How Long Will Your Retirement Money Actually Last?

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This week's newsletter is an adaptation from my recent YouTube video on How Long Will Your Retirement Money Actually Last?

How do you not run out of money during retirement?

It really is one of the worst case scenarios, one that all of finance is really designed to help you avoid, because if you do end up running out of money during retirement, there's very little you can do at that point, including go back to work.

That is why it is really important to make sure you've properly budgeted for a long retirement, taking into account all of the vagaries of what the stock market can do, as well as different asset class performance.

In this week’s Five Minute Money, we're going to talk about how you can not run out of money during retirement, and the very famous 4% rule, and exactly where it fails.

One thing they don't tell you about a lot of these financial rules of thumb is that they are the result of backtesting, using existing past financial data, and they don't really account for what can happen in the future.

So in order to account for that, we ran our own 10,000-simulation Monte Carlo, twice, to also account for a more punitive stagflation scenario, to see the likelihood of running out of money under all of these different scenarios.

After we run that simulation, I'm going to share 6 interesting charts, 3 actionable takeaways, and then we'll conclude by talking about spending guardrails.

Even though this post is focused on making sure you have enough money to last your entire retirement, one of the most common problems retirees face, ironically, is actually having too much money, which you can account for by dynamically adjusting your spending.

Understanding the 4% Rule.

The first place I want to start is with the 4% rule.

You've probably seen this figure if you've ever Googled how much money you need to save for retirement.

It comes from a 1994 paper by Bill Bengen, and is really the foundational structure that a lot of portfolios are built off of, but it's important to know the assumptions embedded in it.

The rule assumes your retirement lasts 30 years, and says you can withdraw 4% of your initial portfolio value every year, adjusted for inflation.

If you had $3 million, 4% of that would be $120,000.

If you had 5% inflation the following year, you could pull out $126,000.

When Bengen ran this test, he tested it across different splits of stocks versus bonds, from 0% stocks and 100% bonds up to 100% stocks, and found that a 50/50 split tended to have the best result, and that you couldn't do less than 50% stocks or more than 75% stocks.

Somewhere between 50% and 75% stock exposure was optimal, which kind of buttresses the very common idea of the 60/40 portfolio.

That original allocation actually comes from Harry Markowitz in portfolio management theory, backed up by research in the '50s and later implemented on Wall Street, though mutual funds were doing 60/40 splits even before then.

Bengen looked at the actual data set going back to 1926, and for every 30-year rolling period, tested withdrawing 4% of the portfolio's initial value, adjusted for inflation, to see how much money would be left at the end.

He didn't account for investment fees, transaction costs, or taxes, which unfortunately you are going to have to incur, and that's one of the problems with a lot of these hypotheticals: they don't take real-world costs into account.

Nevertheless, it's still a pretty good rule of thumb.

What he found was that across all of these historical 30-year rolling periods, someone withdrawing just 4% of the initial portfolio, adjusted for inflation, wouldn't run out of money.

There's a problem, though: this is based on a historical data set of US large cap stocks that could be very different in the future, and while we did have some rough periods over the last hundred years, we also had a lot of really strong stock market performance that maybe isn't the wisest thing to extrapolate forward.

So what happens if the future is different than the past?

How do we test this?

That's where the Monte Carlo simulation we ran steps in.

Monte Carlo Simulation.

The idea is basically to create a bunch of fictitious return numbers for both stocks and bonds, see how portfolios hold up under a randomized draw, and run that 10,000 times to see what returns look like in the future.

There are some criticisms to this, because returns aren't necessarily correlated the way they would be in the real world between stock returns, bond returns, and inflation.

To adjust for that, we also ran a third stress test, a stagflation scenario, since 2022 was very destructive to the classic 60/40 portfolio: the stock market went down, inflation was high, and the Fed raised rates quickly, so bond prices fell a lot at the same time too.

The whole point of splitting between stocks and bonds is to diversify, since their returns usually aren't correlated, but in environments with particularly high inflation and rising interest rates, both asset classes can fall together, so we wanted to explicitly account for that.

In this first simulation, we start with the idea that the average stock market return is around 10%, with a distribution of returns that I adjusted to have fatter tails.

A standard probabilistic distribution doesn't assume a high enough likelihood for very unlikely events, like a 20% single-day drawdown, which has happened before, such as Black Monday in 1987.

Our fat tail distribution accounts for more of these high-impact, unlikely events, for both negative and positive outcomes, which is one of the main reasons we get different results than the historical data set.

We also made adjustments to life expectancy: we're assuming people retire at 65, but instead of a blanket 30 years, every simulation pulls from an actuarial statistical account of how likely people are to live at a given age, which helps us see how often people are over-saving or under-saving with a more realistic lifetime assumption.

A lot of times people's money does outlive them, which isn't the worst problem, but you'd probably have liked to spend that money while you were alive.

Six Key Charts From the Simulation.

Chart 1: The 4% Rule Succeeds in 96% of Scenarios.

The first chart shows that in almost 96% of scenarios, the 4% rule was enough money, and very often left us with almost too much: in almost 90% of scenarios, you would've been able to withdraw 5% instead of 4%, almost 25% higher spending.

This does suggest the 4% rule can be quite conservative.

So why not use a 5% rule instead?

Even with the 4% rule, in almost 4% of scenarios you don't have enough money, about 1 out of 25 times, and if you increase that to 5%, the likelihood you run out of money goes up further.

So a general takeaway is that the 4% rule is good enough for almost all circumstances, and does edge on being conservative.

Chart 2: Dying Early Is the Biggest Wildcard.

The second chart, a little morbid, shows that dying early is one of the biggest variables here.

Bengen's original research assumed a 30-year lifetime, but when we ran our own math, a 21-year lifetime turned out to be more realistic for most people, which means a higher likelihood you end up with more money than needed.

The solutions here aren't easy, because no one wants to plan for a shorter lifetime, and if you do and end up living longer, you're kind of out of luck.

I think the best thing to do is err on conservatism; worst case, you can accelerate your spending later in life, or you'll just have more money to give away.

This is worth flagging, because it's one of the main reasons you probably have too much money saved currently if you're taking standard advice.

Chart 3: Sequence of Returns Risk.

Chart 3 has to do with sequence of returns.

If you have bad stock market performance right when you retire, you're in a much worse position than if that bad performance came later in life, because you're withdrawing money against a portfolio that's flat or shrinking instead of growing.

This could be one of the biggest risks to retirement planning.

As a result, you should do something called dynamic spending, which we'll get to later.

But what this chart shows is that even if you get that worst quartile of stock market performance, you still have an 87% chance of having enough money through retirement.

That's a drop from the initial number, but still a pretty high likelihood, another reason the 4% rule is pretty conservative.

Chart 4: The Cost of a Higher or Lower Withdrawal Rate.

Chart 4 matters for people wondering why not just spend 5% instead of 4%.

If you jump to 5%, the likelihood you have enough money to fund your full retirement drops from 95% to 89%.

That's what you're giving up.

For some people, going from about 90% odds versus 95%, in exchange for 25% more spending, might be a gamble worth taking.

But even at 95%, that still means a 1 in 20 shot you run out of money.

What if you want to be even more certain?

If you drop to 3%, you only get to 99% certainty.

This shows how expensive it is to buy that last little bit of certainty to be good in more retirement scenarios.

Chart 5: The Historical Range of Safe Withdrawal Rates.

This chart shows, based on the historical data, how much you could have withdrawn and still lasted a 30-year retirement.

Our model is slightly different from the original 4% rule because it assumes some transaction costs and cost of maintaining the portfolio, and our bond durations are a little different, plus we have more data now.

If you retired in 1966, one of the worst possible times, you could've only withdrawn 3.75%.

If you retired in 1982, you could've withdrawn 10%.

That wide range of outcomes has to do with stock market performance thereafter, which is why dynamically adjusting your spending is better than any blanket rule.

The 4% rule itself still works in almost all scenarios; it only fails a few times, and just barely, so it's still a pretty robust rule of thumb if you want to keep things simple.

Chart 6: How Much You Actually Need to Save.

The last chart is about how much money you should save for retirement.

If you can only withdraw 4% of your portfolio to spend, and that 4% is equal to your expected expenses, then you can take 1 over the 4% rule to get a 25x multiple, and multiply that by how much you're spending to get what you need to save.

So 1 over whatever withdrawal rate you decide gets you a multiple: 1 over 4% gets you 25x.

This chart shows 3 different scenarios to get a more robust number.

Using historical data, it comes out close to the 4% rule, a 25x multiple.

In the Monte Carlo simulation, which has more punitive potential future data, lower expected stock returns, and a higher potential for drawdowns, it comes out to a 3.5% rate, or a 29x multiple, a little more conservative.

And in our stagflation stress test, which correlates the idea that if stocks are doing badly because inflation is high, bonds are also probably not doing well because interest rates are actively rising, we're looking at about a 3% withdrawal rate, or needing to save 33x your expenses.

Three Takeaways for Retirement Planning.

If we had to summarize this all into 3 easy takeaways: the first is that you should save somewhere between 25-30x your expected expenses for retirement.

That works out to a withdrawal rate of around 3% to 4%, depending on how conservative you want to be, and how much you're willing to stress test against a punitive future.

The second rule is that you are more likely to end up saving too much money than not enough, even if you do follow these rules, largely because of the dying-early risk covered in chart 2 and the conservatism built into the 4% rule itself.

That should be taken into account with dynamic spending, which we'll get to next.

The other thing to keep in mind, and this is the tricky part, is that it makes the most sense to spend more money right when you retire than later on, because that's when you're healthiest and most able to travel and do the activities you want to do.

If there are things you really want to do, it's probably better to spend that money right after retirement and enjoy your life, since that's the point of retirement, and cut down your spending in the middle to back half.

What usually ends up happening is a bit of a dip in the spending pattern: initially, you're spending a lot on travel and lifestyle activities, then as you get older you curtail some of that and those expenses go away, and then as you get even older, medical expenses tend to increase.

If you've been working and saving your whole life, it makes sense to spend on the things you'd really enjoy while you're still healthy, rather than waiting 15 or 20 years to maybe do it then.

Now I'm going to slightly contradict myself here with the third takeaway: sequence of return risk, starting initially with poor returns, is going to be the most detrimental risk to your retirement, so in that scenario you should dynamically adjust your spending down.

But that's not going to happen in all scenarios; there's some likelihood you get hit with a few bad years of returns right after retiring, but it's pretty unlikely to happen for 10 years straight.

If you do get hit with that, you can curtail some spending, and then as the market recovers, boost back some of those travel expenses.

Spending Guardrails.

So the best way to figure out how much you can withdraw without running out of money is to do something called dynamic spending, adjusting your spending based on how the stock market and your portfolio are doing.

This protects against both the downside risk of running out of money and the upside risk of having too much, because they're both risks.

If you saved up $3 million and, 20 years later, you still have over $3 million because performance has been so good, and now you're regretting not taking those vacations or buying the extra car, that's also a risk, because the point of your money is ultimately to serve you.

There's a 2006 research paper published by Guyton and Klinger that gives us 4 guardrails for spending that can help you adjust to both the low end and the high end, instead of being stuck to a stationary 4%, 4.5%, or 3.5% rule.

These rules are based around whatever withdrawal rate you originally picked, let's say 4%, and all adjustments are made to that initial number.

For example, if you have $3 million, the 4% rule says you could withdraw $120,000 in the first year, and all of the following adjustments are based around that $120,000 and that 4%.

Rule 1: The Inflation Rule.

The first rule is that you don't get a cost-of-living inflation increase if you had a negative return the prior year.

So if returns are bad the prior year and inflation is 4%, you don't get a 4% bump on your next payment; it stays the same.

Hopefully that doesn't happen too often, but if it does, it means you need to tighten your belt a little bit.

The good news is there's an opposite version of this rule for when things are going well, which lets you spend more, covered in the third rule below.

Rule 2: The Capital Preservation Rule.

The second rule is the capital preservation rule: if your current withdrawal rate is 20% higher than your initial withdrawal rate, you need to cut spending 10%.

If you take that original $120,000 and keep increasing it with inflation while your portfolio isn't doing quite as well, and the amount you're withdrawing creeps up to 5% instead of the initial 4%, this rule is triggered.

So the threshold, starting at a 4% rule, is that anywhere up to 4.8% there's no adjustment, but once you're pulling out more than 4.8%, this rule kicks in to help you cut spending and preserve more capital.

Rule 3: The Prosperity Rule.

The third rule is basically the opposite, a prosperity rule.

If your portfolio is going so well that you're up 15% or 20%, and your cost of living adjustment is much smaller, say 3% or 4%, then all of a sudden you're only pulling out 3% of your overall portfolio value instead of the 4% you started with.

In that case, you can bump your spending up 10%.

So the range runs from 4% up to 4.8% with no adjustment either way, and once you dip below 3.2%, on the low end of withdrawal rate, you get a pay bump and can pay yourself more.

Rule 4: The Withdrawal Order Rule.

The fourth rule has to do with how you fund the spending.

The typical assumption is that it comes evenly out of your equity and fixed income portfolio, rebalanced every year, but this rule says that if equities become overweight in the portfolio, you sell equities first, and if equities are down for the year, you sell fixed income first instead.

Together, these 4 rules help you more dynamically adjust your spend rate as you enjoy your retirement.

For more on How Long Will Your Retirement Money Actually Last, check out the video below.

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