Most clients have no idea what retirement failure means to them and how a given failure rate should influence their planning. We present a planning framework that improves on existing models by dynamically adjusting for market performance and longevity.
Research shows the most popular reason people seek professional advice is to understand how much they can safely spend in retirement. How much can a retiree spend each year without running out? Advisor William Bengen first sought to answer this question through research he published in 1994. His goal at the time was to illustrate the historical inconsistency of safe withdrawal rates to rein in his own clients and steer them away from unrealistic spending expectations that could lead to failure. This failure-rate methodology has come to dominate retirement-income planning conversations.
Bengen’s 4% rule and its variants rely upon a fixed real spending strategy that does not adjust to portfolio performance. Under unlucky circumstances of low returns or high inflation, this drives a portfolio to ruin; under lucky ones, it accumulates an ever-growing pile of assets. Neither situation reflects realistic retiree behavior, nor does it consider a client’s lifestyle and legacy preferences.
Fixed withdrawals make retirement-income planning seem both scary and depressing: scary because of the emphasis on failure; depressing because a very low probability of failure can only be achieved by using a very low fixed withdrawal rate. Specifically, simulations that fall on the extreme left-hand-side tail of the distribution deplete assets over a fixed time horizon and drive the need for low withdrawal rates.
Planning software that guides client conversations about safe spending rates predominantly relies on the failure-rate lens. On top of the negative framing, a failure-based plan provides little insight into what spending could look like during retirement.
Two blind spots of fixed spending
There are two main problems with the 4% rule framework. The estimate of success or failure provides little insight into how returns and longevity affect the risk of spending a fixed amount: a black box to both the advisor and the client. Second, it doesn’t provide enough information about longevity risk.
Success means that a retiree can spend the same real amount to a specified age with some legacy value. This ignores the value of the portfolio over time. Whether the strategy falls short by $5 or $5 million, each run gets placed in the success or failure category. Turning up the dial on investment risk might improve the success rate of a marginally funded portfolio without showing how equities increase the magnitude of failure should markets falter.
A retirement lifestyle isn’t a football game where the only goal is getting the ball into the endzone. This threshold approach places too much emphasis on meeting a single inflexible lifestyle over an arbitrary time horizon. A retiree may be perfectly willing to accept a lifestyle that dips below this threshold if it means that she won’t have to worry about running out of savings later in life.
After experiencing a loss, you may be slightly less happy cutting spending a bit next year, but it’s worth the sacrifice to reduce the likelihood of cutting back significantly in your 90s. Increasing spending rigidly by the rate of inflation also requires spending more conservatively early in retirement. But you may be better off spending more initially and adjusting spending by an amount less than the rate of inflation when prices rise. For example, in 2022 a retiree could have taken fewer vacations in the face of high gas and flight prices.
A retiree shouldn’t ignore both good and bad fortune when deciding how much to spend every year. A black box that estimates the probability of failure at a single moment early in retirement doesn’t provide any information about a client’s potential lifestyle paths 10 years later. A saver wouldn’t establish a savings rate early in life according to historical returns and then ignore performance over time. We’re much better off traveling with a GPS that changes routes along the way to identify the best route to reach our destination.
How should a retiree address longevity risk? Monte Carlo analysis must estimate failure using a target lifespan, for example age 95, with no reassurance of safety if the client is still alive beyond that age. Higher-income Americans bear a higher-than-average risk of living beyond that age. A retiree who celebrates their 90th birthday isn’t going to spend as if they’ll drop dead at the age of 95.
Any reasonable advisor would suggest that their 90-year-old client spend less to make sure they have enough to last at least another decade. Ignoring this reality means that failure-rate analysis will not capture the benefit of products that transfer longevity risk to a financial institution. Delegating this risk allows the retiree to spend more throughout retirement because they don’t have to worry as much about the possibility of cutting back later in life to preserve savings.
Because a retiree who bears longevity risk must be more conservative with their spending to avoid the possibility of ruin, passing off this risk allows them to spend more each year from the amount allocated to longevity-protected wealth. This means they can spend less from their unprotected portfolio to fund their income goal, resulting in more attractive spending paths over the lifespan.
Helping clients understand retirement risk
Returning to the spirit of Bengen’s original goal when designing the failure-rate method, we ask the question: How do we help people understand how much they can safely spend? How can we present a persuasive analysis of retirement-income risks to help consumers make decisions that best suit their preferences?
The key is to start with a spending model that accurately represents expected retiree spending behavior. Flexible spending adjusts with portfolio value changes, much as individuals do in practice. There are various approaches for this, but we used a model that allows up to a certain percentage up or down from one year to the next in a white paper we published in March 2024.
Although we do not include visualizations within the paper, the results lend themselves to images that convey the tradeoffs of two important choices in retirement: the selection of products that provide lifetime income guarantees and equity allocation. Providing spending adjustments over time in response to investment returns and illustrating the impact of transferring longevity risk to an institution allows individuals to choose a path of income that matches their lifestyle goals.
The median represents the most likely slope of spending, which can be rising, flat, or declining through retirement. The choice of slope is a preference rather than an issue of optimization. The visual allows a retiree to decide whether they would like to spend more early in retirement and anticipate a decline in spending needs later in life, a pattern that research shows lines up with retiree spending in aggregate. This slope is one component of the lifestyle choice that retirees make when they start spending during retirement (whether they realize it or not).
The second key element is to go beyond the median to provide the range of outcomes throughout retirement rather than either the failure percentage or a deterministic sequence. A single market sequence does not show where that one path falls in the range of results under certain assumptions. But adding the range of outcomes illustrates downside risk and upside opportunity.
Spending flexibility is key to freedom to spend
Spending flexibility provides a relatable, more realistic pathway for spending that demonstrates how both equity risk exposure and longevity risk mitigation affect outcomes. And then, by displaying a range of results, we can create a picture of risk that is intuitive. It also allows us to avoid relying on a concrete planning timeline entirely and moves the objective away from failure.
Although retirees may be asking for advice on how much they can spend safely, they are ultimately seeking a certain retirement lifestyle. The cost of a fixed spending rule may be sacrificing greater certainty later in retirement in exchange for less income in early retirement when that is the opposite of their goal. Similarly, positive investment performance should reward retirees with the freedom to spend.
Finally, there is an element of Bengen’s original work that often gets lost in the mix: the expectation that clients receive regular guidance and adjust their spending through retirement. While he did not integrate flexible spending into his modeling, he assumed it as part of the relationship with clients and famously did so himself in response to the pandemic-related market slump.
By the same token, any visualization to help retirees take their first steps into retirement is not a rigid trajectory but is instead the initial guidepost in the journey. During the decades of retirement, retirees are likely to need a course correction in response to changes in markets, personal circumstances, and other factors. In all stages of retirement, we should empower individuals to have a strategy that suits their lifestyle preferences and gives them the confidence and freedom to spend.
Michael and Tamiko started IncomePath (www.incomepath.com) to provide better ways for retirees to decide how to meet their own lifestyle goals in retirement. They will be launching a tool for individual financial professionals in the first half of 2024.
Michael Finke, Ph.D., CFP® is IncomePath’s chief strategist and is also a professor and Frank M. Engle Chair of Economic Security at The American College of Financial Services. He leads the Granum Center for Financial Security.
Tamiko Toland is CEO of IncomePath. She has focused on lifetime income since she was a trade journalist covering annuities over two decades ago. Tamiko is a recognized thought leader who has a separate consulting firm and has worked at TIAA, Strategic Insight, and Cannex Financial Exchanges.
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