While 4% generally has been considered a safe withdrawal rate for retirees for the better part of the last three decades, a new paper by Morningstar argues that, given current conditions, the rate should be lowered.
In The State of Retirement Income: Safe Withdrawals Rates by Morningstar’s Christine Benz, Jeffrey Ptak and John Rekenthaler, the trio explain that 4% has been the starting point for spending discussions since 1994. Back then, according to the paper, financial planner William Bengen had demonstrated that over every rolling 30-year time horizon since 1926, retirees holding a portfolio consisting of 50% stocks and 50% fixed-income securities could safely withdraw an annual amount equal to 4% of their original assets, adjusted for inflation.
Under those same assumptions, a 4% withdrawal rate may no longer be feasible, they argue. “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 of the past,” Benz, Ptak and Rekenthaler write.
Using forward-looking estimates for investment performance and inflation, the Morningstar researchers estimate that the standard rule of thumb should be lowered from 4% to 3.3%. This is assuming a balanced portfolio, fixed real withdrawals over a 30-year time horizon and a 90% probability of success.
Since these assumptions are conservative, the researchers caution that this should not be interpreted as recommending a withdrawal rate of 3.3%. Instead, given current conditions, retirees will likely have to reconsider at least some aspects of how they define their “safe withdrawal rate” to make their assets last, they observe.
Redefining Safe Withdrawal Rates
In their 59-page paper, the researchers examine historical withdrawal rates, assessing the rates that different asset allocations would have supported in the past, and then, using estimates of future stock and bond returns, assess what withdrawal rate is likely to be supported for people retiring today. They note that, because their forward-looking withdrawal-rate estimates are low relative to the standard guidance that points to 4% as a safe number for inflation-adjusted withdrawal rates, they assess several strategies for increasing the portfolio’s withdrawal rate and review the trade-offs some of those strategies entail.
Accordingly, they find that retirees can take a higher starting withdrawal rate and higher lifetime withdrawals by being willing to adjust some of these variables, such as tolerating a lower success rate or forgoing complete inflation adjustments.
For example, being willing to tolerate a slightly lower probability of success than 90% would result in an improved starting safe withdrawal amount. Retirees who are willing to accept an 85% success rate could reasonably take 3.7% of a balanced portfolio initially, while retirees who are willing to live with an 80% success rate could withdraw 3.9% to start, the researchers explain.
Similarly, reducing the time horizon for drawdown by, for example, delaying retirement a few years could also contribute to a higher starting safe withdrawal rate.
According to the research, delaying retirement by five years and truncating the in-retirement spending horizon to 25 years from 30 results in a starting safe withdrawal amount of 4.1%.
Retirees can also achieve meaningful increases in starting safe withdrawal rates and lifetime withdrawals by being willing to depart from fixed real withdrawals and instead embracing variable retirement spending systems, according to the paper.
Variable Withdrawal Approaches
To that end, the researchers analyzed four different variable withdrawal approaches, including:
- forgoing upward inflation adjustments;
- required minimum distributions;
- so-called “guardrails” based on market performance; and
- a 10% reduction following losing years.
According to their research, some flexible withdrawal systems would support a starting withdrawal rate of nearly 5%, but the trade-off would be that year-to-year cash flow might be more volatile. “We found that even modest adjustments to a fixed real withdrawal system—for example, forgoing inflation adjustments following years in which the portfolio has posted a loss—support higher starting and lifetime withdrawals than a fixed real withdrawal system,” writes Benz.
Being willing to make more significant adjustments—taking less after a portfolio has declined and more when it has increased—can lead to even higher starting safe and lifetime withdrawals, the paper notes. “Our research finds that a guardrails-type system—flexible withdrawals with parameters, or guardrails, around how high or low withdrawals can go in a given year—does the best job of enlarging payouts in a safe and livable way,” the researchers emphasize.
Likewise, a simple fixed real withdrawal system that forgoes inflation adjustments following a losing year does a “decent job” of enlarging lifetime withdrawals versus a fixed real withdrawal system and does so without a lot of cash flow volatility on a year-to-year basis, the paper observes.
Still, determining the optimal amount to take out of a portfolio annually without prematurely depleting one’s assets is “a question that vexes professional financial advisors and institutions nearly as much as it does individual investors,” Benz, Ptak and Rekenthaler write.
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