The withdrawal rate debate — that is, what is the best percentage to pull from retirement savings each year — has been heating up, especially as interest rates have been near zero. Although the 4% rule, first noted by Bill Bengen in 1994, has been a standard recommendation, that number has come under more scrutiny of late.
Bengen used a 30-year time horizon, starting in 1926, to demonstrate why the 4% rule worked. He assumed a portfolio holding 50% stocks and 50% fixed income securities.
Using those same assumptions, three Morningstar researchers found that the 4% rule may "no longer be feasible." Christine Benz, director of personal finance and retirement planning; Jeff Ptak, chief ratings officer; and John Rekenthaler, vice president and director of research, outline their reasoning in a recent paper, The State of Retirement Income: Safe Withdrawal Rates.
"Because of the confluence of low starting yields on bonds and equity valuations that are high relative to historical norms, retirees are unlikely to receive returns that match those in the past. Using forward-looking estimates for investment performance and inflation, Morningstar estimates that the standard rule of thumb should be lowered to 3.3% from 4%," they state in the paper.
That said, "this should not be interpreted as recommending a withdrawal rate of 3.3%," they say, adding that their conventions underlying their calculation were "conservative."
In the study, they presumed:
- A time horizon that exceeds most retirees' expected life spans.
- Fully adjusting all withdrawals for the effect of inflation.
- A fixed withdrawal schedule that does not react to changes in investment markets,
- A high projected success rate for the plan (90%).
The paper demonstrates that "by adjusting one or more of those levers, current retirees can safely withdraw a significantly higher amount that the 3.3% initial projection might suggest."
A caveat, of course: "Many of today's retirees will have to be more resourceful to support their income needs."
Portfolio Strategies
Some portfolio strategies that retirees can employ to expand portfolio payouts include relaxing these assumptions and adopting a more flexible spending approach, the paper states. Retirees can safely "sustain higher withdrawals, with a 4.5% starting real withdrawal rate achievable under some scenarios," they state.
Strategies that improve the ability for higher withdrawal rates include:
- Equity-heavy allocations, which tend to support higher lifetime withdrawal rates under flexible spending methods.
- A 50% stocks/50% bonds portfolio, which consistently outperforms one that is all fixed income when tested on a rolling 30-year time period.
Nonportfolio Strategies
Of course, there are "nonportfolio" strategies to maximize retirement income, the paper states. These include:
Delay Retirement
"The simplest way to achieve a higher withdrawal rate is to work longer and retire later," the authors state. This reduces the time horizon of retirement and allows the retiree to increase the size of their portfolio and have a longer compounding period.
Calibrate/Reduce Expenses
Several factors influence how much a retiree needs to withdraw. One is level of wealth: While 75%-80% is "considered a reasonable rule of thumb for income replacement," wealthier retirees may need to replace a smaller share of income, according to the paper.
