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!