Safely Enjoy a Better Retirement? A Little Budget Flexibility Helps

Just ask anyone who retired in 2022…

The sequence of returns risk is a thing and inflation can turbo-charge it!

• Stock investments? Dropped by 18.1 percent.
• Bonds? Lost 16.5 percent.
• Inflation? Soared 6.45 percent.

How 2022 Hammered Retirement Portfolios and Future Prospects

Say you retired in early 2022.

You managed to amass $1 million, invested 50/50 in large-cap US stocks and 10-year treasuries.

On Jan 1, 2022, you took out 4 percent of your portfolio since, you know, the 4-percent rule…

Through 2022, your remaining $960k lost 17.3 percent, and you ended the year with $794k. From that, you’re supposed to draw $42.6k, which is now 5.4 percent of your remaining portfolio!

A recent Morningstar State of Retirement report tells us your risk of running out of money in the next 29 years shot up from its original 13 percent to a staggering 54 percent!

Not convinced?

Say 2023 ends with a flat return on your portfolio (bonds have lost 5.3 percent to date that will likely only get worse if the Fed tightens again between now and the end of the year, and while the S&P 500 total return is up 13.4 percent, that could easily turn down).

If inflation for the full year ends up at 4 percent, your draw would increase to $44.3k, while your portfolio would remain at $751.4k so your fractional draw would increase again, to 5.9 percent!

Another (hypothetical) flat year with 3 percent inflation would push up your fractional draw to 6.5 percent ($45.6k out of a $707.1k portfolio)!

And if 2025 ends up with another 10 percent drop, let alone a 20 percent bear… 

It doesn’t take a lot of imagination to see where that’s heading…

A Way Out of That Downward Spiral

That same Morningstar report highlights five different so-called “dynamic” withdrawal strategies.

My favorite is the Guardrails Approach. It would let you keep a 90 percent success likelihood with 4.8 percent initial draw instead of the 3.8 percent recommendation for this year’s new retirees who want a static draw in real (inflation-adjusted) dollars.

And that’s with a 50/50 stocks/bonds allocation, the sweet spot for static draws.

Increase your stock allocation to 80/20 and that 4.8 percent safe initial draw increases to 5.6 percent!

At a 100/0 allocation, it hits 6.3 percent!

How the Guardrails Approach Works

The guardrail strategy has you cut your withdrawal by 10 percent if your fractional draw (i.e., your draw divided by your portfolio value) hits the upper “guardrail,” 20 percent above your (e.g., 4.8 percent) target (e.g., 5.76 percent).

This pushes you to reduce your withdrawals so you sell fewer shares when your investments are down, making it easier for your portfolio to recover when the market goes up.

For example, even a one-time 10 percent cut in your withdrawal following the dismal 2022 would have reduced your risk of running out from 54 percent to 46 percent. Imagine what keeping the cut in place for another few years would do…

Conversely, if your fractional draw drops by 20 percent below your target (which for a 4.8 percent initial draw would be 3.84 percent), you hit your lower guardrail and increase your withdrawal by 10 percent.

On average, over a 30-year retirement, you’d hit the lower and/or upper guardrails multiple times — simulations say you should expect about three of each.

The Real-Life Consequence of Using Dynamic Draws

The biggest problem is that if the market has a bad year, especially with high inflation, you may need to cut your draw by 10 percent. That’s a lot of dollars you’d need to trim from your spending.

Worse, that cut doesn’t go away until and unless your portfolio recovers enough to get your fractional draw to hit the lower guardrail.

If you retire early and rely solely on your portfolio and hit this situation, you’d have to cut your budget by the full 10 percent.

Ouch!

Imagine if your non-discretionary expenses (think taxes, housing, utilities, groceries, auto loans, fuel, health, etc.) take up 90 percent of your budget, you’d have to stop 100 percent, i.e., all discretionary spending!

No more vacations, eating out, gifts, shows, movies, or even buying a magazine or book!

Double ouch!!

Clearly, this isn’t sustainable.

7 Ways to Avoid This Fate

As in most things in personal finance, there are few absolutes, and lots of compromises are required.

The following are 7 areas in which you can consider taking actions as appropriate to your personal goals and circumstances.

1. Add as much (quasi-) guaranteed and/or side-hustle income as possible. This could include rental real estate, Social Security benefits, online writing, Etsy stores, etc. The benefit is easy to see — if you have more non-portfolio-derived income, you’ll be able to live with a smaller draw from your investments. Also, if you need to trim 10 percent from your portfolio draw, and that draw is 80 percent of your retirement income, you’d only have to trim your spending by 8 percent instead of 10.
2. Downsize your home. According to research, not only is housing the biggest expense category for retirees, it is also the one most prone to large year-over-year increases. Whether it’s a rent increase or a major repair, such events can cause a 25 percent increase in spending. Finally, given that housing is non-discretionary, the smaller a part of your budget it becomes, the larger your discretionary expenses are, which lets you trim spending more readily if needed.
3. Complete major renovations, remodeling, and home repairs before retiring. Since, as mentioned above, housing can bust your budget, it’s best to take off the table the biggest potential culprits while you still have earned income.
4. Similarly, take care of any major medical expenses before retirement, especially procedures that aren’t covered well by Medicare (think dental). These are also (usually) non-discretionary, so here too, taking them off the table before retirement makes trimming your spending easier.
5. Consider moving. This can have multiple benefits. First, moving to live near your kids will reduce the cost of visiting with them. Second, moving to a walkable neighborhood may allow you to downsize from two cars to one, or from one to none. This can have a major positive impact on both your budget and potential budget-busting repairs. And, here too, reducing transportation costs, which are mostly non-discretionary, shifts the balance toward more discretionary spending that’s easier to trim.
6. Pay off debt, especially high-interest debt like credit cards. This category of spending is also non-discretionary, so minimizing it as much as possible will make it easier to trim spending when needed.
7. Finally, stay active and healthy. This has the dual benefit of keeping health-related expenses lower, and providing fun and usually free activities to fill your days and weeks. On the flip side, it means that, on average, you’ll live longer, so your risk of running out of money increases. Still, even if I had to start with a slightly lower spending level, I’d take that trade in a heartbeat.

Another idea comes from Chris Chen, Insight Financial Strategists who says, “Guardrails are nice, but what about buckets? With a bucket strategy, retirees budget a short-term bucket for spending needs for 3-5 years. Subtracting social security, pension, and other income spending gets to the retiree’s cash need for this short-term bucket. This is invested in no/low-risk instruments with low returns, and replenished periodically. Further-out buckets are invested more aggressively for better returns. When the latter decrease in value, as they will, they have time to recover. With this strategy, retirees’ current income is assured and long-term assets don’t have to be drawn down.”

Cristina Guglielmetti, President, Future Perfect Planning agrees, “When approaching retirement, consider accumulating cash instead of adding to investments (you may continue 401k contributions for the tax break and employer match). Maintaining 2–3 years of expenses in liquid, accessible assets such as high-yield savings accounts or short-term treasury bills as part of a bucket strategy lets you can avoid selling stock in case of a downturn. As income and expenses rise and fall, e.g., when you reach RMD (Required Minimum Distribution) age or pay off your mortgage, you adjust the cash bucket size.”

The Bottom Line

If you want the financially safest way to maximize your spending in retirement, dynamic withdrawal strategies like the Guardrails Approach are your best bet.

However, as a consequence, you’ll most likely have to trim your expenses several times during the average 30-year retirement.

The above offers 7 arenas where you can take action before retirement to make such trimming as painless as possible.

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Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.