A flaw of conventional retirement planning is its detachment from reality. This disconnect often leads to overly conservative retirement income plans that require retirees to make unnecessary spending sacrifices. That’s a problem because the goal of retirement planning is to maximize quality of life, which involves taking a realistic look at a retiree’s situation to enhance retirement income and to encourage spending.

Let’s explore four common factors contributing to overly conservative retirement income plans and how to avoid them.

#1 Not Having a Flexible Spending Strategy

Financial advisors and DIYers tend to anchor to rules of thumb (I’m looking at you “4% rule”). This is reinforced by the easily digestible headlines favored by financial media. While I don’t have anything against rules of thumb, they can overshadow alternatives that better align with many retirees’ preference to maximize spending during their lifetime.

In its most recent annual safe withdrawal rates research, “The Good News of Safe Withdrawal Rates,” Morningstar proclaimed that the 4% rule may finally hold true. While that made for a flurry of clickable headlines, the bigger story was the expanded variety of withdrawal strategies the site tested. Most notably, there was the inclusion of flexible “guardrails,” which call for withdrawing less from investment portfolios in bad markets and more in good ones.

The table below shows the results of Morningstar’s research. As you can see, the flexible guardrails method provided higher starting and lifetime withdrawals and a lower portfolio ending value (less money left on the table) than the “base case,” which used a 4% annual withdrawal rate adjusted for inflation. In other words, guardrails are a much more efficient way to spend from an investment portfolio than the 4% rule and the other tested methods.

Better yet, guardrails provided even higher safe withdrawal rates for stock allocations commonly seen in retirees’ portfolios (50%-70% stocks).

But despite attractive alternative spending methods, like guardrails, many people still rely on rules of thumb—like the 4% rule—because they are ubiquitous and easy to understand. Unfortunately, this can result in a plan that generates less retirement income than is possible and leaves larger account balances upon death than desired.

#2 Monte Carlo Limitations

Monte Carlo simulation is used in retirement planning software to determine the viability of a retirement income plan. This involves running many simulations with random sequences of investment returns to create a range of possible outcomes—including good, bad, and downright ugly investment return scenarios throughout the retiree’s plan. Afterward, the results are tallied to determine the likelihood of the investment portfolio funding the planned withdrawals.

For example, if 1,000 simulations are conducted (common for retirement planning software) and 900 of them show that the retiree’s spending plan is sustainable, the result would be a 90% probability of success.

While Monte Carlo simulations are helpful, they aren’t without limitations. One issue is that investment markets are not purely random. As an example, a 49% drop in the S&P 500, like during the dot.com bubble from 2000-2002, does not mean an equal likelihood of a 56% decline in the following years, as seen during the Financial Crisis. Nonetheless, Monte Carlo simulations may still include such extreme scenarios in their results.

Markets tend to go up more than they go down, and downturns are often followed by recoveries and vice versa. Monte Carlo doesn’t capture this behavior, so the highly positive and negative scenarios it produces are less likely to happen in reality. When interpreting Monte Carlo’s results, be aware that downside risk and upside potential may be overestimated as a result.

#3 Targeting a 90% ‘Probability of Success’

Retirement planning isn’t an Olympic event, so aiming for a 90%+ “score” might be overkill. Many retirees aim for a 90% probability of success (i.e., 90th percentile success rate), interpreting it as a 10% chance of failure. However, this isn’t how it works.

Looking at it another way, a 90% probability of success actually means there’s a 10% chance that you may need to make adjustments during retirement to avoid depleting your savings prematurely. It’s about making adjustments, not facing failure. Often, these adjustments are minor and infrequent, but they can meaningfully increase safe withdrawal rates because they better manage the sequence of returns risk compared to being inflexible—as highlighted by the guardrails spending method in this year’s Morningstar study.

Typically, the retirement income plans we build for our clients include guardrails that call for more pay increases than decreases by design. For example, the screenshot below is from a client’s income plan targeting an 80% probability of success (and 20% probability of adjustment). The income adjustments call for a modest spending decrease of 2% on average every eight years to keep the plan on track. By being flexible, this client was comfortable reducing their target success rate from 90% to 80% for the benefit of increasing their spending by about 10%.

#4 Ignoring Spending Patterns

Many retirees anticipate their spending will rise during retirement; think of expenses like a long-awaited European vacation and skyrocketing healthcare costs. However, research suggests the opposite is true. When adjusted for inflation, spending typically decreases as we age. This often leads to an overestimation of retirement costs.

In his 2014 paper, “Exploring the Retirement Consumption Puzzle,” David Blanchett, a CFP, noted that overall retirement spending tends to decrease by about 1% yearly. However, this doesn’t mean retirees aren’t enjoying an espresso in Rome or needing help with daily tasks. Instead, spending often increases in the early (“go-go” years) and late stages (“no-go” years) of retirement with a decline in between. This pattern has been coined as the “Retirement Smile,” as illustrated below.

Developing a retirement spending plan that accounts for these patterns can significantly boost your retirement income. When Morningstar tested its base case with spending reductions (the “actual spending” method), the safe withdrawal rate increased from 4% to 5%! Simple steps, like adjusting your spending plan to reflect the likelihood that you won’t be scuba diving the Great Barrier Reef at age 85, could allow you to retire earlier or take an additional vacation now.

Creating a spending plan might seem daunting, but it doesn’t have to be. Many of our clients have found success by reviewing their credit card spending summaries to set a baseline (most of the work is already done for you). From there, you can identify expenses most likely to change over time and update your retirement income plan accordingly.

Bridging the gap between retirement planning and real-life circumstances is necessary to design more effective retirement income plans. Planning to adjust, understanding the limits of our tools, and creating more thoughtful spending plans go a long way toward preventing unnecessary spending sacrifices in retirement. Retirees can meaningfully increase their sustainable retirement income and, perhaps, their quality of life by taking a more realistic approach to retirement planning.

If you need extra help with planning for retirement or have questions about the best way to save your money in tax-protected accounts, hire a WCI-vetted professional to help you figure it out.

How have you thought about spending in retirement? How flexible do you want to be? Does the guardrails system seem like a good fit, or is there another system you’re going to try in retirement? If you’re already in retirement, what system are you using?

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