Calculating safe spending rates in retirement is challenging. Everyone wants to be conservative and be sure they will have enough money. But understanding what numbers to use is not simple.

The most common request we get is for a back-of-the-napkin calculation of future yield, interest or income. People assume they can safely spend the income and thus refrain from touching the principal. But rather than being conservative, this strategy may actually lead people to spend too much.

Consider Michael and Jennifer Madison, a newly retired 65-year-old couple who want to play it safe. They have $1 million that they invest entirely in bonds paying 6%. They believe if they can live off the interest, they won’t need any of the principal. Every year they spend $60,000, confident about their conservative choices. But after several years, they begin to feel strapped for cash. They have not provided for the inevitable increase in the cost of living. Too late they realize that inflation is eroding their buying power. The idea of leaving their principal intact is not working.

In just 10 years, the couple’s $60,000 only has the purchasing power of $36,000. Their lifestyle has dwindled to 60% of what it used to be. With inflation averaging 4.5% over long periods of time, they need their principal to appreciate. Each year their dollars stay constant, they lose their buying power.

Additionally, although their bond portfolio was getting a 6% return when they started the process, bond yields fluctuate as much as stocks do. When the Madisons find themselves in a low-yield environment like today, they don’t know what to do. Inflation has eaten the principal. The Fed has swallowed the yields.

Leaving the principal untouched is even more difficult to interpret when you consider the difference between stocks and bonds. If your investments are in bonds, your principal has no growth to help keep up with inflation. But the interest payment may be higher than you should be spending.

If your investments are in growth-oriented stocks, however, they may pay no dividend at all even if they double in value. Without a dividend it isn’t clear what keeping the principal intact means. We don’t distinguish between more value from income and more value from appreciation. In either case, spending all of your growth leaves nothing to keep up with inflation.

From an investment point of view, a stock that appreciates 6%, a stock that provides a 6% dividend and a bond that pays 6% interest are equal. Some companies provide a better return by reinvesting earnings in the business. For others it is better to distribute those earnings to shareholders. Attempting to live off the income and preserve the principal often leads people to create asset allocations that are all income and no appreciation. They mistakenly believe this is the best of all worlds. It seems like both overly conservative investing and overly conservative withdrawal rates, when in fact it is neither.

Because retirement may last more than 35 years, you need significant appreciation just to keep pace with rising costs. With inflation averaging 4.5%, spending at age 100 will be more than 4.5 times what it is at 65. So if you get no interest or appreciation on your portfolio, you can spend only a tiny fraction the first year. You will have to save 4.5 times the dollar amount to have the same lifestyle your final year.

Put another way, if Michael and Jennifer stuff their million dollars in the mattress, they will only be able to spend 1.16%, or $11,606, the first year. They must save the remainder for the $54,168 that same standard of living will cost if they live to 100.

Note that because no interest is paid in your mattress, even this ultraconservative 1.16% withdrawal rate is depleting the principal. And any higher withdrawal rate depends on some level of income or appreciation.

Also bear in mind that any specific asset allocation including an allocation entirely to U.S. Treasuries will produce fluctuating returns. Sometimes even bonds drop in value. Long-term government bonds lost 7.03% in 1994 and another 8.6% in 1999. Even short-term Treasuries lost 0.58% in 1994.

Given these shifting returns, the rate of return we assume for our projections is critical. Even if you are ultraconservative, put no money at risk and have a withdrawal rate of 1.16%, you may still run out of money. You may live to be 101 or older. And inflation may exceed 4.5%. There is always a chance of failure in the infinite combinations and permutations of returns, inflation and longevity.

For this reason, financial planning doesn’t guarantee with 100% certainty that you can withdraw a certain amount of purchasing power for 35 years and not outlive your money. Instead, astute financial planning seeks an 80% chance and then relies on annual course corrections over the next 35 years to adjust your spending to cover the remaining 20%.

This is an excellent approach. First, keeping 80% of the wild scatterplot of returns exceeding your safe withdrawal needs means the average is much higher than you need. Most of the time, returns that fall in the bottom 20% are more than compensated by the 80% that do not. And because the average return is higher than you need, your portfolio will most often be able to make up for poor returns early in retirement.

Second, if 80% exceeds the needs of your safe withdrawal rate, it produces a lot of excess returns. So although you are planning to deplete the portfolio, 80% of the time you will leave a significant legacy. What you are trying to accomplish is your best chance at enjoying your preferred lifestyle. And your best chance of achieving it is aiming to deplete the portfolio in less than 20% of the wild scatterplot of returns.

This 80% success rate sounds more threatening than it actually is. In truth, it means you will be able to increase your spending rate by more than inflation 80% of the time. But 20% of the time, you will have to defer any spending rate increases by inflation until excess returns have helped your portfolio rebound. These annual adjustments allow a near 100% success rate by adjusting your standard of living by a small amount based on how your portfolio has actually performed.

At age 65 the safe withdrawal rates using this method are 4.36%, or about $43,600 for a million-dollar portfolio.

Photo by Megan Marotta