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By Christine Benz | 06-22-2012 11:00 AM

Finding Your Ideal Withdrawal Rate

Vanguard's John Ameriks says distribution-rate rules are good starting points for an in-retirement spending plan, but asset allocation and time horizon also should be key factors.

Christine Benz: Hi, I'm Christine Benz for Morningstar. I'm here at the Morningstar Investment Conference, and I'm joined today by John Ameriks. He is a principal at the Vanguard Group. He's also head of the firm's investment counseling and research group. John, thank you so much for being here.

John Ameriks: I'm happy to be here, Christine.

Benz: John, I know one area that your group has done a lot of work on is the area of withdrawal rates, so setting your in-retirement withdrawal rate. Our readers are mainly individual investors attempting to navigate this complex decision on their own. I'm wondering if you can share some insight into where to begin this process and also what sort of variables you need to be armed with in order to make a good decision.

Ameriks: I'd be happy to. I hope we have a lot of time.

Benz: It's a big topic and evolving. There is a lot of research being done including some that you all have come up with.

Ameriks: There are studies that go back a long time looking at withdrawal rates, and it's likely that a lot of people have heard about the basic result from a lot of that, which has been to focus on the so-called 4% withdrawal rate.

Benz: So let's unpack that for a second because I think sometimes people think while that's 4% fixed year-in, year-out, but really that wasn't the underpinning of that research.

Ameriks: Right. Exactly. That seems simple, the 4% withdrawal rate. But what's in the denominator? And how does the numerator work, and what's exactly is the strategy? So these studies, what they will do is they will look at a diversified portfolio, usually with the fixed asset allocation that tends to be what we would call a moderate allocation, say, anywhere between 40% in equities to 60% in equities. It's a withdrawal rate from a portfolio that looks like that.

When we say 4%, what do we mean? Well, we mean spend an amount that's equal to 4% of that balance as of the start date. So a 65-year-old enters retirement with $100,000 in an IRA, and we say, well, let's think about 4%. Well, 4% on $100,000 is $4,000 a year. The strategy is then to increase that $4,000 withdrawal every year going forward by the rate of inflation. That's how most of these studies are done. So, 4% applies at the beginning, but as you go on, depending on what the markets do, it might be a larger or smaller portion of your portfolio. That's the modeling framework that it's done, and the question that leads to the 4% answer is, "I've got a portfolio. How much can I spend? Is it 4% or 5% or 3% of my total balance? How much can I spend and not have it run out of money in, say, 25 or 30 years?"

Benz: So, if the market goes down, and I'm using that initial withdrawal amount and I've been adjusting it for inflation, if the market goes down a lot and my balance drops a lot, I could be way higher than that initial 4%, maybe dangerously higher.

Ameriks: That's exactly right. You can imagine, as time goes on and you're in year 28 of such a drawdown strategy, you might be spending an enormous fraction of what's left or in a really good market scenario, you may not be spending very much. So that's the analysis that went into determining that 4% rule. I think at this point it's probably important to step back a little bit and think more broadly about, well, what's that useful for and how should I think about those drawdown rules over time?

I think these types of analyses are really good for people who are considering what they should start with and what's reasonable, but I don't know how much these rules really help people with every year. Should I really do that every year? I should adjust my portfolio by inflation even that means I'm spending half of my assets in one year? I don't think many clients are comfortable with that. Certainly, many financial advisors wouldn't be comfortable with that. You got to understand that the reality that you experience over time may not line up with what those assumptions were in that kind of analysis.

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