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Swing Factors for the 4% Withdrawal Rate

More diversification, shorter or longer time horizons, lower-volatility strategies, and market-sensitive spending adjustments can all impact a sustainable withdrawal rate in retirement, says Michael Kitces of Pinnacle Advisory Group.

Christine Benz: Hi, I am Christine Benz for Determining a safe withdrawal rate is one of the most important decisions that retirees make. Here to discuss some current research on this topic is Michael Kitces. He is partner and director of research at Pinnacle Advisory Group.

Michael, thank you so much for coming in to talk to us.

Michael Kitces: My pleasure. Happy to be here today.

Benz: Michael, a lot of retirees focus on that 4% rule that Bill Bengen came up with so many years ago, and there have since been a lot of additional pieces of research on this topic. I am wondering if you can summarize the state of the state in terms of withdrawal rates because it is a big area of interest for you and your research?

Kitces: What we really see from the safe withdrawal rate research as it stands right now, Bill's research laid a fantastic foundation for us, but there were certain constraints to it, primarily around simply the way that the assumptions had to be built. That's sort of the way any research comes together. We had this fixed time horizon, this fixed spending pattern.

Benz: 30 years.

Kitces: You are going to go 30 years. We’re only going to adjust our spending exactly for inflation every year, no more, no less. Even if we're heading for disaster, we won't take any normal rationale steps like adjusting our spending even though we certainly see that's what most people do in the real world.

So what we've really had over the past 20 years are various ways that we've built on that foundation to say, "What are the other levers that we can adjust along the way?" This has ranged now anything from what kinds of adjustments can we make when we are more diversified because Bill's original research was a "diversified portfolio." It's 60% large-cap stocks, and 40% intermediate government bonds. And I dare say most investors today own more than two investments as the only things in their portfolio. So we've seen everything from what's the impact of having more diversification, what's the impact of having a longer or shorter time horizon, and what's the impact of adjusting spending levels along the way. If you have spending flexibility, what does that do to your starting level if you're willing to take cuts in difficult times then make it up later. We've seen research impact [along the lines of] what does valuation do to change this picture, and what does being more tactical do to change this picture?

One of the notable things that we saw even early on from Bill's research is it really made the point that it's not just about the total return that you get, it's about the path that you take along the way. And so strategies that quite literally reduce volatility even if they don't necessarily enhance return lend out with higher withdrawal rates.

Even if we give up some peaks, if we smooth out some troughs, we end up with higher sustainable spending levels. So, we really see a world now where all these different pieces are built on top of each other and you end up with frankly, just a much more customized safe withdrawal rate to an individual's own circumstances or goals.

Benz: So let's start with this issue of time horizon, which can be very impactful, and I think the general consensus is that the shorter your time horizon, the higher that safe withdrawal rate. But maybe you can summarize how investors can think about that question?

Kitces: We absolutely see that. You take the original safe withdrawal rate, which is essentially 4% for 30 years. If we push it down to about 20 years, we go from a 4% to 5%-plus. If we go down even further to about 15 years, it starts rapidly creeping toward 6% and 7% because essentially as you get shorter and shorter, particularly below 15 years, you start approaching a point where you would in essence just have a laddered bond portfolio that would systematically liquidate over the time period.

When you get to longer time horizons, we need some equities; we start building a little bit more of a cushion for it. When we go in the other direction, we see a withdrawal rate that at 4% again at 30 years, creeps down to about 3.5% at 40 to 45 years. And it really stays there pretty much any longer time horizon than that, as well. This is because what we really see in terms of the kinds of paths and sequences that create retirement problems for folks, it's those what we are now starting to call secular bear markets, these sort of 15- to 20-year periods, where you just get a really tough investing environment, such as 1929 until the '40s and '50s, mid-1960s until the early 1980s.

These stretches in which if you can keep your spending low enough that you survive the difficult period, eventually, you get to the good returns. They're kind of explosively good when you finally get there and it basically means if you make it that long with enough padding, you can pretty much make anything longer than that.

So, we don't really see the safe withdrawal rate decline further down than about 3.5%; that in essence becomes roughly the perpetuity safe withdrawal rate. And then we also see asset-allocation shifts along that spectrum, as well. We're a little more equity-heavy when we are doing longer time horizons. And we see that especially when you get to 20 years and fewer, you really lose the payoff value of having much equities in there at all. [By being equity-heavy with a shorter time horizon] you introduce a lot of volatility, and if you get a bad stretch, by the time the good returns finally arrive, your time horizon is over. So you didn't really get much of a kicker from equity exposure. We really see in the shorter time horizons equities really become an inflation hedge in essence, and so you might end up with these 20/80 equity fixed portfolios versus the more traditional 60/40s that we see around 30-year time horizons.


Benz: Michael, you mentioned those really difficult periods that retirees can encounter. Today's crop of retirees very much did encounter the terrible market environment. So, let's talk about the role of valuation. I know that some of your work is centered in that area, in market valuation, but also market performance in helping retirees figure out when is the time to ratchet that withdrawal rate up or down based on those factors.

Kitces: Absolutely. When we look at Bengen's original research, 4% for safe withdrawal rates, and we go a step further and say, "What's actually going on that we need these 4% withdrawal rates? Why can't we withdraw 5% or 6% or 7%?" If we look at the average for the past 100 years, the average withdrawal rate was about 6.5%.

So, what is it that makes you need the 4% and not the 6.5%, and what we see by far the greatest predictor of the really bad environments turns out to be valuation, which is no great surprise saying one who follows the kind of the investing theory end of it.

If you retire when stocks are expensive--just in the aggregate, not a particular stock, but the market overall--that's when you tend to get extended periods of substandard returns and the kinds of environments where you'll be really thankful you were taking your 4% withdrawal rate. But what we see at the other end is if you don't actually retire in a really bad valuation environment, even if your returns are merely so-so, kind of average, that's enough to carry you to a much higher withdrawal rate. And if the valuations are actually good, you get a dramatically higher withdrawal rate.

So, we see sort of our starting number as this 4% or maybe 4.5% that we add about 0.5 a point to our withdrawal rate simply by not being in a bad valuation environment. And then we can add another what I would characterize as at least 0.5 a point to start by being in a good valuation environment, and there's an overwhelming likelihood you are going to ratchet your spending up further.

For people who retire starting in good valuation environments, we see average withdrawal rates over 8%. So, I mean it's just huge spending. When the market is that tightly coiled and finally gives you your explosive returns, it carries enormous spending.

Benz: Early 2009 perhaps?

Kitces: Right, early 2009, and those who retired in the early 1980s. As I like to sort of jokingly put it, if you just retired with the safe withdrawal rate of 4% in 1982 and you ran the numbers forward, you had a bazillion dollars by the time you got to the late 1990s, such that even with the difficulty that happened in the past decade or so relative to what your original 4% spending goal would've been back in 1982, all of the volatility for the past 10 years would have been irrelevant. You were so far ahead on the goal.

What we see in general is when you get to start in good valuation environments you get so far ahead that you end up really, as we recommend now, both starting spending at a higher level and being prepared to adjust spending up even further once the good returns finally manifest, and we're sure we're on a positive track.

Benz: Well, I'd like to follow up on that because in addition to looking at valuation when setting that initial withdrawal rate, it seems that a lot of retirees employ midcourse corrections where they might make changes to their withdrawal rates based on what's going on in the market. Let's talk about the research there and how retirees should think about that issue.

Kitces: Great question. So we had a number of research studies that came out about five to seven years ago from a planner named Jon Guyton up in Minnesota who sort of looked at how we can create a framework around making these midcourse corrections, and John likes to call them guardrail.

We're going down a road. It's kind of a little bit of a windy road, but we can set some guardrails in place, say if you're veering too far off to one side really, or the other, either you're spending is outpacing your portfolio, which creates one set of concerns or your portfolio is outpacing your spending, which creates another set of concerns. I don't really want to die with the giant pot of money; I'd like to enjoy some of it along the way.

What we saw from Jon's research is that you can set some rails around say things like if your withdrawal rate starts at a number like 5% because you're willing to make some adjustments and your valuation started reasonably. If you're willing to start at 5%, but the number slips up to 6%, which means now your spending is outpacing your portfolio, it's time to cut your spending a little and get you back on track.

If you started at 5% and your withdrawal rate has crept down to 4%, which means the portfolio is now outdistancing your spending levels, it's time to take an extra 10% bump up. And so by taking sort of extra kickers like this to bump you back on track if you are getting too far off, we see just a good framework for how to keep spending on a sustainable path throughout retirement, including some tools to deal with something like what happens if we're going to a new world we've never seen before. [We don’t want to] get so far past the point of no return to which we say, "Oops." [The framework] gives us some guidance about how to stay on track.

But at a more general level, what we see is that, itself, now nudges the withdrawal rate a little bit higher, and we're seeing numbers more like 5.5% simply because the ability to make those midcourse adjustments--in particular, the ability to damp down spending in difficult years--is itself is a self-correcting mechanism that helps to take the edge of how damaging environments are.

Now, obviously we all kind of have to match that to our own clients or our own personal spending styles. Not everybody is really comfortable doing those kinds of spending cuts. For some of us, our spending really is our floor; you really can't go below that. So we don't want to adopt that kind of midcourse correction path with someone who needs that sort of floor. We may just take the starting number lower to be safe.

But for most folks, if we really sit down over a conversation and say, "Could we trim a vacation, trim how much we eat out a little bit, or do things for a year or two if times are really tough?" Most people say, "Yeah." I hope the times won't be tough, but if they are, I'm a rational human being. I can tighten my belt for a little bit. I am not living so close to the bone that I don't have some ability to make adjustments along the way.

Benz: Well, Michael, thank you so much for sharing your insights into this very important area of retirement planning. We really appreciate you being here.

Kitces: Absolutely. My pleasure.

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