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Wondering About Withdrawal Rates?

Noted retirement researcher and financial planner Jonathan Guyton visits to discuss his take.

Christine Benz: Hi, I'm Christine Benz from Morningstar. The topic of sustainable withdrawal rates has been getting a lot of attention lately, with some researchers arguing that starting withdrawal rates ought to be lower. Joining me to discuss that topic is Jonathan Guyton. He is principal at Cornerstone Wealth Advisors, and he has also done significant research on the topic of in-retirement withdrawal rates.

Jon, thank you so much for being here.

Jonathan Guyton: Glad to do it.

Benz: Let's talk about the starting withdrawal rates and the sustainability of starting withdrawal rates. There has recently been some discussion--well, actually, it's been going on for a while--about whether the 4% guideline, whether a 4% starting withdrawal, is sustainable. You think that taking fixed real withdrawals, which is the strategy that underpins a 4%-style system, is really not the right way to go about it. Can you talk about that?

Guyton: Sure. Well, it's an interesting time to be talking about withdrawal rates overall, in part because of what's happened over the last couple of years, which is that because equity markets have done so well, portfolio values are larger, quite a bit larger than they were, let's say, at the end of 2018. And so, it wouldn't be surprising for a retiree to look at their portfolio and the amount they take out and calculate their withdrawal rate and find that it's 15% or 20% lower than it was two years ago. So, in a sense, the talk about you need to start at a lower place is much ado about nothing, because that's where you already are. It's certainly where existing retirees already are.

To your point about fixed real withdrawals, of course, that goes back to the groundbreaking work that Bill Bengen did about a little over 25 years ago. And it's not so much that I think that that's the wrong approach. But I think that it's an approach that doesn't really match human behavior. And so, for people who pin their retirement withdrawal strategy on something that says you get a raise for inflation every year whether you need it or not, there's a little bit of a disconnect there. For one thing, most people who spent their entire working careers saving for retirement and put themselves in a good position had to do so through years where spending needed to fluctuate. Maybe one year somebody was out of the workforce for a period of time or another year somebody got a bonus and then next year you didn't get a bonus. And so, we get used to making adjustments in the spending decisions that we make, particularly around things where there can be flexibility. And so, I've just felt that to incorporate that behavioral element into how we think about withdrawal rates is something that could be helpful, especially if that kind of flexibility could mean that the amount you would take out could be higher than if you didn't have that flexibility. And of course, that has turned out to be the case that the research has shown.

Benz: Let's talk about that--how that flexibility can actually help improve sustainability. Can you talk about the interplay between being willing to be flexible about withdrawals and potentially also increasing the likelihood that your portfolio will last over all of your retirement years?

Guyton: Absolutely. So, when you think about the withdrawals that you take out of a portfolio from one year to the next--let's say, from last year to this year--there really are four different things that could happen. One is you could increase what you are taking out by inflation. That's the static method that you referred to earlier. The second is you could just take the same amount as you did last year with no increase. The third possibility is you could reduce what you are taking out. And the fourth possibility is that you have an increase that is actually more than inflation. So, when we are talking about flexibility, what we are saying is we are putting all of those on the table based on the conditions that are going on at present right now.

The analogy I like to use is like you are driving a car. You are on the road. You are driving the car. You know, without even thinking about it, you are looking in your mirrors, you are paying attention to what's going on, the road conditions and the weather conditions all matter, and sometimes you need to take your foot off the accelerator and sometimes you need to tap the brake. Hopefully, you never need to slam on the brake. But just those little things: Adjusting your speed slightly. If I were to say to you, "Start your trip, and you always have to keep the exact same pressure on the accelerator all the time," well, first of all, you'd think I was crazy, but the second thing you'd say is, "Well, if I had to do that, I would have to go much more slowly." And the speed is the withdrawal rate. So, if you have the option to take your foot off the gas or tap the brake, you can go faster because you have the ability to adjust. And the same is true with the money you take out of your portfolio. If you have the ability to make small adjustments, then you can start out by going faster, which is a higher initial withdrawal amount or withdrawal percentage.

Benz: People might hear about this idea of taking flexible withdrawals, and they might immediately latch onto the idea of just taking out a same percentage year after year. So, just taking 4%, year in and year out. Does that kind of system work for people in practice? It seems like it would lead to potentially too much variability if you're just tethering your withdrawals to whatever is going on in your portfolio.

Guyton: Well, it certainly wouldn't work for me because if your portfolio happened to drop by 20%, that means that next year's withdrawal is 20% lower. So, not only are you dealing with a big decline but you also didn't have time to prepare. And so, fortunately, there are other approaches that can allow you to be flexible without that tether but also that do take into account that: Hey, you know, if my balanced portfolio drops 20%, well, first of all, that probably meant that the stock market went down over 30%, for my portfolio to go down 20%. But there are ways to make smaller adjustments. And where if things get better that you only have to make one small adjustment. If things stay bad, you may have to make several adjustments over a couple of years just to be sure. It's the kind of the "stitch in time saves nine" approach.

Benz: The system that you pioneered--you worked on with William Klinger--it's sometimes called the "guardrails approach" to setting your withdrawal rate and then adjusting it as time goes by. Can you kind of shorthand that for people who are interested in being more flexible but want to ensure that they don't have these radical swings in their standard of living based on what's going on with their portfolios?

Guyton: I'd be happy to. It goes back to that car analogy and the different things that the different changes that you can make potentially to what you take out each year. So, like I said, you are putting all those on the table, and it's just a matter of knowing when you need to use each one of them. 

So, there are a couple things you need to know just like things you need to be aware of when you are driving the car. You need to know what your withdrawal rate or your withdrawal percentage is right now. And that's easily calculated. It's just: What are you withdrawing over the course of a year, including what you pay in for taxes if there's any tax money withheld from, say, an IRA distribution? And you divide that by what your portfolio is worth at the beginning of the period. And you could calculate your withdrawal rate every day if you wanted to but doing so once every three to six months is certainly appropriate enough.

The second thing you need to know is at what point would that withdrawal rate change to a degree that you might need to make some kind of adjustment. And so, that's the guardrails that you spoke about. Back to the car analogy: If there's icy roads or there's fog and you just can't control where the car is, you sure hope that by the edge of the road there are guardrails there that you can kind of bump into and keep you from going over the edge if things really do get dangerous. And then, that's the analogy here.

So, let's suppose that right now given where--I mentioned earlier that withdrawal rates are a little lower for most people because equities have done well--so, let's say that your withdrawal rate is down right now at 4.6%. And normally it might have been closer to 5%, and you've said that I'm going to set my guardrails at 20% above 5% and 20% below 5%. So, that would be 6% and 4%, and right now, you are at 4.6%. So, what happens is that in a normal year where you are between those two ranges, you give yourself a raise for inflation, just like you would normally do under any other approach--except if last year's investment return was negative. And if last year's investment return was negative, then you just freeze. You don't give yourself that inflationary raise. And that's all you need to do, and you go on to the next year. And the next year that occurs, you measure what your withdrawal would be, and you calculate that percentage, and as long as it's between 4% and 6%, that's all you really need to do, like I said earlier.

But let's suppose that the stock market drops over time, and it takes a while to recover, and your withdrawal rate is inching up and you find that, "OK, the amount I would take out this year if I adjusted for inflation would actually be 6.3%." And that's above--you've hit the guardrail--that's above the 6% number. So, what you do is, whatever dollar amount that is, OK, you just reduce that by 10%. That's the largest adjustment that you would make at any point in time. So, if you think about it, if your withdrawal rate was going to be 6.3% and you knocked 10% off that, that takes it down to about 5.7%. You are back in within that range. Now, you are pretty close to the top, but you are still OK. Maybe the market starts its recovery. Maybe it starts to bring your withdrawal rate back down. Maybe it doesn't. Maybe next year or a couple years later you need to do that again just to keep things safe. That's what we found in the research was that when you start to get above that, you need to do something to take a little bit of the pressure off your portfolio.

The other thing, and this is actually what's a little more relevant today, as withdrawal rates are falling--notice I said, "Imagine you are at 4.6% right now, and that lower guardrail is 4%," well, what happens if you go below that? The markets continue to do well, your withdrawal rate drops to, say, 3.8%. Then, if you want, you get a bonus. You can just take whatever your withdrawal would have been and move it up 10%, and that just becomes your base going forward. That's because you've created so much extra room, so much safety, if you will, things were so much better than you would have predicted. But it turns out you can do even more. And what this research shows is you can take that money once you've hit that other threshold. It takes that 3.8% number and moves it up by 10%. It's now 4.2%. You get to enjoy that money, and you go on from there. So, it really just comes back to knowing your withdrawal rate at any point in time, knowing where your guardrails are, and then making the adjustments for the 10% shifts only when you need to.

I'll make one other comment. Sometimes people hear that, and they say, "Wow, I might have to reduce my income by 10%." That's actually not true. First of all, your Social Security benefits didn't change. It's only the income coming from your portfolio. Secondly, if your withdrawal rate has been rising, it's because your portfolio value has been falling. That means, for instance, your IRA isn't worth as much. It means your required minimum distribution isn't as high. So, when you reduce the amount of money you take out, part of that money is money that would have gone to income taxes. So, if your withdrawal happens to be--if it would have been $50,000 and you knock it down to $45,000, you don't really lose $5,000, you might only lose, say, $3,500 because the rest would have been taxes you would have had to pay.

Benz: That's a helpful encapsulation. I have a related question, which is about the where of withdrawals. And I'm curious how you approach this with your clients in terms of whether you suggest that they spend any sort of organically generated income that's coming from stocks and bonds in the portfolio. Would you suggest that they reinvest those dividend distributions back into the portfolio and then just do rebalancing? How do you approach that issue?

Guyton: Well, you pretty much just answered your own question. Because whether you use mutual funds or individual securities or exchange-traded funds, you know that many of these pay their interest or dividends regularly, whether it's monthly or quarterly. So, they are always making money available that you are going to need to take out or you are going to want to take out because most retirees like their regular portfolio income to come monthly. So, this is actually a monthly question. Or it's a period where you need some money available every month in order to do so. So, we find that taking interest for any account where you are withdrawing money regularly-- now, you might have a Roth IRA, for instance, that you are not drawing from regularly, so, there, of course, it would make sense to reinvest--but when you are drawing money out regularly, go ahead and have that interest and dividends in cash. It just means that's there to help fund what's coming up. Then, like you said, you will rebalance periodically, and certain equity asset classes hopefully are overvalued. That means equities have been doing well. You'll sell some of those off, and that can be used as another source. Rebalancing, of course, works the other way too, which is when markets fall and your equities are undervalued, you have an opportunity to repurchase those. The best opportunity we've had in the last 10 years to do that occurred March a year ago in the teeth of the pandemic.

And then, finally, if all the equities are in the tank and the interest and the dividends or the cash that you are holding is not enough, then you are looking at selling some of the fixed income that you are holding, which is exactly what it's there for. It's a common misconception we find that people think that the primary role of--or the only role of-- fixed-income bonds in retirement for distributions is the interest that they pay. Yes, the interest that they pay is useful. But the most important reason why you have bonds is to have something that doesn't go down when equities are down, and you don't want to touch them until they recover. And so, when you were looking at doing that, that's really when you would be selling some fixed income in order to do that. But that's the basic order: Cash, you might be holding, interest, dividends, rebalancing from the equities, and if that isn't enough because conditions are just not good right now, you are going to be selling off some of the fixed income along the way until you are pleased that equities are recovered enough to start using them again.

Benz: Jon, this has been such a helpful discussion. Thank you so much for being here today.

Guyton: Glad to do it. Thank you for having me.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.