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Retirement withdrawal rate

Retirement

Get Up-to-Date Retirement Income Advice From the Pros

Read Time: 5 Minutes

Safe withdrawal rates are one of the hardest problems to solve for in financial planning.

That’s according to Christine Benz, Morningstar's director of personal finance and retirement planning. She says that retirement planning grows complicated because of the volume of un-knowables.

How long will our nest eggs need to last? How will the market behave in the future, and how will that affect our portfolios? Will inflation rise steeply or gradually?

At a high-pressure juncture in their financial lives, soon-to-be retirees need personal coaching from an investment expert.

Benz and John Rekenthaler, Morningstar director of research, compared retirement withdrawal strategies in a recent webinar.

Here’s what they covered.

What Is the 4% Withdrawal Rate?

Using historical market returns, groundbreaking researcher Bill Bengen created what’s now known as the 4% guideline. The rule of thumb was meant to protect investors from the worst market conditions and ensure that retirement savings can last for 30 years.

Bengen recommended that investors withdraw 4% of their total investments in the first year. Each subsequent year, the investor would withdraw more to account for inflation.

Here’s how it works.

Imagine an investor has reviewed their spending—food, housing, travel, taxes—and decided they need $50,000 a year to meet their retirement goals. In their first year, that investor would need $1.25 million in a well-diversified investment portfolio. With 3% inflation the following year, the investor could increase spending by 3% to maintain purchasing power and withdraw $51,500.

But today, retirees are buffeted by inflation and volatile market conditions. Does the 4% withdrawal rate still hold?

For the annual State of Retirement Income report, Morningstar researchers created a model to calculate a forward-looking safe withdrawal rate.

What Is Considered a Good Retirement Income?

Morningstar researchers found that with a well-balanced portfolio, investors can safely withdraw 3.8% each year (adjusted for inflation).

This might look disappointing to investors counting on 4%. But financial advisors should know this is a conservative starting point. It reflects a 30-year time horizon after retirement and a 90% success rate.

The model also doesn’t include personalized options—it uses fixed withdrawal rates and the full inflation adjustment. Advisors can help their clients dial into an approach crafted specifically for their financial goals.

What Is a Typical Retirement Withdrawal Rate?

In a recent Fidelity survey, an alarming one in five respondents thought a financial professional would recommend a 10-15% withdrawal rate in retirement [PDF].

That’s far above Bengen’s 4% rule of thumb and risky under even ideal market conditions.

Dating back to the Great Depression, safe withdrawal rates have varied widely for equity portfolios. Rates ranged from 2.3% under the worst historical conditions to 7.2% on an all-equity portfolio under the best conditions.

The most important determining factor? When investors retire.

High stock prices, low bond yields, and rising inflation all tend to correlate with lower safe withdrawal rates. This dangerous combination can rock even stable retirement plans.

What Is the Best Retirement Withdrawal Strategy?

Every retirement strategy requires trade-offs. Dynamic withdrawal strategies grant some flexibility to retirees through market fluctuations.

Financial advisors can help investors weigh their options and customize a plan for their retirement goals. The State of Retirement Income report tested and compared dynamic withdrawal strategies (including one new method).

The Guardrails Method

The guardrails method, popularized by advisor Jonathan Guyton, sets maximums and minimums on spending at the outset of retirement.

In bull markets, investors can withdraw more from their portfolios—but not more than that predetermined guardrail. In poor market conditions, investors must withdraw less, but never below a supportable income threshold.

This withdrawal strategy works best for clients who are open to cash flow changes from year to year. Retirees will have less money at the end of their retirement, which might make it a poor fit for clients who want to make charitable bequests.

Retiree spending often follows a smile pattern. Retirees tend to spend more in the early years of retirement—often when their health is good, they’re active, and there's pent-up demand after a lifetime of work. Spending often dips in the mid to later years of retirement before rising again.

The haircut method responds to these lifestyle considerations. Under this approach, retirees increase their withdrawals each year for inflation—just one percent less than the actual inflation rate.

When Morningstar experts trimmed spending a percentage point lower than our baseline inflation assumption of 2.8%, it boosted starting and, in turn, lifetime withdrawals.

The haircut method gives early retirees permission to spend more. One trade-off: Spending early on in retirement has a ripple effect. Retirees would get more for their money by deferring spending.

The Required Minimum Distribution Method

Advisors can divide an investor’s portfolio balance by life expectancy, like the required minimum distribution tables that underpin IRAs.

One big trade-off is cash flow volatility. Investors will be buffeted by their portfolio value, which could be stressful for retirees with slimmer budgets. The RMD approach also consumes a portfolio over the retiree’s lifetime, which could conflict with a strong bequest motive.

The TIPS Ladder Method

For inflation-conscious clients, financial advisors can also explore treasury inflation-protected securities, or TIPS.

A TIPS ladder takes advantage of inflation-adjusted payouts to give investors a predictable source of retirement income. As one portion of an investment portfolio, TIPS ladders could help assuage inflation fears and cover necessities.

Let’s work backward. A TIPS ladder has one security that the investor can redeem each year. Picture an investor looking to cover $20,000 in annual fixed costs in retirement.

In their first year of retirement, they would buy a new 30-year TIPS worth $20,000. Thirty years later, the Treasury Department will redeem that for $20,000 in Year 30 dollars.

To receive $20,000 in Year 29, the investor would purchase TIPS that mature that year—but since they’ll earn interest payments on that first bond, the face value can be slightly less than $20,000. And so on.

A TIPS ladder will spend down the entire portfolio over the planned time horizon. In contrast, plans that are constructed to succeed at the 90% rate will likely still have money left in 30 years.

What Are Three Sources of Retirement Income?

Well before the outset of retirement, financial advisors should help investors review their spending and consider different sources of cash flow.

Sources of retirement income include:

  • Defined contribution plans. An investment portfolio works best as a flexible resource. Because the value in 401(k)s, IRAs, and other tax-friendly plans will fluctuate with the market, investors need a plan to make their retirement savings last.
  • Brokerage and savings accounts. Benz is a proponent of the bucket approach, where retirees hold money in different “buckets” to account for both short- and long-term goals.
  • Social Security. The predictable payments with cost-of-living adjustments can help cover necessary expenses.
  • Fixed and variable annuities. A source of guaranteed income can relieve some of the pressure on retirees.
  • Reverse mortgages. With a reverse mortgage, homeowners can convert home equity into a loan for a tax-free income stream. That debt is eventually repaid by selling the property.

Create Lifelong Confidence With Retirement Planning

Flexible plans can make retirees feel more in control of their financial well-being. Advisors need the tools to guide personal conversations about how each client envisions their retirement.

With clear, careful planning, advisors can create peace of mind as their clients transition into a new life phase.

Build goal-based retirement plans with Advisor Workstation. Through a science-backed preferences survey, you accurately assess client priorities and personalize portfolios. Compare possible scenarios and optimize portfolios for each investor.

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