Bruno: 4% Rule a Good Starting Point, but Mind Allocation

Christine Benz: Hi. I’m Christine Benz for Morningstar.com. How to find a sustainable withdrawal rate is a hot topic in retirement-planning circles. Joining me to discuss it is Maria Bruno. She is senior investment analyst with Vanguard.

Maria, thank you so much for being here.

Maria Bruno: Thank you. Good to be here.

Benz: Maria, there has been a lot of talk about whether that old 4% rule is perhaps too high, given that bond yields are so low and bonds are supposed to be a key ingredient in retiree portfolios. Let's talk about Vanguard’s take on that question. I know that you and your team have done a lot of research on withdrawal rates. Do you think that 4% is perhaps too high?

Bruno: We have [done a lot of research], Christine. We’ve looked at this much like other organizations have, as well. We do believe 4% is still a good starting point, and it’s a reasonable starting point. But you really need to think about the factors that come into play into that formula. A couple of things that come into mind is the portfolio composition. If you think about the premise of this rule and what is baked into that rule of thumb--and we really think of that in terms of it being a rule of thumb--the asset allocation. So it assumes that the portfolio is balanced. So there is some level of equities within that portfolio.

The thought behind it is that it produces a somewhat stable income stream over 30-plus years with a high probability of not depleting your portfolio during that time frame. The big consideration in today’s environment is the low-interest-rate environment. What does this mean? Does that still resonate, or what are the challenges? It is certainly a consideration, and that’s a struggle for retirees today with the interest rates being so low. But if you think about it in terms of not investing for income, but investing for total return--again, this notion of being in a balanced portfolio, so you’re drawing from the income flows, but also the capital appreciation that the equities can offer--finding that right balance really is client-specific, but some level of equities will help with that, as well.

If you look at 2012, for instance, a balanced portfolio using just benchmark returns--for instance, 50% total stock, 50% total bond--it was about a 10% return. So if you think about that in the context of someone who is spending, certainly that’s not coming all from income. But it does afford potentially the opportunity to take from appreciation, as well, and those two components come together in terms of trying to provide a somewhat steady income stream.

Benz: So that’s a shift in mind-set for a lot of retired investors. They maybe are thinking, "Well, if I can just earn a 5% yield on this portfolio, I’ll be set." They’re really quite averse to the idea of tapping their principal. Do you do any work in terms of educating people about how to get comfortable with potentially tapping principal if in fact you’ve seen a great appreciation in your equities?

Bruno:  Yeah. I’ve worked with clients through the years, and this conversation always has to be had, which is really "Where is this income flow, the distributions, coming from?" This wasn’t an issue prior to 2000. For instance, yields were high. So retirees were used to taking income from the portfolio, and quite possibly they could have been net accumulators reinvesting the surpluses. So it’s really become more of an issue as the interest rates have come down. 

So it’s really talking about this balance, and rather than investing for income, because there is danger there in terms of portfolio diversification and portfolio longevity, it’s trying to get back to the basics of having a diversified portfolio and setting up the mechanics. You can do it systematically, like a systematic withdrawal program, where you have income flows that are both the dividends, but also potentially withdrawals. The key there is just to make sure that there are prudent spending levels because certainly if you are spending too high, or not monitoring the spending, you need to really consider the portfolio as a whole. That’s where the danger signs are. But with modest spending both from the income flows and potential appreciation, the two can come together to try and provide that steady income.

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Benz: So the 4% rule is more or less a fixed dollar amount withdrawal that gets inflation-adjusted every year. But it seems that there has been more interest in the retirement-planning community over the past several years that maybe a more variable or dynamic withdrawal rate makes sense to kind of keep up or adjust as the person’s balance fluctuates and as the market fluctuates. Let’s talk about Vanguard’s research in that area, and if you can share any best practices that people might employ if they are using variable withdrawal rates.

Bruno: Of the common methods, one is the 4% spending rule of thumb, which is based upon a dollar amount, inflation-adjusted--the notion of you setting a [withdrawal of] 4% of the initial portfolio balance, and then you adjust that withdrawal rate every year thereafter by inflation. The rule provides a steady income stream; however, it totally ignores market performance. So that’s where the tail risk is there.

The other common approach is percent of portfolio. So I take 4% of my portfolio, maybe using the prior year-end balance, I take 4% of that, spend that, and look at my portfolio balance every year, much like a required minimum distribution schedule. It takes the portfolio balance and allocates a factor here as a percent

Benz:  But your standard of living can get buffeted around, right?

Bruno: Right. So the trade-off there is it produces a more volatile income stream, which isn’t appealing for many retirees.

So, in practice, I think many advisors, many clients actually use some type of hybrid method of a ceiling and a floor, for instance, or a hybrid of these two methods, where when markets are doing very well, retirees may not take the excess, they may reinvest that. And likewise, when the markets aren’t doing so well, they might tighten that buckle a bit and ratchet back that spending. So perhaps you're looking at a ceiling and floor, and what that does is it provides somewhat a more steady stream than strictly a percent of portfolio.

Benz: I think one thing people might wrestle with is when is it OK to take more? So right now, for example, we’ve come through some really good equity market returns. People might be looking at their balances and think, "Is this the time to ratchet up? Or on the flip side, valuations maybe aren’t all that attractive right now, so maybe it’s not a safe time for me to ratchet up."

Bruno: That’s an individualized concern. Certainly you really need to look at your portfolio and say, "What type of sensitivity do I have around this? Am I comfortable with my spending and size of my portfolio? Do I need to spend it?" Look at discretionary versus nondiscretionary expenses, for instance. There are certain things that you need to spend on, but these other nice-to-have things, maybe like travel or things like that, maybe you look at and say, "Well, do I want to do this? Do I feel comfortable taking this? Where is it going to come from versus reinvesting that in the portfolio?"

So [I think there are a lot] words of caution in the press today, and rightly so with the focus on the interest-rate environment. But again, it’s just one piece of it. Look at the portfolio as whole and really look at it maybe throughout a couple of times a year, for instance, not just at one point in time, but [ask yourself], "How do I feel relative to where my portfolio was last year at this time? Do I feel comfortable taking some of this appreciation?" I think some level of flexibility around that is certainly prudent.

Benz: So stay flexible and stay attuned to what the market is delivering at any given point.

Bruno: Yes, and "flexibility" is the one word that we use all the time with any of this, because with any financial plan, you need to go back and revisit that every few years, and spending is a key part of that.

Benz: Maria, thank you so much for taking time to be here.

Bruno: Thank you.

Benz: Thanks for watching. I’m Christine Benz for Morningstar.com.