Should Retirees Still Follow the 4% Rule?

On this special episode of The Long View, Morningstar's Christine Benz, Jeff Ptak, and John Rekenthaler share their thoughts on the future of withdrawal rates.

Here are a few excerpts on the 4% rule, how retirees can increase their withdrawal rates, and the effect of different asset allocations on withdrawal rates from Rekenthaler's conversation with Benz and Ptak:

Real Fixed Withdrawal Rates

Ptak: I wanted to turn back to the study and what was one of the more striking conclusions that we came to, which is that, for people who want to take fixed real withdrawals, they're going to need to be more conservative than the 4% withdrawal rate that's been enshrined in a lot of ways. Maybe, Christine, I'll turn to you for this one. Can you talk about where we think people should land? What did the study find? Is the sustainable withdrawal rate over a 30-year horizon if they're taking fixed real withdrawals from the portfolio and want to have a good chance of succeeding, what's that number?

Benz: Sure. So, this, I'm stealing from John's portion of the research because he did all the heavy lifting here. But the headline number and when subsequent publications wrote about our research, 3.3% was the starting withdrawal for a 50-50 portfolio or really any sort of balanced portfolio over a 30-year horizon, which is obviously quite a bit lower than the 4% guideline. So, that was kind of the headline figure that we came up with, that John came up with in his research.

Withdrawal Rates and Equity-Heavy Allocation

Ptak: And John, how did that change if we shifted the mix towards a more aggressive equity-heavy asset allocation? Did it get closer to 4%, or did we see otherwise?

Rekenthaler: We saw otherwise, which is unusual. Typically, as I said, adding more equities tends to improve the results or improve the withdrawal rates historically. The problem is, it's an interesting issue. It's not that we project that stocks – remember, this is all based on the future projections from Morningstar Investment Management that we talked about. And it's not that those projections are particularly pessimistic about equities. As I said that equity results are lower than in the past, but so are the projected bond yields and interest rates and so forth. So, the real returns are not bad on equities. The problem is, as equity returns go down, as the level of returns go down, then the volatility associated with equities becomes more important and more damaging. Maybe the simpler way of putting it is, if stocks are averaging 10% or 12% per year with an 18% standard deviation, they're not going to hit you with as many double-digit losses as if they're averaging 6% or 7% a year with an 18% standard deviation. So, the volatility just becomes--it hurts stocks more as the level of returns go down. And with bonds and fixed income, yes, the level of returns has also come down, but we don't project them as being particularly more volatile than they were in the past. So, that's why the equity-heavy portfolios don't work as much magic as they did in the past. It's really because the volatility really starts to kick in. As I think anybody who has looked at this problem knows, the real danger when withdrawing from portfolios where more money isn't going into the portfolios, as in the case of a retiree, is spending down after a big loss. And there's just greater likelihood of a big loss when the level of returns is lower, when the level of the stock market returns is not as high as it once was. There are some advantages, and we can talk about those too, or some reasons why one might want to start with a higher equity portfolio. But a higher equity portfolio that's absolutely locked into a fixed 30-year plan as in the exercise that we ran for this study, yeah, not so much. That's not a winner in this by these assumptions.

How to Get a Higher Withdrawal Rate

Ptak: We did look at some other levers that a retiree could pull, so to speak, in order to try to get that withdrawal rate a little bit higher. Every single one of them involves a trade-off. But can you talk about some of those things, some of those variables that we looked at, which are ways for a retiree who maybe isn't satisfied with 3.3% over a 30-year horizon, where they can get that withdrawal rate a little bit higher? Rekenthaler: Sure. There are a number of things that one can do and get that number up actually fairly dramatically, like, say, to the 4% level. Most of these things don't just give you one-tenth or two-tenths of extra--get you from 3.3% to 3.5%. They move you up more dramatically. One not everybody may want to do, which is work longer. But if you work three or four years longer, that's three or four years shorter time during the retirement period, that's three or four years less that the money has to last--although we didn't model it that way. We still modeled a 30-year period. But nevertheless, that is the case, and three or four more years to put more money into the portfolio and three or four more years where the portfolio has a chance to grow. So, that's a pretty powerful effect. Not everybody is in a position to work longer or wants to do so, but definitely recommended. Another strategy, and this ties in with what Christine was talking about, and David Blanchett's work on spending is, if retirees tend not to continue to keep up their spending along with a growth rate of inflation, that is, in real terms, they spend less over time as they get older, absent healthcare costs which admittedly could be an issue, they tend to do fewer things and they're buying fewer things and consume fewer things, then maybe after the first 10 or 15 years in retirement, don't try to keep up fully with inflation. If inflation rises by 4%, grow your spending by 2%, and so forth. That has a big effect as well. A final thing that people can do--our assumptions are at 90% success rate. Well, if you look at the numbers with a 90% success rate of having enough money over a 30-year period, in many cases, that's very conservative. I mean, by definition, 9 times out of 10 in the simulations, you succeed, and for many of the simulations, people end up after the 30-year period having more money than they started with. So, potentially, targeting a somewhat lower success rate and then adjusting, this gets into flexible spending, and I think our timing is good, because I imagine you're going to be going there shortly. But there is some logic for starting with a number that is a little bit more aggressive and optimistic in the sense of having, say, an 80% success rate by the projections, with the idea being that most of the time that's going to work out and if it doesn't, you can pull back and lower that initial spending, right, at which case I will turn to Christine.

Flexible withdrawal and Flexible Spending Strategies

Ptak: So let's talk about that next. We devoted an entire section of the study, and deservedly so, to flexible withdrawal, flexible spending strategies. Christine, that was a big focus for you. Much of the research about withdrawal rates over the past decade plus is focused on flexible strategies as a means of elevating starting and lifetime withdrawal rates. What's the thesis behind being more variable versus taking fixed real withdrawals as we discussed earlier? Benz: The reason that a variable system would tend to support a higher starting withdrawal rate is that the agreement, if you embark on flexible withdrawals, is that you are going to rein in spending if your portfolio drops. And that's really the name of the game with all of the variable strategies that we tested. They all employ downward adjustments after periods of portfolio losses. And then, there are other strategies that aim to enlarge lifetime withdrawals. So, this is the guardrail strategy that I referenced earlier, where the idea is, not only are you taking less in down markets, but you're also taking more and giving yourself a raise in certain up markets. So, those strategies tend to enlarge not just starting withdrawals but also lifetime withdrawals because the retiree is able to take those periodic raises. So, in a 2020-2021 type period, those would typically allow for higher paydays.

This article was adapted from an interview that aired on Morningstar's The Long View podcast. Listen to the full episode.