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By Christine Benz | 05-09-2012 09:00 AM

Swing Factors for the 4% Withdrawal Rate

More diversification, shorter or longer time horizons, lower-volatility strategies, and market-sensitive spending adjustments can all impact a sustainable withdrawal rate in retirement, says Michael Kitces of Pinnacle Advisory Group.

Christine Benz: Hi, I am Christine Benz for Morningstar.com. Determining a safe withdrawal rate is one of the most important decisions that retirees make. Here to discuss some current research on this topic is Michael Kitces. He is partner and director of research at Pinnacle Advisory Group.

Michael, thank you so much for coming in to talk to us.

Michael Kitces: My pleasure. Happy to be here today.

Benz: Michael, a lot of retirees focus on that 4% rule that Bill Bengen came up with so many years ago, and there have since been a lot of additional pieces of research on this topic. I am wondering if you can summarize the state of the state in terms of withdrawal rates because it is a big area of interest for you and your research?

Kitces: What we really see from the safe withdrawal rate research as it stands right now, Bill's research laid a fantastic foundation for us, but there were certain constraints to it, primarily around simply the way that the assumptions had to be built. That's sort of the way any research comes together. We had this fixed time horizon, this fixed spending pattern.

Benz: 30 years.

Kitces: You are going to go 30 years. We’re only going to adjust our spending exactly for inflation every year, no more, no less. Even if we're heading for disaster, we won't take any normal rationale steps like adjusting our spending even though we certainly see that's what most people do in the real world.

So what we've really had over the past 20 years are various ways that we've built on that foundation to say, "What are the other levers that we can adjust along the way?" This has ranged now anything from what kinds of adjustments can we make when we are more diversified because Bill's original research was a "diversified portfolio." It's 60% large-cap stocks, and 40% intermediate government bonds. And I dare say most investors today own more than two investments as the only things in their portfolio. So we've seen everything from what's the impact of having more diversification, what's the impact of having a longer or shorter time horizon, and what's the impact of adjusting spending levels along the way. If you have spending flexibility, what does that do to your starting level if you're willing to take cuts in difficult times then make it up later. We've seen research impact [along the lines of] what does valuation do to change this picture, and what does being more tactical do to change this picture?

One of the notable things that we saw even early on from Bill's research is it really made the point that it's not just about the total return that you get, it's about the path that you take along the way. And so strategies that quite literally reduce volatility even if they don't necessarily enhance return lend out with higher withdrawal rates.

Even if we give up some peaks, if we smooth out some troughs, we end up with higher sustainable spending levels. So, we really see a world now where all these different pieces are built on top of each other and you end up with frankly, just a much more customized safe withdrawal rate to an individual's own circumstances or goals.

Benz: So let's start with this issue of time horizon, which can be very impactful, and I think the general consensus is that the shorter your time horizon, the higher that safe withdrawal rate. But maybe you can summarize how investors can think about that question?

Kitces: We absolutely see that. You take the original safe withdrawal rate, which is essentially 4% for 30 years. If we push it down to about 20 years, we go from a 4% to 5%-plus. If we go down even further to about 15 years, it starts rapidly creeping toward 6% and 7% because essentially as you get shorter and shorter, particularly below 15 years, you start approaching a point where you would in essence just have a laddered bond portfolio that would systematically liquidate over the time period.

When you get to longer time horizons, we need some equities; we start building a little bit more of a cushion for it. When we go in the other direction, we see a withdrawal rate that at 4% again at 30 years, creeps down to about 3.5% at 40 to 45 years. And it really stays there pretty much any longer time horizon than that, as well. This is because what we really see in terms of the kinds of paths and sequences that create retirement problems for folks, it's those what we are now starting to call secular bear markets, these sort of 15- to 20-year periods, where you just get a really tough investing environment, such as 1929 until the '40s and '50s, mid-1960s until the early 1980s.

These stretches in which if you can keep your spending low enough that you survive the difficult period, eventually, you get to the good returns. They're kind of explosively good when you finally get there and it basically means if you make it that long with enough padding, you can pretty much make anything longer than that.

So, we don't really see the safe withdrawal rate decline further down than about 3.5%; that in essence becomes roughly the perpetuity safe withdrawal rate. And then we also see asset-allocation shifts along that spectrum, as well. We're a little more equity-heavy when we are doing longer time horizons. And we see that especially when you get to 20 years and fewer, you really lose the payoff value of having much equities in there at all. [By being equity-heavy with a shorter time horizon] you introduce a lot of volatility, and if you get a bad stretch, by the time the good returns finally arrive, your time horizon is over. So you didn't really get much of a kicker from equity exposure. We really see in the shorter time horizons equities really become an inflation hedge in essence, and so you might end up with these 20/80 equity fixed portfolios versus the more traditional 60/40s that we see around 30-year time horizons.

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