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By Christine Benz and John Rekenthaler | 08-21-2013 10:00 AM

Key Factors for Successful Withdrawal Strategies

Morningstar's John Rekenthaler offers his thoughts on how retirees should approach their withdrawals, particularly the 4% rule, the need for flexibility, and the role of longevity.

Christine Benz: Hi. I'm Christine Benz from Morningstar.com. Is the 4% rule for portfolio withdrawals during retirement broken? Joining me to discuss that topic is John Rekenthaler. He is vice president of research for Morningstar.

John, thank you so much for being here.

John Rekenthaler: Good day, Christine.

Benz: John, there is a lot of confusion about what the 4% rule actually means. I often talk to people who think it means that you can take 4% of your portfolio--in perpetuity--that you just stick with that fixed rate. Let's talk about actually what the 4% rule posited.

Rekenthaler: Yes, the 4% rule or guideline has been around about 20 years. It's important to remember it's the output of a study. A study is different than a life. In the study, the financial planner--Bill Bengen, who did this--looked through past history up to the early 1990s from the market data--he had the '20s through the 1990s--and said, If I just used two asset classes, two asset classes alone, stocks and fixed-income bonds, and I want to run a test over various 30-year time periods to see if I'd run out of money, what figure is the highest figure I can do--what will never happen in any time period, ever--will I always be able to last for 30 years. And he came up with 4%. It's worth noting that he added another asset class a little bit later of small company stocks and he got to 4.5%, but nobody remembers that. Otherwise it could be the 4.5% rule, if it just were to come out.

What I'm trying to convey is there was work behind this, but it's arbitrary. It's arbitrary to decide on the 30-year time period. It's arbitrary to decide that the withdrawal rate adjusted for inflation is the same year after year after year--it never changes. It's arbitrary that there were only two asset classes chosen, and it’s arbitrary that in any time period ever in the study that it demanded 100% success rate as opposed to 99%, for example.

Benz: Right. It's also important to understand that the 4% rule implies that you take 4% on day one of retirement. Then, you just inflation-adjust that dollar amount as the years go by. So it's not that you're taking a fixed percentage.

Rekenthaler: That's right.

Benz: Recently there have been some arguments that that 4% rule deserves modification. People have been talking about a 3% rule. Let's talk about why people are calling for a lower withdrawal rate--why they view that as perhaps a safer rate than the old 4% rule.

Rekenthaler: Right. Well, within the context of the original study, again, it's a study with these conservative assumptions, it's reasonable to say that going forward there might not be 100% success using a 4% withdrawal rate. Bond yields are relatively low right now and stock valuation is relatively high in the period from 1926 to 1993. You don't see both of those conditions happening. Sometimes bond yields were low, but stocks were quite cheap on price/earnings ratio, or stocks were fairly expensive, but bond yields were higher than today.

Asset prices do look more expensive now than at that time period. I would guess within the context of that study over the next 40-, 50-year period, there probably will be times when a 4% withdrawal rate will not work. David Blanchett of Morningstar, among others, has done work like this in running Monte Carlo simulations and testing, looking at current asset prices: Will 4% always be successful? And it won't.

Now the point I want to make, and I think everybody here at Morningstar--I've talked with David about that, I've talked with you about this, I've talked with Michael Kitces, who writes on our site and is a planner who is quite expert in this--we all agree that the thing to convey is within the context of the study that used to be 4%, it probably is 3% now, but that study never meant that's the withdrawal rate that you had to take. It's a very conservative sort of starting point, I would say, for a withdrawal rate.

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