MML# 091: Is Your Withdrawal Rate Too High to Retire? Check the Calendar First

We’re deep into review season here at First Light Wealth, and I’ve been reminded just how different one client’s starting withdrawal rate can be from another’s while still giving both plans the same probability of success. Let me explain what I mean:

Two reasons your withdrawal rate will change

The amount you take from your portfolio in retirement is going to change over time. Some of those changes you can’t predict, while others you can easily identify when mapping out your retirement. 

The first kind comes from the markets. A rough stretch might mean trimming spending a bit, and a strong run might mean a raise. I wrote about this in August using the Income Guardrails framework: The $2.3 Million Retirement That Works Better Than the $3 Million One.

The second kind is planned. The mortgage gets paid off. Social Security starts. You turn 65 and Medicare replaces the private health insurance you were buying.

None of those have anything to do with the market. They can still move your withdrawals a lot.

Why a big withdrawal rate isn’t always scary

Let's put numbers to it. Say you retire at 65 with $2.5 million and need about $120,000 a year of gross income to cover your lifestyle. You plan to delay social security until age 70. (Note, we’re delaying Social Security in this example only to emphasize how a massive change in withdrawal rate can occur in a successful financial plan).

For those first five years, the full $120,000 comes from the portfolio. That's a 4.8% withdrawal rate.

At 70, Social Security starts at roughly $50,000 a year. Now the portfolio only needs to cover about $70,000, a little less in practice because Social Security gets friendlier tax treatment. If the portfolio is still around $2.5 million, your withdrawal rate drops to about 2.8%.

Same family with the same financial plan. The withdrawal rate fell by more than 40% in a single year simply because of the timing of this specific income source. 

Measure the first five years against the 4% rule and 4.8% might look like trouble. Measure year six the same way and it looks like you're underspending at a 2.8% withdrawal rate. Both readings miss the point, because the drop was in the plan from day one.

Again, these figures are just an example. Your numbers may be different. But the point I’m trying to make is that most successful financial plans will not have a level withdrawal rate throughout retirement. Most generalized advice will point you towards a single withdrawal rate. 

Where a simple rule can get confused

A withdrawal-rate percentage guardrail watches one number. If the rate climbs past a trigger, you might cut spending. If it falls past another trigger, you might give yourself a raise.

That works well when spending stays fairly level. But most retirements have a few big steps built in as we’ve already highlighted.

In the example above, a rate-only withdrawal rule would see 4.8% fall to 2.8% and flag it as a reason to spend more. Nothing actually improved. Social Security just showed up when it was supposed to.

The mortgage works the same way. You wouldn't keep withdrawing your $4,000 monthly payment after the loan is paid off. Your withdrawal rate drops, but your retirement isn't any safer than it was the month before.

Measuring the whole plan

There's another way to set guardrails (Spoiler alert: my favorite and what we like to use here at First Light Wealth). Instead of watching your withdrawal rate, we watch your plan's probability of success based on a Monte Carlo analysis, a score from running your plan through thousands of possible market paths.

The planned changes are already in that model: the mortgage payoff in year seven, Social Security at 70, Medicare at 65. So when one of them arrives, the score barely moves.

It moves when something unplanned happens. A long market slump, a big unexpected expense, or a strong few years of portfolio performance. Those are the moments when you may want to adjust a little, either way.

In my practice this gets called a risk-based guardrail. It asks a more useful question: is the plan still on track, given everything we already knew was coming? If you were to implement this yourself, it would look like this:

You may choose a starting baseline probability of success of your choice. Let’s say 80%. In a monte carlo score, this means 80% of trials had a balance above zero at the end of retirement. 

If your financial plan’s probability of success drops to, say, 50% at any given time (i.e. poor market performance, large withdrawal, etc.), then you might decrease your spending to move the needle back to that 80% starting baseline again. 

Likewise, if your initial success score soars to 90%, you may consider increasing your spending. This is just an example—setting appropriate guardrail percentages may differ in your particular situation and risk profile. 

Start with your calendar

Before you judge any withdrawal rate, you may want to write down the changes you can already see coming:

• When the mortgage ends
• When Social Security starts, for you and your spouse
• When Medicare kicks in
• Any pension, deferred compensation, or buyout payments from your firm
• Big expenses that end, like tuition or a parent's care

Each one is a step up or down in what your portfolio has to cover.

Your withdrawal rate is going to move. You can see most of those moves coming years ahead, and knowing which ones are planned makes the unplanned ones much easier to handle.

If you'd like to map out your own calendar with probability-based guardrails, grab a time here.

Cheers, David