Spending correctly in retirement is hard

A reader who lives near Hartford, Conn., recently lamented the lack of sophisticated spending models in retirement, while so many models are available for the accumulation years.

"Saving for retirement is not easy, but it seems that it is not particularly complicated," the reader wrote. "Withdrawing those savings, however, seems very complicated and there seems to be little in the way of comprehensive advice or computer-modeled calculators. How you withdraw can make a tremendous difference in how your money will last. However, there are many different factors to consider and the advice often addresses only one area."


The reader is correct. A simple rule of thumb - such as the oft-repeated strategy of limiting the first year's portfolio withdrawal in retirement to 4 percent of the total, then adjusting for inflation thereafter - cannot address individual circumstances such as life expectancy, potential medical costs, the ability to strategically plan for taxes, or whether the retiree will be knowledgeable enough to appropriately place certain asset classes in the right accounts.

So if withdrawing a fixed amount every year isn't the optimal strategy, what is?


Building flexibility into portfolio withdrawal plans helps retirees guard against their worst nightmare - running out of money, said Stephen Horan, head of private wealth for the CFA Institute in Charlottesville, Va., an organization for financial analysts.

Rather than locking themselves into a fixed withdrawal of the initial 4 percent plus annual inflation, retirees should consider their nest egg as a job that pays variable income, and maximize tax strategies accordingly, Horan argued in a recent paper for the Journal of Financial Planning.

For example, Horan said, retirees who are required to take minimum distributions from their individual retirement accounts might withdraw funds up to the 15 percent tax bracket from their traditional IRA, then take the required remainder from a Roth IRA, in which withdrawals are tax-free. This allows a retiree to plan year by year the best withdrawal strategy, Horan said.

"The thing about flexibility is, it's hard to model," Horan said. But he also points out that most large endowments don't adhere to strict spending rates; rather, they base them on several quarters' average returns.

A retiree trying to do the same might base withdrawals on the size of the portfolio over the past three years rather than continuing to withdraw inflating amounts, even in bad market years.

If you've built in that flexibility, you'll cut spending during market declines, but it will be a moving average, so your spending won't take a substantial hit because of one bad year, he said.

By responding to market conditions, retirees could be able to withdraw a more generous percentage of their total portfolio in a given year, Horan said.

"If you start out with a fixed spending amount and have several years of good returns early on, the strategy should work fine," Horan said. "But if your retirement is front-loaded with negative returns, a fixed-dollar strategy will kill you."


That's because taking a constantly increasing income from a portfolio will deplete it in bad years. By contrast, withdrawals based on the actual value of the portfolio ensure that you withdraw only a percentage of what's in the portfolio.

Financial planner Ty Bernicke of Eau Claire, Wis., generally sticks to the 4 percent withdrawal rule, but builds in flexibility in other ways.

Although he may suggest that initial withdrawal rate, he is less strict about adhering to a constant inflation rate. "I've never had a client call and tell me to bump up their income by inflation," he said. "There may be periodic adjustments, but not every year."

Where retirees get hurt financially is often in the years just after an early retirement until Medicare kicks in, he said. So he sometimes adjusts portfolio income a bit higher in the early years and then lower after age 65. Have a retirement question? Write to, or via mail at Your Money, Chicago Tribune, Room 400, 435 N. Michigan Ave., Chicago, IL 60611. If your letter is selected we may include your question in a column.