How to set a sustainable withdrawal rate is a crucial topic for retirees. With bond yields as low as they are, a recent study by David Blanchett, Michael Finke, and Wade Pfau suggests that a 3% withdrawal rate--rather than the so-called 4% rule--will help improve retirees' probability of success. Click here to read the paper in its entirety.
Christine Benz: Hi, I’m Christine Benz for Morningstar.com. I'm here at the Morningstar Ibbotson Conference, and I had the opportunity to sit down with David Blanchett. We discussed withdrawal rates in retirement, a topic that we have discussed in previous Morningstar videos.
David, thank you so much for being here.
David Blanchett: Thanks for having me.
Benz: You and I did a video a couple of weeks ago, where you talked about a research paper that you had written that looked at where bond yields are today--[they are] very low--and talked about the old 4% withdrawal rate rule and actually suggested that maybe a lower withdrawal rate strategy--3%--was in order given where bond yields are today. I'd like to address some of the feedback we’ve gotten, since we did the video. It’s obviously very controversial, and people don’t like to hear the suggestion that they should be spending less.
So one question that we got was about how costs fit into all of this and you modeled out a 1% cost assumption. Let’s talk about what would happen if in fact, your costs were lower, if you’re able to keep your costs down.
Blanchett: Sure. It’s important to note that every investor pays some kind of fees. If you are a super-low-cost investor, you’re going to pay maybe 10 or 20 basis points a year in terms of exchange-traded fund expense ratios. Obviously, fees matter; they are very important. The more you pay in fees, the more it negatively affects your outcome. So, if you can invest well--and that means, you know, buying good investments and holding them for the long term--you can materially improve your situation even with today’s low yields because you’re reducing that kind of negative outfall on your portfolio.
Benz: Does it mean that if I subtract that 1% fee and I'm able to get away with 10 or 20 basis points, could I maybe take a 3.8% [withdrawal rate]?
Blanchett: I think it’s more like 3.5%. Yes, I mean, it does have a pretty big impact. It’s shocking what fees can do over the long haul for a portfolio withdrawal.
Benz: Another thing I wanted to follow up on is this idea of the static-dollar-amount withdrawal. So the 3% rule or the 4% rule is assuming that you take out a fixed amount in year one of your retirement and then you just ratchet that amount up by the inflation rate?
Benz: You actually are in favor of what you call a more dynamic withdrawal strategy. We’ve talked about this before, but I’d like to go over it again because I think it’s important. If I’m doing a dynamic updating of my withdrawal rate, what are the key things I should be looking at? So maybe, I start with 4% in year one and I want to be dynamic, what would I focus on when making those adjustments?
Blanchett: So, I think it’s important to kind of take a step back and ask, "Where did 4% come from?" Well it's been around for 20 some odd years. And it’s a great kind of research perspective to assume that someone when they retire, they have $1 million and they take out 4%. So then, each year they increase that amount by inflation. So that percentage is based upon the initial balance.
Well, if you think about that, how many people actually follow the same strategy without changing it for 20 or 30 years? Very few. So a more practical approach is to go in every year and say "Given what I have right now, what is a reasonable withdrawal? And I say that’s like a visiting a financial planner. So when you retire 4% could be the right withdrawal from your portfolio; 4%, though, isn't the same right amount for someone who is 75 years old for example.
Benz: They can take more.
Blanchett: Exactly, they can take more. So the key is going in every year and figuring out, given where I’m right now, what is my portfolio balance and how long am I going to live. [I want to determine] what I can afford to take from the portfolio given those two variables.
Benz: So in terms of portfolio balance you want to look at how your portfolio did, and arguably after a very good year, you could take more in the following year. On the flip side, if you’ve had a very poor year that would mean taking it down.
Blanchett: Yes. So there is an interesting relationship where people tend to retire when the markets are at their peak because they say to themselves, "Well, my portfolio has done great; I can retire." And then the problem is the markets. If they do poorly, you have to revisit where you were. Just acknowledging that the income is based upon your portfolio balance--so when your balance changes, so, too, should your income.
Benz: Then in terms of that longevity updating that you’ve talked about--where you want to look at where you are in your retirement, and perhaps being further on in retirement could call for a higher withdrawal rate--how should you think about that? Should you use the RMD tables?
Blanchett: I think the easiest method for older investors is what we call the RMD approach. So RMD stands for required minimum distributions, and for IRAs, for example, after age 70 1/2 you take out 1 over your life expectancy. If you’re going to live 20 years for example, 1 over 20 is 5%. A great kind of rule of thumb for the average person is, if I am 75 years old, I’m going to live 20 more years, I can take out 1 over 20, or 5% from the portfolio.
Benz: David, thank you so much for being here. This is a hot topic among our users. It’s great to hear from you on it.
Blanchett: Thanks for having me.