One of the hardest problems in financial planning is determining how much is safe to spend in retirement.

The reason it’s tricky is that you’re planning for a lot of uncertain variables. You don’t know how the market will behave over your time horizon, and you don’t know how long you’ll live.

But there’s been a lot of great research in this area over the past few decades, and we’ve come away with some conclusions that we can use to make better informed decisions.

In this article we'll discuss five things you should know about in-retirement spending:

1. Beginning conditions in retirement matter a lot

Starting conditions at the outset of our retirement can give us a little clue as to how the market might behave, at least over the first 10 years of our retirement. This is what retirement researchers call sequence risk. 

2. Asset allocation is important

The goal is to maintain a balanced portfolio. Generally speaking, a very conservatively positioned portfolio will tend to deliver a lower sustainable return than one that has a little bit more in equities or at least one that’s balanced.

3. Inflation is a force to be reckoned with

It’s really important to be mindful and take steps to protect against inflation in the plan. If inflation stays nice and low during your drawdown period, that tends to be a good sign for a higher safe withdrawal amount initially. On the other hand, if inflation is high, especially early on in retirement, that argues for being a little bit more conservative with that starting withdrawal rate. 

4. Retirees’ own spending is apt to be a variable of the lifecycle

Lifestyle considerations should be factored into withdrawal rates. Retirees don’t typically take a fixed real withdrawal amount over the whole of their time horizon.

5. Variable withdrawal approaches can enlarge starting and lifetime withdrawal rates

If you are willing to take a look at some of the variable strategies, you should be able to enlarge your starting withdrawal and you should be able to enlarge your lifetime withdrawal.

Let's dig into these 5 must-knows in detail. 

Must-know 1: Pay attention to starting conditions


I’ve talked about what we don’t know and why this is so difficult. Now, I’d like to get into what we do actually know about safe withdrawal rates, and one of them is that starting conditions at the outset of our retirement can give us a little bit of a clue as to how the market might behave, at least over the first 10 years of our retirement.

Typically when you embark on retirement, if you’re, say, in your mid-60s, you want to be sure that your portfolio lasts 25 or 30 years at a minimum.

I think it’s helpful to put a little bit of a dashboard together, where we’re looking at some of these key variables and making some assessments about whether we think things might work in our favor or things might work against us.

The ideal conditions for starting withdrawals would be that you’d come into retirement with low equity valuations, so stocks are cheap, and during your retirement, you’re able to sell them off to meet your cash flow needs and you’re able to sell them at ever higher prices. Decent cash and bond yields are another huge plus. And finally, low inflation is another big plus. 

The flip side is also true. Poor conditions for starting portfolio withdrawals would be that stocks are expensive at the outset of retirement, that cash and bond yields are very, very low and that inflation is high.

The good news for people who are thinking about retirement right now or perhaps for those who have just retired is that 2022, even though it was a painful market in many respects, does foretell better things for new retirees. So, we had stock prices fall. We had bond prices fall at the same time, largely because of rising interest rates. Just a handful of categories managed to perform well last year. If you had a fairly vanilla portfolio, you probably saw losses in your portfolio last year. It wasn’t a comfortable year. It wasn’t an easy year. But the good news is the fact that we have depressed stock prices and certainly, bond yields coming up due to depressed bond prices, that conspires to make market conditions more attractive for new retirees today.

The good news is when we have better market conditions, better expected stock and bond returns, that lifts what is a safe starting withdrawal amount.

So, when we did our research on starting safe withdrawal amounts in the 2020-2021 period, our conclusion was that a 3.3% starting safe withdrawal rate had a 90% probability of success with a balanced portfolio over a 30-year time horizon. When we revisited the research last year, so at Sept. 30, 2022, we came up with a better number, a 3.8% starting safe withdrawal rate, in large part because market conditions have improved along the lines of what I just discussed.

This is a good news story that starting safe withdrawal rates are higher. But the bad news story, and I think I have to address it, is the fact that investors saw their portfolios decline last year. It may be roughly the same, maybe even a little bit less than would have been the case with that 3.3% on a higher portfolio balance.

Read more from Mark LaMonica on how he set up his mother's portfolio for retirement.

Must-know 2: Maintain a balanced portfolio


Lesson one is to pay attention to starting market conditions because they can be very important in determining how much you can safely take out. Lesson two is to maintain balance in your portfolio.

These are various asset allocations, various combinations of stocks and bonds and cash, that someone might have used during their retirement drawdown period. And what we can see is that a 100% stock portfolio did in fact support the highest withdrawal rate in market history. So, if we look at 30-year time horizons over market history, if you had that 100% equity portfolio and you hit it exactly right, you could have taken a 6.5% starting withdrawal over that time horizon.

The problem with that all-equity portfolio is that if you hit it exactly wrong and you picked a terrible time to retire with that equity-only portfolio, the safe withdrawal amount would have been meaningfully lower. In fact, it would be fully half of the highest safe withdrawal amount.

So, this research that looks at historical data and was compiled by my colleague John Rekenthaler very much points to the value of having a balanced allocation. The portfolios that have at least some fixed-income assets in them tended to deliver a pleasing safe withdrawal amount, neither terribly low nor terribly high. And of course, high is good, but the idea is that you would like to try to improve the odds and to ensure that you can take out the most from your portfolio as is possible.

This very much reinforces the value of having balance into the portfolio that you bring into retirement, which can be achieved using the Bucket Approach to retirement investing. 

Must-know 3: Protect against inflation


Another key conclusion in the research on retirement spending is that it’s really important to be mindful about inflation and to take steps to protect against inflation in the plan.

Inflation tends to build upon itself, and that can be a real negative for people embarking on retirement. For example, if there’s a 10% inflation rate in the first year of retirement and then it gets back to normal afterward, every future year of spending has been impacted by that first-year inflation rate.

Even if the inflation rate gets back to normal, retiree spending will still be at that elevated level, even though that spending will be inflating at perhaps a smaller rate going forward. So, that’s just one of several reasons why inflation can be a big deal in retirement. 

The tricky part is that actually insulating that portfolio and plan is a little bit more difficult.

So, at the portfolio level, you’d want to think about a few key categories. Stocks are by no means a direct inflation hedge, and we certainly saw that on stark display last year when we saw stocks go down even as inflation went up. But over very long periods of time, if we have a sufficiently long time horizon, we know that stocks really more than any other major asset category have the best long run shot at beating inflation, which again gets back to the value of balance—of having safe securities in your portfolio but also having growth-oriented securities in your portfolio to help beat back inflation. So, those are things to consider at the portfolio level.

It’s also valuable to think about inflation as you calculate your portfolio spending plan, as you figure out how much to take out of your portfolio. If you have reason to believe that inflation will be high in especially the early years of your retirement, it makes sense to be a little bit more conservative in terms of your starting withdrawals. On the other hand, if you believe that inflation will be very, very low for whatever reason, you could potentially take a little bit more from that portfolio in terms of your starting withdrawal.

Must-know 4: Factor in lifestyle considerations


Lifestyle considerations are the next key takeaway as we think about the conclusions that we can use to inform starting safe withdrawal rates.

This is what’s been called the retirement spending smile. This is a piece of research that my former colleague David Blanchett produced that examined the trajectory of actual retirement spending over people’s retirement time horizons.

What the research concluded is that in contrast with that base case that I mentioned we use when we’re thinking about starting safe withdrawal rates, when we look at actual retiree spending, we see that spending starts higher and that often coincides with people’s good health years, where there’s pent-up demand perhaps to do travel, and then we see that spending tend to decline in the middle to late retirement years, and then it often elevates later in retirement, often in keeping with healthcare expenses, long-term-care expenses, higher medication costs, and so on. This is in a lot of ways a statement that that base case that we use is a little bit of a straw man because it doesn’t depict how retirees actually spend.

I mentioned much of the research assumes that fixed real expenditure pattern, but we see when we look at the data, when we look at David Blanchett’s data, we see that decline throughout the middle to later years of retirement.

But before retirees take this and run with it, they just need to be comfortable with their end of the bargain. So, yes, it suggests that withdrawals early on in retirement in those pent-up demand years can be higher, but it does necessitate lower spending as retirement unfolds. It’s also important to think about someone’s own health situation, and specifically the plan for long-term care and whether there is a plan for long-term care. If there is not a plan for long-term care and the older adult could see a significant spike up in spending later in life to cover those long-term-care costs, that argues for being a little bit more conservative with those starting safe withdrawal amounts.

Must-know 5: Consider a variable strategy


The final point I want to touch on is the value of being variable. The strategy that I just outlined is a simple twist on a basic fixed real withdrawal system, but there are a variety of other systems that you can explore, and these are various systems that we explored in our research at Morningstar on safe withdrawal rates.

The variable systems vary a bit, but most of them do try to ensure that the retiree doesn’t take so much in down-market environments, and some of them try to give you a little bit of a raise to compensate you in periods when market performance has been very, very good.

We examined a variety of different flexible strategies. You could use a simple fixed percentage each year. In fact, I sometimes encounter retirees who tell me that they’re taking just 3% or 4% of their portfolio each year regardless of what their portfolio’s value is. The big trade-off, of course, with a strategy like that is that your cash flow is buffeted around a lot by whatever is going on with your portfolio. So, my view is that such a strategy would tend to be best for people who have a lot of nonportfolio income sources, so where they have a pension and they’re just using their portfolio for extras. Such a strategy would only be appropriate in those situations.

We examined a pure required minimum distribution system in our research. We also looked at the guardrails system, which was developed by financial planner Jonathan Guyton and computer scientist William Klinger. The guardrails is a system that in our 2022 research and in our 2021 research showed itself to be a really good system in terms of delivering the highest lifetime withdrawals, especially for equity-heavy portfolios.

You can also just make simple tweaks to a fixed real withdrawal system. One system that I like for people who are looking for simplicity is simply to forgo the inflation adjustment in the year following a year in which the portfolio has lost value. So, coming out of a 2022, for example, if you’re going for a strategy like this, the trade-off would be that in 2023, you would not be able to take an inflation adjustment based on what happened in the market last year. 

See the full presentation from Morningstar's Christine Benz here.