How Much to Spend and for How Long?

As it turns out, there isn’t one. “Investors put too much weight to these rules of thumb,” Fisher tells PLANADVISER. In fact, all investors really need to think of is their particular situation when considering how to handle the sustainable withdrawal question.

It’s one of the biggest questions for an investor: how much money he can afford to pull out of a retirement nest egg each year. Fisher notes that people naturally want to avoid outliving their savings.

Financial planners call this longevity risk, and it’s a growing problem since people are living longer.

“The notion that a 3% or 4% or 5% is something you can start with and stick with for 40 years is unrealistic,” says Fisher, a certified financial planner and the founder of Gerstein Fisher. “The only thing we know about projections 40 years into the future is that they won’t look like what we think they will look like.”

In a paper on the firm’s site, Fisher examined the experience of a hypothetical investor under different withdrawal rate scenarios, assuming a 50/40/10 portfolio – 50% of the portfolio invested in domestic S&P 500 Index stocks, 40% in intermediate-term U.S. bonds, and 10% in cash reserves. Fisher notes that investors also should factor in other income sources, such as Social Security, pensions, and annuities.

“Many of us have lived through different market environments, and we know the real challenge to an investor is what they will do when the market is down 50% or when something changes,” Fisher says. Hundreds of situations, from death, to divorce, to a range of medical costs, to aging parents, can crop up and influence investor choices.

The Limits of Empirical Data

Imagining that an investor’s future returns and future withdrawal rate are influenced only by empirical data is nonsense, Fisher says. “We all use empirical data to learn from history and see what may have worked and what didn’t work,” he adds. Looking backward to seeing what would have worked does not always factor in the realities of people’s lives and circumstances. “The empirical data is not enough,” Fisher says. It has to be blended with reality and a reasonable economic framework.

“An important input to the analysis is, When will I die?,” according to Fisher. The longevity risk is an underrated problem. “People come up with a combination of reasonable factors, but if you die closer to 85 than 95, then you didn’t spend enough.”

Determining the appropriate withdrawal rate requires a fine-tuned set of factors and tools. Taking a 3% withdrawal is a prudent path for advisers to take with investors, but it can backfire depending on the client’s lifespan. “For the next 20 years they do the right thing,” Fisher says, taking the 3%, and then they die after 20 years with a sizable amount of money left in the portfolio—call it a full tank of gas.

How will the adviser feel, recalling that his recommendations were for the investor not to travel, not go out to dinner too often? Of course the investor might still be healthy at age 85 and still have another 20 years left. “That’s where 3% to 4% is the right advice,” Fisher says.

Recommending a drawdown rate is a challenging emotional issue for advisers who care about their clients. “It’s hard to win,” Fisher says. “You want to protect your clients from this significant risk

Speculation and forecasting are useful only up to a point, Fisher says. Monte Carlo simulations and talking in probabilities are common, but these tactics don’t yield a lot of actual information.

Hoping for a Prediction

Investors often rely on their advisers to tell them what to do, and Fisher observes that it’s hard for them to realize that advisers often don’t really know.

Determining a sustainable rate is more than just a matter of forecasting or knowing probabilities and numbers. It’s very much about the relationship between an adviser and an investor, who is looking to the adviser for some certainty. “They want an adviser to be able to predict the future,” Fisher says, unaware of the huge variables from how the market will do, to tax rate changes, to market returns. “When I read these articles about 3%, 4% withdrawals, they miss the bigger point about what it means to us as human beings to sit down with our clients,” he says.

Fisher feels advisers must understand the two biggest risks in conversations with investors. The first is the longevity risk. “The 10 years at the tail end makes a much bigger impact,” Fisher says. Future costs and unexpected human events can be impossible to predict, but they’re big concerns and they are hard to deal with when doing the projections.

Behavioral risks are also considerable. A 4% withdrawal, annually adjusted, or spending an amount contingent with market performance are two reasonable strategies. “But in real life, people don’t do this,” Fisher says. In severe market downturns, people are willing to adjust to economic realities. Even if they can afford to, they generally don’t just increase their income.

Advisers need to stay dynamic and flexible in the way they look at these factors with investors, and realize that it is all but impossible to put together a plan that will work for the next 30 years. After examining the different rolling periods and combinations of stock and bond portfolios, Fisher says his firm has concluded that good advice, on average, is to keep about two years’ worth of living expenses in cash, subtract other streams of income, such as Social Security or pensions.

“Also consider, if you’re very young, and retiring early at 55, 60 maybe you take 3%,” Fisher says. “Or do 4% but have a backup plan, such as go back to work or find a way to make a few dollars. Work in the years the market is down, perhaps sell your home.”

Most of the time, Fisher says, a 4% withdrawal, whether adjusted for inflation or adjusted every year, is a workable approach. “We’re talking about the future,” Fisher points out. “Nothing should work all the time.”