How to not run out of money in retirement

The last three years have made this perennial question more urgent than ever: how do I know my retirement savings will be enough? Life is unpredictable and expensive, even without stubborn inflation; and the markets have been so capricious lately that even the sturdiest portfolio does not feel entirely safe.

The two obvious factors in your savings’ longevity are 1) how much you withdraw from them, and 2) whether they earn good or bad returns. But it is every bit as important to consider when you withdraw (i.e. your sequence of withdrawals) and when you experience good or bad returns (sequence of returns).

One of these you can directly control; the other, sadly, you cannot. But accounting for both will help you get the best possible mileage out of your retirement savings.

Why you should plan your retirement spending

Suppose you hit retirement with a good-sized nest egg split between cash savings, a Roth IRA, and a 401(k). You could just have the same amount drawn from each account every month and call it good. But while that set-it-and-forget-it approach is attractive, it is probably not a good idea for three big reasons:

  1. Your income needs will likely fluctuate throughout retirement – Suppose you want to move closer to your kids within five years of retiring, and they happen to live in a more expensive metropolitan area than you currently do. This means you will have some major expenses apart from your regular income needs, and you definitely want to plan for that.
  2. Your assets may carry different tax burdens – When those moving costs do come around, will they be covered by your cash savings, the Roth, the 401(k), or some combo? Bear in mind that 401(k) withdrawals are taxable, while Roth withdrawals are tax-free. And if you pull a big chunk of change out of your 401(k) all at once, you will likely end up paying even more tax on that money than you would on regular income.
  3. Different asset classes will grow at different rates – Finally, suppose your Roth happens to have a large proportion of “slower” assets like bonds, while your 401(k) favors stocks. This means that – in this example at least – the 401(k) has greater growth potential than the Roth. And if you pull a lot of money out of it early on, that potential will be lost.

All of these factors can make a big difference to the total amount of savings you have to work with in the long run. The good news is you have a degree of control over all of them. But in addition to these, there is an elephant in the room that we should address…

What about the markets?

I have said it many times and I will say it again – do not try to predict what the market will do! But you may want to prepare for certain possibilities. One in particular, actually.

Imagine two retirement accounts that each have a $1M starting balance and earn an average annual return of 7% over the course of 30 years. They are identical in pretty much every way but this: the first 10 years bring exceptionally good returns for the first account, while for the other (suppose it’s in a parallel universe) they are poor to mediocre.

As you can see, the difference in outcome is dramatic. Even with 7% average returns over the course of those 30 years, the slow-starting portfolio will end up running out, while the other one will not!

This possibility, of bad returns early on screwing everything up later, is known as sequence of returns risk. I’m sorry to say there is no foolproof way to eliminate it. But you can mitigate its effects with – surprise, surprise – a solid sequence of withdrawals.

Planning your sequence of withdrawals

Now that you have all these considerations to juggle, how do you put them together? The process looks something like this:

  1. Make a rough map of your anticipated spending needs throughout retirement;
  2. Rank your various assets by their projected RoR and tax status;
  3. Use those rankings and spending forecasts to “schedule” which assets to spend down sooner and which ones later.
  4. If possible, adjust this schedule to allow a little extra cash in the first 5-10 years, while leaving higher-growth assets as intact as possible. This will shield you a bit against a bad sequence of returns.

If this looks like a lot of homework… well, it is. But the thought and foresight involved will help you get more bang for your buck in retirement.