Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Setting a sustainable withdrawal rate is a key factor in success during retirement. I recently sat down with Maria Bruno, a senior investment analyst at Vanguard, to discuss her research on withdrawal rates.
Maria, thank you so much for being here.
Maria Bruno: Thank you, Christine.
Benz: You work a lot on retirement-related research. You recently did a piece where you examined the 4% rule for retirement portfolio withdrawals. Let's start out by talking about what that means exactly, and what assumptions underpinned that 4% rule research?
Bruno: The 4% spending rule really is … I say, it's a rule of thumb, because it's really a guideline for someone who is entering retirement, [with respect to] how much they could spend from the portfolio, while still balancing a good expectation of not outliving the assets during their lifetime. So it's meant as a starting point for someone at that stage, and it does assume that you have a balanced portfolio. So, we look at that in terms of how much can one spend without potentially depleting their portfolio over their planning horizon.
Benz: I think sometimes people get confused. When they hear 4%, they think they will withdraw 4% every year. In reality the research that underpins the 4% rule actually means, you look at 4% of your portfolio on Day 1 of retirement, and then you inflation adjust that every year, correct?
Bruno: Yes, primarily. There are different methods, of course, but the body of work around the 4% spending rule of thumb typically is a dollar amount grown by inflation. So, it does look at the portfolio balance when you start spending, and then it adjusts that withdrawal amount every year for inflation.
Benz: So, you revisited the viability of that strategy. We're in a very low-yield environment. In the past, the retiree may have been able to get that whole 4% from taking income from their bond and stock portfolios. Now a total return approach for most people is probably more realistic. But you found that in general, that 4% rule still holds up as a decent starting point.
Bruno: Yes, … it always is at the forefront of planning, but recently over the past decade, interest rates and yields on the portfolios, and balanced portfolios, have really come down. So in the past, it may not have been an issue for retirees. And in fact with rates being high earlier, people are actually net accumulators, rather than spenders from their portfolio. So it wasn't as much of an issue. But with the yields being what they are today, retirees are faced with this worry of, can I still spend 4% or what is that right balance?
What we did is, we did some analysis around this, and we still feel that it's a reasonable starting point. And I say starting point because you really need to think about time horizon, what your asset allocation is, and really how comfortable are you with the simulations that support this. So we call that either a success rate or a certainty level of not depleting your portfolio. So it's a balance of those factors. And 4% could be a good starting point. Certainly once you start overlaying costs, you need to probably ratchet that down a little bit more conservatively.
Benz: So if you have a high-cost portfolio for whatever reason--and this is Vanguard, of course you don't advocate that--but if one has a high-cost portfolio, you'd probably want to use a more modest withdrawal rate.
Bruno: Yes, and it could be even as far down as, say, 3.5%--or a half a percentage point that could cut into it. So you need to think about fees in that, it's over a 30-35 year time horizon that you may be planning to. So those fees and what they do to the portfolio potentially on an annual basis, and how it compounds over time, it's kind of the reverse impact of performance per se. So you need to think about that in terms of that overall [4%] guideline, and I think flexibility is key. I don't think generally investors will stick with a very rigid spending rule of thumb, but may apply some flexibility around that on a year-by-year basis.
Benz: Are you saying that if the market is way down in a given year, I should think about taking my spending level down as well?
Bruno: Well, that is one of the things to consider when you are following such a withdrawal strategy in terms of, what percentage is that of the portfolio. So, if you think about a dollar-inflation adjusted strategy, it adjusts itself based upon what inflation is, but it doesn't really account for market performance. So, particularly if you are at the onset of retirement, and you are experiencing a bear market, like recent retirees for instance over the recent financial crisis, you really need to look at, is 4% really 4%, or is it something greater because my portfolio balance is much lower? So you may need to recalibrate that.
Nothing is "once and done" around this. You certainly need to go back and just see, has anything changed? Is my asset allocation still in check? My spending needs? Those types of things need to come together, and yes, you may need to be a little bit more flexible in terms of ratcheting down that spending. And just because you may be able to spend more, maybe you don't need to, you could reinvest that when there is excess--so some flexibility around that.
Benz: In addition to paying attention to market sensitivity, it's also valuable, based on the work that you've done, to look at your asset allocation, look at your time horizon, and customize your spending rate based on where you are in terms of those two things. Let's start with time horizon. First of all, say I am retiring, I'm 65, what sort of time horizon should I plan upon. What's realistic?
Bruno: Well, as good starting point, it's very feasible for someone who is 65, to plan for a 30-year retirement. Again, certainly you need to overlay things like health, family history, but in lieu of that, 35 years is a pretty good standard to use for the basis of planning. You certainly want to be a little bit more conservative, because again here we are talking about … longevity risk in terms of depleting the portfolio. So, that's probably a good time horizon.
And when you think about the spending rule of thumb being 4%, that is for someone who's retiring at age 65, for instance, looking at a 30-35 year time horizon. What that means is, someone who's retiring earlier will certainly need to be more cautious, and be able to spend lower amounts versus someone who is a late retiree, maybe someone in their 80s. They shouldn't necessarily be locked into a 4% at that stage. They might be able to spend 6% or more than that.
Benz: Asset allocation you have noted is also in the mix. So if I am willing to have a more aggressive asset allocation, does that mean that I can spend more?
Bruno: Generally speaking you could, but you need to be comfortable with the year-to-year volatility on the portfolio. So longer time horizon, more aggressive portfolio could theoretically sustain a higher spending rate, but again you need to balance that with your tolerance for that interim volatility.
Benz: How about the other extreme, someone who has a very low risk tolerance and is hunkering down mainly in high-quality bonds and cash: What should they bear in mind when thinking about their spending rate?
Bruno: Well, in that situation, then it's the opposite. So, if you have invested more conservatively, you need to factor that in, and … because the growth won't be there as much from the equity potential, you probably need to ratchet that down lower, maybe closer to 3%.
Benz: OK, Maria. Thank you so much for sharing your thoughts on this very important topic. Our Morningstar.com users cannot get enough information about withdrawal rates. So thanks so much for being here.
Bruno: Thank you. Happy to.