How to avoid outliving your savings

Outliving your savings is a hot topic – and not just among retirees.

FIRE investors – financial independence, retire early – are often very young but they argue endlessly about the sustainable amount that can be withdrawn from savings, which is particularly vital to know if you retire young.

The fairly universal rule of thumb until recently is that if you can live off 4% of your investments, adjusted annually for inflation, they should last your entire life, but this has recently been challenged by many US analysts who claim that it should now be a much lower rate – some as low as 3.3%.

The problem is that the longer your retirement lasts, the greater the chance that you will run out of money even if you follow the 4% rule.

Rule of 4% withdrawals is widely debated

Even the guy widely credited as coming up with the 4% rule – Bill Bengen – said it is often misinterpreted and used too simply, given it was designed for a “worst case” time such as October 1968 when inflation was high and share markets were roaring.

He suggests the rule would have worked fine since 1994 when he came up with it, but given lower inflation now, it could possibly be revised up to 5%.

Of course, inflation is very difficult to pick at the moment but certainly seems to be climbing rather than falling, so that number might need to fall back again.

Indeed, other financial planners and analysts who have examined the rule have come up with much lower “safe’’ numbers.

Morningstar opts for 3.3%

Investment research firm Morningstar suggests the withdrawal rate should be as low as 3.3% for people who want to ensure their retirement savings last their lifetimes, assuming a balanced investment portfolio and fixed withdrawals over the span of 30 years.

That calculation means that the retiree had a 90% probability of not running out of money in retirement, although the lower withdrawal payments would mean they would need to work longer or save harder.

“Given current conditions, retirees will likely have to reconsider at least some aspects of how they define their ‘safe’ withdrawal rate to make their assets last,” the research said.

“Our research finds that retirees can take a higher starting withdrawal rate and higher lifetime withdrawals by being willing to adjust some of these variables — tolerating a lower success rate or forgoing complete inflation adjustments, for example.”

Vanguard finds FIRE investors should be very careful

Vanguard also did some research on the 4% rule – especially as it applies to FIRE investors – and came up with some gloomy findings for those who want to save like crazy and drop out of the rat race very early.

When you look at a 50-year retirement – which is a FIRE goal for many – then many things change compared to the more conventional 30-year retirement.

Vanguard’s study found that as the retirement horizon grows, the odds of running out of money when you use a 4% withdrawal rate increase dramatically.

For a 30-year horizon, there is an 18% chance of running out of money, slightly higher than that found in the original research because Vanguard assumes stocks and bonds will have a lower return compared to historical averages.

At the 40-year horizon, the failure rate jumps to a worrying 46% and for the 50-year horizon, it is 64%.

Two thirds will run out of money before 50 years

So, if you retire at 40 and hope to live for another 50 years, there is a two out of three chance that you will outlive your savings.

Here in Australia, this research is particularly interesting because the 4% rule is effectively enshrined in our superannuation system as the safe “initial” withdrawal rate after retirement.

Due to the significant tax advantages within superannuation, the risks of running out of money are probably lower but there is another wrinkle to consider.

There are statutory minimums for super withdrawal and they go up significantly with age.

Super withdrawals go up rapidly in retirement

At the moment due to some interim pandemic rules, the statutory minimums have been halved, meaning that the minimum withdrawal level is just 2% for those under 65.

That is likely to rise back to the conventional 4% at the end of the 2021-2022 financial year.

That 4% rate rises to 5% for those aged from 65 to 74, 6% for those between 75 and 79, 7% for those aged from 80 to 84, 9% for those aged 85 to 89, 11% for those aged 90 to 94 and a whopping 14% if you are lucky enough to hit 95 or above.

Superannuation is designed to be withdrawn

The reason Australian withdrawal rates go up is because superannuation is designed to be wound down over time, with retirees who can’t spend the income generated usually saving the payouts outside of tax advantaged superannuation.

That makes the FIRE calculations for Australians a bit more complex than for those in the US, although having an age pension system underwriting retirement strategies is a big advantage and can permit more aggressive drawdowns.

Owning your own house also changes the calculations, with home-owners much better able to live on the age pension.

The house can also then be used as the ultimate fall-back to fund aged care needs.

A dynamic approach can be useful

Even if you want to remain independent of government pension payments, the combination of superannuation and savings outside superannuation can be very powerful and allows for a more dynamic approach.

For example, a FIRE advocate could decide to increase or reduce their annual income before dipping into their super by their overall investment performance.

So, if their investments returned 30% in a year, it might make sense to increase income for that year but if returns turned negative, they could be reduced to the bare minimum required.

They are complex and very individual calculations but the research take away is that it might be optimistic to rely on the 4% withdrawal rule, with the risks increasing the earlier you want to retire.