A few weeks ago, Morningstar published its annual State of Retirement Income report for 2023, finding that new retirees hoping to use a "safe" fixed real withdrawal strategy for managing retirement income can plan to withdraw 4% of their portfolio's value in the first year of retirement.
In the analysis, a trio of Morningstar researchers including Christine Benz, director of personal finance and retirement planning, show that a starting withdrawal rate of 4% delivers a 90% success rate over a 30-year time horizon for new retirees — even while accounting for inflation.
A few days after the report's release, Benz hosted her Morningstar colleagues and report co-authors Amy Arnott and John Rekenthaler in an extended episode of The Long View podcast. In the episode, the trio dug into their research findings and broke down the data for practicing financial advisors.
The topline 4% "safe spending" finding is an important result, according to the group, especially when considering that the safe spending figures for 2022 and 2021 were 3.8% and 3.3%, respectively. This steady increase over time owes largely to higher fixed income yields, Benz explains, along with lower long-term inflation estimates.
But perhaps the most important part of the research update, the authors suggest, is the detailed section that considers four distinct flexible withdrawal approaches. As the authors argue, rigid spending frameworks and binary success probability metrics can be important reference points for advisors and retirees, but they aren't an actual retirement plan.
In the real world, retirees' spending needs and preferences change over time, and very few people actually follow a rigid annual pattern. For this reason, the researchers contend, financial advisors should take pains to study up on the growing variety of retirement spending approaches that are being developed in both academic and professional settings.
By helping clients see the need for flexibility and by coaching them through the potential income fluctuations they can expect, advisors can help them retire with more confidence and peace of mind — all while boosting their anticipated probability of success.
Skip Inflation Adjustments
As Arnott explains, the first flexible spending strategy considered in the paper is also the simplest.
"One would be a very simple approach where, any time you have an annual portfolio loss, you skip the inflation adjustment when you make withdrawals the next year," Arnott says. "So, it's very simple, but you are making some adjustments to your spending, which can really help support a higher withdrawal rate over time."
As the report explains, this might seem like only a modest step, but the cuts in real spending, while small on an individual basis, are cumulative.
"That is, the effects of such cuts ripple into the future, as these changes permanently reduce the retiree's spending pattern," the report states.
With this approach, a starting withdrawal rate of 4.4% is "safe," Arnott points out, meaning it will succeed over a 30-year time horizon 90 out of 100 times. The average safe annual withdrawal is about 4.1%, and the median result for a $1 million starting portfolio sees the retiree end the initial 30-year retirement period with a higher $1.4 million balance.
Follow RMDs
The second flexible approach considered in the report is the required minimum distribution method.
"This is the same framework that anyone who is required to make minimum distributions from a 401(k) or an IRA is familiar with," Arnott explains. "It's basically just taking the portfolio value divided by life expectancy, and we use the standard life expectancy table from the IRS and assume a 30-year retirement time horizon."
As Arnott notes, this method is "inherently safe," because retirees are always taking a percentage of the remaining balance, which means they never run out of money. However, because it is based on two variables — life expectancy and portfolio value — any given individual can have a lot of variability in cash flows from year to year, which may be very undesirable for some.
While changes in life expectancy are gradual, Arnott adds, the fact that the remaining portfolio value can change significantly from year to year adds substantial volatility to cash flows.
