It’s good to be able to do another episode together. This will be a good one. So, as we looked back on all the podcasts that we’ve done, and I know you and I have been part of some of these, we’ve done many episodes on the accumulation side of wealth planning and financial planning, right? How to prioritize your savings, taking advantage of different tax techniques, things like that. But what about once you’ve reached the mountaintop? You’re done accumulating. You’re done the saving. Now you’re at the top of the mountain. Now it’s time to get down the mountain safely. So, in today’s episode, we’re going to approach a couple of different things. First, we’ll sort of broach that larger question of how to approach that kind of, do you have enough to retire idea. Before we talk about some of these common withdrawal strategies or rules of thumb that often pop up in finance, you see them around on the internet if you do some searching and then we’ll discuss how it makes sense for you to actually approach it.
So, just to set the table a little bit more, some of these strategies you see, the 4% rule, we’ll talk about that.
And we’ll talk about a simpler version of the 4% rule as well. I’m also talking about something called the bucket strategy. We’ll talk about Monte Carlos, all this good stuff.
Ooh, lots of exciting stuff. Okay.
Exactly. Yeah. So, any other thoughts before we dive into the meat?
No. I really like this topic. So much of the planning that we do both personally and with our clients is really surrounding that accumulation phase of life. So, getting to the top of the mountain, and then once you get there, it really is like, do you have enough money to stop working? Are you prepared for retirement? And then now that you’ve arrived, you’re at the top, you’ve reached retirement, what do you want that next phase of your life to look like, right. Do you need a larger travel budget? Are you going to purchase a second home? All of those types of things. And then, most importantly, how are we going to pay for it? So, I’m glad we’re talking about this today.
Yeah. Really, if you think about it, all these guidelines and rules of thumb, they exist for one purpose and it’s to try to figure out if you have enough money to stop working. That’s why most of us are here in this business to try to help folks understand if they can retire. But I think it’s important to put some parameters around, why these rules of thumb could be useful and when they might not be so useful, when they might be a little overly simplistic. The way we do planning, we’re using someone’s financial plan as a way to determine their optimal withdrawal strategy, I think.
When we’re creating a financial plan, we’re trying to determine, have you accumulated enough assets to use your bucket that you just mentioned, Andrew, to stop saving and filling up that bucket because once you’re in retirement, you’re now switching on that spigot starting to drain out, those assets that you’ve been saving over time. So, a lot needs to go into that. A lot of ingredients into understanding, especially expenses. So, in retirement, do you think that your expenses are going to remain about the same? Maybe they’re going to increase since you’ve got more free time on your hands, going to be traveling a little bit more, maybe gifting into the grandkids or maybe things are going to slow down a little bit. We’ve also got to remember to factor in inflation. I think that’s something that can get overlooked. So, I know when we’re building our financial plans, we like to use that 2.5% of the inflation.
And for health care too, right. You talk about inflation, that’s another area that we inflate aggressively is health care costs. And that’s unfortunately been the historical trend with that category of spending medical and health care expenses tend to rise faster than the price of eggs as it were.
Right. Right. Yep. And then another one of those major ingredients, of course, is income sources. So, once you’ve mapped out, “Okay, I think my budget in retirement, I’m going to be spending X number of dollars every month or each year. And I know that I’m going to get this much in from social security.” Perhaps you have a pension, investment income, rental income, you can back into what that gap amount is. So, X number of expenses, Y would be my income to know what kind of drip you need to turn on from that spigot, so to speak. Yeah.
That makes sense. So, you know, you think about creating a financial plan for somebody. Those are really the ingredients that we need to gather. We need to know those expenses. We need to know income sources. Of course, we need to know what assets are available for you to spend. And that starts to put together a rough picture of how much somebody will be needing to withdraw from their portfolio every year in retirement. So, it’s not like we’re using a rule of thumb such as the 4% rule and saying, “Okay, how do we apply this rule to this person’s financial plan?” It really works the other way around, the more that I’ve thought about it, I feel like we’re customizing the withdrawal strategy to the plan, if that makes sense.
I think you’re exactly right. And you know that 4% rule that you just mentioned that I think is one of the most common methodologies out there of how to think about what you’re going to need in retirement, that 4%, but you just want to keep in mind that 4% you’ve got to escalate it over time with the inflation and I think up until this year, maybe inflation hasn’t really been talked about or thought about as often as it should.
But now in the last year, we’ve all seen the prices of many goods rise very quickly. So, would be remiss, we mentioned the 4% rule a few times here, but let’s open that up a little bit and start talking about these different guidelines and starting with that 4% rule, because I think that’s probably the most commonly known one, I would say. I see it around on the internet a lot or talked about on the news every now and then. And recently it has been debated, the viability of it. So, let’s start by discussing the history of this rule and the background of it.
Ooh, I feel like I’m being quizzed here.
You are, yeah.
I think this idea, it was first introduced in a Journal of Financial Planning article published in 1994. And I’m not going to tell you how old I was in 1994, but I was absolutely old enough to have read this article. The 4% rule, it was really intended to make sure that your retirement savings could last for 30 years or more. So, traditionally people entering retirement in your sixties and making sure you have enough to last a really nice time horizon. So, when somebody retired, if they had a portfolio comprised of about 60% equities, 40% bonds, and that if you withdrew 4% and continue to ingest that for inflation each year. So, not Andrew necessarily 4% of the total balance each year, but that initial 4%, that would create a steady income stream to last you throughout those 30 years of retirement. So, that’s the Cliff Notes version of that rule of thumb.
Got it. So, it’s been around since 1994, but been around a while. What do you think is the appeal to this approach? Why do you feel it took off from a magazine that not a lot of people read?
I would read it.
We read it, but a lot of people don’t. Why is it so widely known today, do you think?
Yeah, I think a huge portion of that success is the simplicity with it. That’s real easy to remember, 4% and I’m going to generate this consistent stream of income. But as we know, Andrew, from building so many financial plans for people that managing retirement is really a balancing act for that saving. So, even if you’re using this rule of thumb of that 4%, if you withdraw too fast in maybe one year, oh, I’m just going to go a little bit above that 4% this year, you could potentially run out of money. And then on the flip side, if that number is too conservative, then you may have spent all this time in accumulation, saving this nest egg, so to speak and then not turning on enough of that spigot to drain the bucket. So, you’re kind of walking that fine line there of that balancing act.
Right. So, the simplicity is both the strength and a weakness of this. The founder came up with that 4% figure by looking at historical market returns and inflation data going all the way back to 1926. So, then essentially kind of looking forward from there looking at, okay, if someone retired basically every year thereafter, how long would the hypothetical retirees nest egg last from retirement to however long given every possible market condition. And then he kind of landed on this 4% as all right, no matter what happens in the market, you’ll always be okay if you stick with this 4% rule. But having said that this 4% rule has been debated recently, especially in the last couple of years, what’s your take on that?
I think we’re seeing this debate really happen on both sides. So, some people on one side of the coin saying that, “Oh my goodness, that 4% is way too generous.” Or that 4% is a little bit too conservative. I know Michael Kitces, one of the other financial planners that we follow, thinks that 4% rule is a little too conservative. And so, I think this is a wonderful back of the napkin rule of thumb to kind of double check your financial and retirement readiness, but isn’t necessarily the only thing that you should rely on.
I really like that way of looking at it. It’s a back of the napkin approach. I think that’s perfect. This is not the end-all, be-all of “you check this box and you’re good to retire.” I think it’s a fun kind of exercise to go through and kind of mental framework, but I’m not sure it really should be used beyond that. If you can ideally work with a financial planner to create your own financial plan, and we’ll talk about this as we go on, but I think that’s a really good way to put it. And there’s another version of the 4% rule that’s even simpler.
Tell us about it.
Well, this is the constant percentage strategy. Really the only difference here is that inflation doesn’t really come into play, right. So, instead of adjusting that withdrawal, like you said, for inflation every year, this is just, “No, we’re sticking with a flat percentage every year.” And you never really do any math beyond that. That’s what you take your portfolio every year and you move on.
I know we were speaking about this earlier this morning on a unrelated subject, but I’m wondering how many people really are factoring in inflation into that when they’re doing that back of the napkin 4% rule. So, I’m wondering if almost this simplest, younger sibling, as you say, has kind of become the predominant strain, like the predominant way of thinking of just that 4% without factoring in inflation, I don’t know.
That’s kind of interesting. You kind of wonder how these rules of thumb in theory actually get used in practice. I think you probably are right. That inflation sometimes isn’t really taken into account, especially like you said up until recently with inflation, who was talking about it?
Well, we were, and reading financial planning articles.
Yes. Yeah, that’s true. All right. So far, we’ve talked about the 4% rule, we’ve talked about the constant percentage rule. I want to also talk about another strategy that I think has some popularity and that’s the bucket strategy.
I really like this bucket strategy. I know I use it a lot personally and with clients. And so, as I kind of even alluded to at the beginning of us speaking here, with the bucket theory, you’re really thinking about the different pools of money, like different spots and types of money. So, I think of it as I’ve got these buckets of money and they’re not all space apart equally. So, the bucket that I have closest to me is going to be my cash. And so, my savings account, my checking account, and so that bucket of money is also going to be, also my safest assets. So, that’s, my readily available, in case I have an emergency and I need it tomorrow and then seated a little bit further away from me and another type of bucket I’ve got my joint brokerage account. So again, it is taxable money that is readily available if I need it, but a little bit further away, so that I can take on a little bit more risk, because I’ve got a slightly greater time horizon.
The next bucket, I’ve got my retirement assets and then even further out from that, being my bucket of my Roth IRA. So, that money, since it has such a long time horizon could also be my riskier assets.
Yeah. So, this strategy, I think feels very natural from what you’re saying from almost like a mental accounting standpoint, right. Where you’ve got this short-, medium-, long-term money that you can assign different goals to and purposes for.
Having this bucket strategy can also create a little bit of, more of a sense of calm. So, it’s no secret that this past month in the market has had quite a bit of volatility. So, if you know that I’ve got these different bucket strategies and each bucket is serving a different purpose and I’m turning the spigot on of that bucket at different times, so like you said, knowing that I’ve got that safe bucket of all of my cash and my other assets that I’ve got enough emergency savings, I think can also help calm when there is that volatility.
If there is one, what is the downside you think of this sort of a strategy.
Yeah. I know that I’m kind of biased because I am such a big proponent of this bucket strategy. I like the idea behind it, but I think the biggest downfall is just, it’s not necessarily telling you which assets to tap into first, unless you’re also thinking of it in terms of the risk of each of those buckets. So, if that is a downside, I guess that could be a downside.
Right. It might be harder to manage on your own.
I guess because you’d be moving some money around between the different buckets and things like that, probably best done with the help of a financial planner or advisor, right. So, I hear you there. So, that’s a good overview of the bucket strategy. I want to talk about another strategy that’s actually similar to what we use and the plans that we create. And that’s sort of this idea of the probability of failure are using Monte Carlo simulations. Basically all this is going to do is determine the risk of running out of money, given various different withdrawal rates, spending levels.
And so, I think the appeal of this when we run financial plans for folks is they can stress test their plan. They can see, “All right, I’m not going to run out of money most likely if I’m spending $8,000 a month. What happens if I spend $10,000 a month? What does that look like?” So that is also kind of an overly simplistic way of how we do it but I think the Monte Carlo Simulation is a nice way to stress test your plan.
Well, just to back up, so the Monte Carlo, I’m sure most listeners already know. The Monte Carlo, so what we’re doing there is we’re taking a client’s portfolio investible assets and applying it to a thousand different market conditions. So to your point, Andrew, just to show, okay, how well do your assets and your portfolio hold up regardless of the market conditions. And so, I think that is providing a lot of peace of mind for a lot of individuals to see, “Okay, even if I have terrible market returns after terrible market returns, that I am well set up to just ebb and flow with the turns in the market.
Yeah. No, I think that’s a great explanation of it. Well, you know what, let’s tie this all together. I was thinking as you were talking to and I just remembered, I think in a lot of these conversations we have with folks who are getting ready to retire, there’s another question I think that comes along and it’s not only do I have enough to retire, but it’s also where is this money going to come from? And so, I think that’s another, maybe shortfall of just using a rule of thumb to create withdrawal strategy, if that makes sense. I think to really understand, “Okay, how am I going to turn this portfolio that have built up into a paycheck?” I think that’s sort of a conversation that you need to have with your advisor.
Right. Well, just like your own personal investment strategy based on your risk and things like that. There really is no one size fits all. So, this is just that a good rule of thumb, but from our experience, you really need that customized, unique approach for your situation on what your goals are and something that is able to pivot and evolve as your goals evolve. Thirty-year retirement is a long time horizon, so a lot can happen.
Absolutely. And our goal is to help you achieve peace of mind throughout retirement. So, we’ll work with you to find a strategy that best suits you and your portfolio. And, I guess this is my final thought, and then I’ll kick it over to you too. I think plan monitoring is so key to, that’s another point to touch on with these withdrawal strategies is that it never should be a one and done idea when you’re creating your strategy to go into retirement. It should be reviewed annually every couple of years or when circumstances change to just make sure that you’re still on track.
Absolutely. And, not to bring in bad news again, but I think that’s also important. I always say that’s one of our main jobs as a financial planner is that we’re trying to poke holes in someone’s plan and almost trying to make it fail and that’s just to find those areas where we can strengthen it.
Again, I think just erring on that side of being overly conservative when you’re making these assumptions and looking at your own withdrawal rate in retirement, just kind of tucking on a little more expenses. Like if you think it’s $50,000 a year, plan it out for $60 and vice versa, just a factor in all those unknowns, because if the past two years have taught us anything, it’s that emergencies and pandemics and all sorts of things can happen. And so just to really be sure you’re prepared.
Yeah. We do not like to paint overly rosy pictures, that’s for sure. And I think that’s something we’ve tried to take with us and all the plans that we build. Well, this has been a wonderful conversation. I know it’s been on the minds of many people and many listeners. We’ve gotten questions about this, so I’m glad we took the time to sit down and do this episode. This has been Andrew Busa and Diana Linn from Adviser Investments, thanking you for listening to The Adviser You Can Talk To Podcast. If you enjoyed this conversation, please subscribe and review our show. You can also check us out at www.adviserinvestments.com/podcast. Your feedback is always welcome. And if you have any questions or topics that you’d like us to explore, please feel free to email us at infoadviserinvestments.com. Thanks for listening.
Podcast released on February 23, 2022. This podcast is for informational purposes only. It is not intended as financial, legal, tax or insurance advice even though these topics may be discussed. Information and events addressed in this podcast, as well as the job titles, job functions and employment of the podcast’s participants with respect to Adviser Investments, LLC may have changed since this podcast was released. Personalized tax advice and tax return preparation is available through a separate, written engagement agreement with Adviser Investments Tax Solutions..
The Adviser You Can Talk To Podcast is a trademark of Adviser Investments, LLC. Registration pending.
© 2023 Adviser Investments, LLC. All Rights Reserved.
Investment insights.Right in your inbox.
Adviser Investments' logo is a registered trademark of Adviser Investments, LLC.