There are some big changes happening in the world of retirement planning. Some big and really good changes. First some background.
One of the most studied and researched topics in the field of financial planning is NOT the study of the accumulation phase of your life, where you’re saving and investing for the future. Instead, the subject that draws the most attention in the academic as well as professional world of personal finance, by a longshot, is that of the withdrawal phase of your life. The phase where you begin to distribute the money you’ve saved either with a planned retirement income strategy or a flying by the seat of your pants strategy.
The ever increasing attention and focus scholars and professionals are applying toward this endeavor is good news for us all - the young, those on the cusp of retirement or currently in retirement. And here’s why the news is so good.
Deciding on a tax savvy withdrawal strategy once you’re retired is crucial to the success of any retirement plan. The most enduring strategy to date is what’s referred to as the ‘4% Rule’. Developed by William Bengen, a U.S. researcher, it is also referred to as the ‘safe withdrawal rate’.
Bengen back-tested a 4% withdrawal rate with a balanced portfolio of U.S. stocks and government bonds earning overall market returns. He found that you would be able to safely withdraw 4% of your portfolio, adjusted annually for inflation, over any 30-year period since 1926 and never risk running out of money.
This has been and probably will remain the default strategy for the majority of comprehensive financial planners when designing a retirement income strategy for their clients. And for good reason. The research behind this work is impeccable. It stood the test of time and my sense is that it will continue to do so.
Yet the 4% rule, as great as it is, needs a challenger, a contender, or better put, a ‘new and improved’ strategy. Retirement planning research at its core seeks to continually optimize current solutions.
We’re now slowly but surely moving to a new withdrawal model called dynamic retirement income planning as opposed to the current static model of 4% withdrawals a year. The effect of this new evolving strategy will have a positive impact on many people’s lives.
D.R.I.P
D.R.I.P., short for dynamic retirement income planning will be the new go-to model we use at Spiritus for our soon to be, as well as our clients currently in retirement. The key benefit of this new income distribution model will, for many, mean the strong possibility of needing less money saved up before launching into retirement as well as a more nimble and dynamic spending plan while in retirement.
Less money needed to retire = retiring earlier than originally planned. That’s the biggest take away of this new strategy. Here’s how and why that works - first the how.
Your retirement will most likely be the most expensive purchase of your lifetime. Whether you need $2 million to retire with the lifestyle you desire or $5 or $10 million, your number is calculated based on many factors. One of the major factors is how much you plan to spend during retirement, which after adding in Social Security, Pensions and other sources of income, your planned portfolio withdrawals will fill in the gap between income and spending.
By using a D.R.I.P system to determine your number as opposed to the 4% rule, suddenly that number is lower, often by a considerable amount. A lower number means less to accumulate before retirement. That’s how it works.
And why it works is even more beautiful.
One of the keys to a dynamic distribution plan compared to a static plan rests with your spending assumptions. With the 4% rule, the assumption is you will continue to spend approximately the same amount annually adjusted for inflation throughout the course of your life. That’s a very safe and conservative assumption to make.
With a dynamic spending plan, you change the assumptions. For example, one scenario would be to lower total spending at age 80 by 20%, and lower spending by another 10% at age 85. Assuming a life span of 95 years, this strategy would lower your number considerably.
Yet another scenario would be to lower spending by 5-10% every 10 years. So at age 70, lower your total overall spending by 10%, again at 80 lower by 10% and again at 90 and who knows, maybe at 100 if you live that long. These phases of retirement are often referred to as the; go-go years, slow-go years and no-go years.
The assumption being, you’ll plan to spend more money the first 10 years of retirement than you will the last 10 years. This also assumes health care costs will be higher towards the end of your life while discretionary spending will be lower.
As opposed to the rigid 4% Rule, the future of retirement planning is in developing a dynamic spending plan.
This requires sophisticated financial planning software that has scenario modeling capabilities built in as well as an independent financial planner willing to learn and apply the latest science and offer that up to their clients. At Spiritus, we’re all over this. Our planning software was built for just this type of planning and yours truly loves helping clients retire earlier than anticipated.
Financial planning done well helps you better understand the range of possibilities and trade-offs that apply to your unique situation. Now’s the time to discover your number.
What are you waiting for?
Photo credits by Nikk Valentine