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Investing Specialists

What We Know for Sure About In-Retirement Withdrawal Rates

You'll never be able to calibrate your withdrawal rate perfectly, but the body of research can point you in the right direction.

A retiree's portfolio withdrawal rate can make or break her plan. Take too much and she runs the risk out of running out of money prematurely. Take too little and she reduces her standard of living--and potentially her quality of life--over her retirement years.

Yet as important as the topic of withdrawal rates is, the "right" withdrawal rate for any given retiree is necessarily an educated guess, based on what we know about market history. As with the perfect asset allocation, the optimal withdrawal rate will be apparent only in hindsight. It will depend on the performance of stocks and bonds over the retiree's time horizon (not just his rate of return over the whole time horizon, but the sequence of those returns), as well as the investor's own allocations to each of those asset classes and the inflation rate. 

Given the inherent guesswork of sustainable withdrawal rates, retirees planning portfolio drawdowns shouldn't get too bogged down in precision. Rather, focus on what we know for sure about withdrawal rates to help guide their decision-making, then craft a withdrawal strategy that's customized to the situation, provides peace of mind, and allows for flexibility.

And reassuringly, there's broad consensus in the retirement-planning community about many withdrawal-rate matters. Here's a roundup of some of the widely agreed-upon points.

1. Most retirees don't want huge swings in their portfolio paychecks (and standards of living) determined by outside forces.
Much of the retirement research centers around the notion that retirees would like their incomes to be stable in retirement--similar to what they had when they were earning a paycheck. Indeed, supporting a stable standard of living is what financial planner Bill Bengen had in mind when he developed the widely used 4% guideline for retirement-portfolio withdrawals. Thus, the 4% guideline assumes that a retiree takes out 4% of his portfolio in year one of retirement, then inflation-adjusts that dollar amount in ensuing years. For example, a retiree with an $800,000 portfolio who's employing the 4% guideline would take $32,000 initially, $32,960 in year two of retirement (assuming a 3% inflation rate), and so on.

2. But in reality, spending changes throughout retirement.
That said, anyone who's managed a household budget knows that spending isn't a flat line. There might be several years when spending clusters in a tight range, as well as budget-busting periods when there are splurges for the big-ticket vacation or multiple unplanned expenses--car repairs, big outlays for home repairs or improvements, vet bills, and so on. Retirement is no different. In fact, due to lifestyle factors, retiree spending may be even more erratic than spending during the working years. Morningstar Investment Management's head of retirement research, David Blanchett, has examined retiree spending patterns and arrived at what he calls the "Retirement Spending Smile." His research has found a tendency for retirees to spend more during the early years of retirement (for heavy travel, for example), a bit less during the middle years of retirement, and more toward the end of life, when healthcare and long-term care outlays often increase (but not enough to completely offset lifestyle-related spending declines). How retirees expect their lifestyles to evolve during retirement--along with whether they've purchased long-term care insurance--should play a role in their spending plans. Some retirees even create spreadsheets where they model out their expected outlays on a year-by-year basis, factoring in lumpy expenses like new car purchases and big travel expenditures.

3. Over many retirement periods, the 4% guideline has been too conservative.
The original impetus behind the 4% guideline was to determine the most a retiree could have taken out initially without depleting a balanced portfolio, even if he or she encountered a terrible market. Financial planner Bill Bengen's subsequent conclusion of 4% as a sustainable withdrawal rate centered on the time frame between the late 1960s and late 1990s; the front end of that period was marked by runaway inflation and rising interest rates in the 1970s and a terrible equity market in 1973-74. Over many other 30-year windows, however, 4% would be much too low, as depicted in the first graphic in this posting on Michael Kitces' Nerd’s Eye View blog.

 4. But many people would rather be safe than sorry.
Yet even as the safe withdrawal rate has been well over 4% for most rolling 30-year periods (assuming a balanced portfolio), many people would rather forego consumption (and take a lower withdrawal rate) if it means that they'll reduce the likelihood of running out of money later in life. That’s why the 4% guideline has enjoyed such widespread acceptance as a starting point in the financial-planning community--because it factors in a catastrophic market environment.

5. Lower expected returns put the 4% guideline at risk, especially for bond-heavy portfolios.
An open question, however, is whether the catastrophic market environment that led to the 4% guideline, while the worst in history, is the worst we'll see. Blanchett and co-researchers Michael Finke and Wade Pfau made waves a few years ago with their paper "The 4% Rule Is Not Safe in a Low-Yield World." In it, they argue that low bond yields, which typically portend meager returns from the asset class, increase the probability of failure for retirees employing the 4% guideline. Other retirement researchers aren't as pessimistic that the 4% guideline won't hold going forward. One key takeaway from the research from Blanchett et al., however, is that investors employing overly conservative portfolios (that is, holding 50% or more of their portfolios in bonds) ought to also be conservative when setting their withdrawal rates. 

6. New and soon-to-be retirees should be prepared to rein in spending.
Moreover, the combination of low starting bond yields and relatively high equity valuations make this a particularly challenging time for sequence-of-return risk--that is, that new retirees could encounter a lousy confluence of events at the outset of their retirements that in turn could crimp their portfolios' sustainability. Taking too much out of a portfolio in a weak market environment can deal a portfolio a blow from which it might never heal. That argues for recently retired and soon-to-be retirees taking a cautious tack on their upcoming withdrawals, beginning with withdrawals of less than 4% and being willing to rein them in further if a calamitous market drop materializes early on in their retirements. Retirees who have been drawing for their portfolios for several years already are less at risk for a market shock; they'll have losses amid an equity-market downturn, too, but they've already made it through their most vulnerable years. 

7. Income-centric strategies aren't a shield. 
One other fact to remember is that portfolios don't know where withdrawals come from: Spending a portfolio's bond and equity-dividend income counts as a "withdrawal," just as withdrawals of capital gains and principal do. I'm a believer in staying flexible on a portfolio's source of cash flow, being willing to harvest income distributions as well as to engage in rebalancing to help source the cash flow needed. I'm also a fan of employing a cash "bucket" to provide liquidity in years when tapping principal or harvesting income is ill-advised (like when the market is down).