Transcript:
Hey, guys. Mike Frontera here, back with another retirement theory video.
So a question I get all the time: I've got a $1 million portfolio. How much can I withdraw from it? And then the thing that typically follows next is: I've heard of this 4% rule that says I can draw 4% or $40,000 per year. So, is there any validity to that? Does that make sense in the real world?
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And it's sort of like a lot of these other things where it's a yes and no. So first, where did this 4% rule come from?
Well, it came from about 30 years ago, in 1994. There was a retired financial advisor named William Bennion. He had gone back historically and looked at a portfolio that had 50% stocks and 50% bonds and realized that if he took a 4% withdrawal out each year and increased it for inflation, that at the end of the 30 years about 90% of the time, you would not run out of money.
And so this 4% rule kind of took hold, and now it has been used as a common rule of thumb for many people. However, the major thing that it is missing is that in a real-world scenario, withdrawals just don't occur that way. If you start to think about it, we have Social Security, maybe part-time work, you have different income needs at different stages in your life.
So what really I'm going to be looking at here is the importance of having a cash flow projection out into the future so that, given a sum of money in a portfolio, what is actually a reasonable amount to withdraw. So, let's go look at this hypothetical scenario with Jerry and Ginny, and we can see how all of these different factors play in.
Okay, so we got Jerry and Jenny Sampleton, both 60 years old and retired. They have exactly $1 million in assets. We have their life expectancy set to 30 years, so basically the same setup that we were talking about with William Bennion’s 4% rule example. Let’s dive in. We’re first going to assume that we are invested moderately, I’m assuming roughly a 5% rate of return each year. What this software does is this will help us figure out how much income we’re actually going to get out of this portfolio.
So again, no other factors in here. Literally, these guys are in a vacuum with just $1 million in an IRA. I’m going to run maximum retirement spending. If I run that, there it is actually pretty darn close to $40,000. Now this is assuming a net $39,000, so it’s actually going to draw off a little bit more than that. You can see that, as far as getting a reasonable rule of thumb around that 4%, that’s pretty close.
Let’s also take a minute and talk about these assumptions. This is assuming an 80% probability of success. What that means is this is all run through what’s called a Monte Carlo simulator. What a Monte Carlo simulator does is it takes a thousand different trials with all different market conditions—good markets, bad markets—and it says, “What percentage of those trials do you get to the end of your lifetime with money left over?” Here, this is set to 80%.
Let’s see what happens. I’m going to save that to the plan, and if I go here to my withdrawals screen and update this, it should show us around a 4% withdrawal rate. Now again, this is in a vacuum, so this is not taking into account any of the real-world stuff that happens when a couple retires.
Let’s first assume that Jerry and/or Ginny decide they want to do some part-time work. I’m assuming between the two of them, they earn $24,000 a year for the first five years in retirement. If I turn that on and recalculate our maximum spending, and all of a sudden we should see this jump up. There you go. So that $24,000 a year for five years means, on average, they could actually expect to live on a total of $43,000 a year in retirement. I’m going to save that to the plan.
The other thing we hadn’t taken into account before—and this is one of the big ones—is Social Security. I took the average Social Security benefit in 2024, which was $1,907 a month at full retirement age. This base scenario assumes that they actually take it early, so they’re going to get less, but the point is going to be the same. Between the withdrawal income and the Social Security income, it’s going to drastically change the pattern of their withdrawals.
We’re going to run that maximum retirement spending again, and now, lo and behold, we have $72,000 a year. Let’s take a look at what these withdrawals look like because I think that is where you are going to see a difference from that 4% rule. You’ll see bigger withdrawals in the beginning, a big drop after that, and then it continues on. So that percentage actually starts higher, drops way down, and then bumps back up again.
Why is that? Let’s zoom out a little bit and look at the entire cash flow picture. We’ve got part-time work showing up here in the first year, and total expenses close to about $82,000. We are drawing about almost 6% of the portfolio, which is a reasonable amount to draw because all of this still setting the probability of success at 80%.
Now when we look at the income flows a little bit closer, the biggest thing that is going to do is change the pattern of withdrawals from the portfolio. As we create these cash flow projections, one of the most important things to do is break out some of your expenses. For example, your bills, mortgage, and any of these other “have to have” expenses. A mortgage, for example, that’s going to go as long as you still owe money. But the amount of money you need to cover on a mortgage doesn’t go up for inflation, it stays the same. However, your utilities and necessary expenses tend to go up with inflation. Then you have fun expenses like vacations or socializing, which tend to tail off as time goes on in retirement.
I’ve got a very basic display of those breakouts of expenses. You’ll notice it’ll change how much we can expect to get in retirement income based solely on breaking out these expenses. If we look at maximum retirement spending based on just Social Security and some part-time work, we get a maximum spending of $72,000 a year.
Let’s take this opportunity and assume we are going todelay Social Security. Now I’ve got Jerry and Ginny taking Social Security at 70 instead of 62. If I recalculate this, we can expect to live on $76,000 per year, just from making that small assumption change.
Finally, I’ll take these different expenses and break them out. We set a travel expense of $10,000 a year for 15 years. We set that a separate piece that will fall off after that time. Then these discretionary expenses, these nice to have expenses, these little extras, all that kind of money. These are the type of expenses that tend to slow down as time goes on. So what we did here is I added, no cost of living adjustment on those. So we’ve got this big chunk of money that is not going to increase. It’s going to be a flat $40,000.
And then finally, medical expenses tend to increase and increase at a faster than typical inflation, so my inflation assumption is about 2.5%, a little bit less than that. But my medical expenses I’m figuring are going up by 5% every year. Let’s run this again.
And we should see this decline, it goes down to $26,000. Reason being is we are separately accounting for $60,000 of expenses. So, going back to what our previous assumption was, is that we could spend $76,000 a year in retirement. With just breaking these expenses out a little bit more intelligently, now we have $60,000 that we can spend here, plus $26,000 to spend where.
Now, again the same $1 million portfolio when we started out we were figuring about $40,000 a year. Now we are over twice that. We are figuring now about $86,000 per year. And further let’s go into that withdrawal screen. So we actually start with a much larger withdrawal.
So if you come into retirement and you are thinking, “I’ve got to stick to this $40,000 a year, or this 4% rule,” there is a good change you are leaving a ton of money on the table.
And by the way, we haven’t even talked about any optimization regarding different account types, a lot of people have either brokerage accounts or Roth IRA assets. We haven’t talked about Roth conversions or any of these different things that can help boost this retirement income picture even further. We also haven’t talked about changing our risk within the portfolio. We also haven’t talked about changing our risk within the portfolio. We stayed at a very conservative to moderate type of portfolio risk here. So there is a lot more that goes into it vs just sticking to that 4% rule of thumb. And I think that rule of thumb is, for many people, so far off of what reality is, that it’s more harmful than useful in most cases.
Do you have questions for me? Come visit me at RetirementTheory.com or send me an email at Mike@RetirementTheory.com. Thanks for watching. We’ll see you next time.