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How much do you need for retirement?

Among many threats to their financial security, retirees have two primary risks — long life and investment market downturns. These risks are known but tough to navigate with confidence. The most prominent concern I hear from people starting retirement is fear of running out of money, even if they have substantial financial resources. It can be scary not to know how much lifetime spending you’ll need to cover, or to what extent investment markets will be in your favor.

This is not a new phenomenon. Over the past 20 years research has sought to provide a guide for how long investment assets can be expected to last. Unfortunately, well-intentioned modeling of scenarios is often flawed when applied to personal circumstances. In some cases, these guidelines steer people toward a lesser living standard than they actually can afford.

A common rule for addressing life longevity and investment risk suggests that the average retiree can spend up to 4 percent of invested savings each year (adjusting the withdrawal for inflation annually) and likely not run out of money over a 30-year retirement. But the 4 percent rule comes from the lab not reality.

The 4 percent research is meant to identify a sustainable withdrawal rate that would work even if investment performance is worse than average over a 30-year retirement horizon. And it has typically used a balanced portfolio of 60 percent stocks and 40 percent bonds to determine investment returns. The problem with this research is too much precision. Financial planning and investment performance are — even at best — imprecise and variable.

When you become more sophisticated about a personalized financial plan, rules of thumb like 4 percent withdrawal rates don’t fit uniformly with everyone. Few people spend in consistent patterns year after year. They might buy a vehicle every several years, mix in a more expensive vacation from time to time, have a medical event, or one of many other expenses that distort their average spending.

The 4 percent guideline also can lead to significantly different outcomes depending on the character of the accounts being withdrawn from. If your retirement income withdrawals come from a tax-deferred account such as a 401(k) or IRA, they will be much lower after-tax than withdrawals from a Roth IRA (generally tax-free) or a brokerage account subject to capital gains taxes instead of ordinary income taxes.

If you take 4 percent withdrawals from a conservative portfolio (especially at today’s low interest rates on bonds), the likelihood of success will be lower than 4 percent withdrawals from a more growth-oriented portfolio.

Models that led to the 4 percent rule of thumb are based on sustaining withdrawals through potentially poor market environments. If markets happen to be in your favor over a long period as has historically been the case more often than people generally think, then the 4 percent rule would be too limiting. More often than not, I find myself demonstrating to retirees that they can afford to spend more than they now do.

In an article in Financial Planning magazine, industry expert Michael Kitces presented evidence that when using investment performance data back to the 1870s “following the 4 percent rule, more than 90 percent of retirees finish with more than their starting principal after 30 years.” While these outcomes can be modeled in the financial lab using historical returns, it still presents a challenge knowing what will work going forward. If you only used investment return data back to 2000, the results would be less robust. The idea of living off investment income and not touching the principal would be less realistic, especially when you factor in taxes, inflation and investment expenses.

This is why regular re-evaluation of a retirement income plan is important. It allows for a new assessment of the probability of meeting your goals and allows for correcting investment strategy and spending.

Using software to model alternative options or “stress test” your financial plan and investment strategy can help you analyze the difference between say 95 percent likelihood of plan success at the 4 percent withdrawal rate vs. 75 percent probability of success at a 5 percent withdrawal rate. The difference in your living standard could be meaningful if you’re comfortable with lower but still likely probability of success.

If you desire 100 percent certainty of your retirement income, you’re likely to leave much of your lifetime savings unspent. Your heirs will enjoy your frugality but that is rarely something people tell me is important to them.

Gary Brooks is a certified financial planner and the president of Brooks, Hughes & Jones, a registered investment adviser in Gig Harbor.