Financial planners who focus on retirement income increasingly voice skepticism about the traditional 4% safe withdrawal rule popularized by research originally conceived of and executed nearly three decades ago by Bill Bengen.
The rule suggests a given client in retirement should add up all of their investments and simply plan to withdraw 4% of their total wealth during their first year of retirement. The withdrawal amount is then adjusted annually to account for inflation.
According to Bengen's original analysis, based on a now-popular statistical technique known as Monte Carlo simulations, this spending pattern is virtually guaranteed to leave a client with sufficient assets to navigate a 30-year retirement, even one during which the markets perform poorly by a historical standard.
That simple safety "guarantee" is what has driven the rule's popularity.
Yet financial planners know they can do a lot better for clients, helping them to optimize their spending plan in retirement based on their unique and evolving personal goals, risk tolerance and market conditions.
One way they are doing so is by bringing forward an important metric beyond simple probabilities of success and failure: the magnitude of failure.
Bringing this metric into the planning effort allows advisors and their clients to move beyond binary planning strategies and to embrace a new degree of flexibility in the planning process, one that can help their clients maximize spending in retirement while protecting them from the worst-case scenario of retirement bankruptcy.
Why Magnitude of Failure Matters
Oscar Vives, a wealth planner at PNC Wealth Management, recently gave a presentation during a webinar hosted by the Investments and Wealth Institute, during which he dug into the weakness of the traditional 4% withdrawal rule and how it can be complemented by newer planning insights and techniques.
As Vives explained, when reporting binary Monte Carlo results to a client framed around probability of success, anything less than 100% can sound scary. For example, for a client with a 75% probability of success at a given starting spending amount, the notion of failing one out of every four times simply does not sound acceptable to many people.
Vives says it is crucial, however, to think carefully about what a 75% success result in a Monte Carlo simulation actually implies. While on the one hand this metric suggests one in four projected retirement scenarios will "fail," this metric alone actually tells a client nothing about how severe that failure is.
For example, if 90% of the client's required future income is expected to come from guaranteed sources, such as a pension and Social Security, then "failure" in such a scenario really just means running 10% short of one's stated goal. This isn't an ideal scenario, Vives notes, but it's far from a catastrophe.
"This is where the whole concept of the magnitude of failure comes into play," Vives explains. "By giving clients a better sense of how much risk they are really running with a spending plan, we can help them feel more confident and spend more, especially when we pair this perspective with the concept of using pre-defined spending guardrails. That's really a powerful approach."
How Retirement Spending Guardrails Work
According to Vives, the real power of the magnitude of failure metric is that it points advisors and clients away from binary projections and towards what many consider to be the new, emerging best practice for structuring "safe" retirement income: using retirement income guardrails.
