I often say this to clients, a phrase that has stuck with me since my high school football days: “Keep it Simple, Stupid.” The old KISS method. While I subscribe to this philosophy for many financial topics, retirement income is an exception. In this article, we’ll explore key withdrawal strategies and how we approach them as a firm.
Key Takeaways
- There are several evidence-based, well-researched withdrawal strategies to choose from.
- Many common “back-of-the-napkin” methods leave retirees with far too much money unspent.
- Overly conservative spending can lead to unnecessary sacrifices in retirement.
The Art and Science of Retirement Withdrawals
How you withdraw money from your retirement portfolio is both an art and a science. Several evidence-based strategies can help retirees balance sustainability with enjoying their wealth. Today, we’ll focus on three:
- The 4% Rule
- Guyton’s Guardrails
- Risk-Based Spending
First things first
Do you have a written or easy to understand withdrawal or spending plan? Most people will focus all their attention on the investment side of the coin. Which is to say, when will you rebalance? What asset allocation will you use? What types of investments might you include in your portfolio? All valid questions. These will also be of use when inevitable market volatility rears its head.
A written statement or spending strategy is equally as important. Say you are retiring with $1,000,000 today. In 9 months, you just received a quarterly statement showing the balance at $750,000. You might know what to do with your investments. How should you adjust your spending? Should you?
Whether it be the 4% rule, Guyton’s Guardrails, total return investing, dividend investing in retirement, or risk based guardrails, a more rules-based framework will provide you clarity n answering that question.
History Lesson: The 4% Rule
One of the most widely cited retirement spending rules is the 4% rule. In the early 1990s, financial planner Bill Bengen (see above link for original article) analyzed historical market returns for a 50% stock, 50% bond portfolio and determined that withdrawing 4% annually (adjusted for inflation) was a “safe” withdrawal rate. His goal was to understand what level of spending avoided failure in all but the worst of the market outcomes.
This rule has largely stood the test of time, but with one major caveat: Many retirees who followed it ended up with far more money than they expected late in retirement. In other words, they left a lot of spending on the table—much to the delight of their heirs. According to Michael Kitces research on the subject, the odds of doubling your retirement income portfolio using the 4% rule is 80%!
Interestingly enough, companies like Morningstar over the last several years have come out with their own estimates that utilize an even more conservative spending percentage. In an era of higher than average equity valuations, extended longevity and healthcare costs, and lower interest rates – they postulate that the 4% rule may be outdated. I think it’s a fair argument to consider asset prices and interest rates at the beginning of retirement when considering your withdrawal strategy. However, historically it hasn’t mattered.
That withstanding, most Monte Carlo simulations show that a 4% withdrawal rate often results in retirees ending up with two to three times their initial portfolio value (in nominal terms). This is because the rule works in almost any scenario except the most extreme market conditions—such as prolonged stagnation, sustained high inflation, or a severe market crash at the outset of retirement. While these scenarios are possible, they represent the far tail of risk. I think of these as the scenarios in which everyone fails. There isn’t much insurance for these scenarios other than hoping they don’t happen.
So, if you are on the verge of retirement and expect to double your money over time, the logical question is: Should you be spending more? Retirement spending is so often viewed through the lens of “what if I run out of money?” In fact, the better (or more likely) outcome is you asking “what happens when I double my money”? if you are going to go the 4% route.
Enter the Guardrails
In 2006, Jonathan Guyton introduced a guardrail methodology that allows for more dynamic withdrawals based on market conditions. Unlike the 4% rule, which assumes a static withdrawal rate, the guardrail approach adjusts spending up or down depending on market performance.
The general idea is straightforward: If markets rise and your withdrawal rate decreases, you increase spending to maintain a “new” sustainable rate. Conversely, if markets decline and your withdrawal rate rises, you cut spending to a sustainable level.
Example of Guyton’s Guardrails
- Initial withdrawal rate: Typically between 3-6%, depending on age and client circumstances.
- Upper guardrail: If the portfolio withdrawal rate falls 20% below the initial rate, increase withdrawals by 10%.
- Lower guardrail: If the portfolio withdrawal rate rises 20% above the initial rate, decrease withdrawals by 10%.
- Inflation adjustments: Withdrawals increase with inflation, except in years with negative portfolio returns.
- Longevity considerations: No lower-guardrail-triggered decreases in the final 15 years of the plan.
To put this into numbers:
- Initial withdrawal amount: $1 million portfolio x 5% = $50,000 per year.
- Upper guardrail: If the withdrawal rate drops to 4%, the new spending amount would be $55,000.
- Lower guardrail: If the withdrawal rate rises to 6%, the new spending amount would be $45,000.
This approach provides retirees with clear, rules-based adjustments that help them navigate market swings without second-guessing their strategy. Not only that, but adjusting your spending for what is likely to be a trending up market over time, the income derived from your portfolio over the course of your retirement should be considerably higher!
Dynamic spending strategies such as Guyton’s in comparison to the 4% rule are a much better tool in harnessing market dynamics and allowing retirees to “eat” more of their portfolio in the form of safe spending.
However, one major drawback of Guyton’s guardrails is that, in severe market downturns, the required spending cuts can be drastic. For example, a retiree following this method during a major downturn (such as the early 2000s or 2008) could be forced to cut spending by nearly 50%—a potentially unmanageable adjustment.
A Smarter Approach: Risk-Based Spending
One of our preferred methods builds on Guyton’s guardrails but takes a more personalized, risk-based approach. Instead of relying solely on percentage thresholds, we incorporate Monte Carlo analysis to assess the probability of a retiree’s plan succeeding under various market conditions.
We generally aim for a 70-100% probability of success (meaning a retiree won’t run out of money). For comparison, the 4% rule typically has a 93% success rate. If a retiree’s probability of success drops below 50%, we would consider adjusting their withdrawal rate until it reaches a safer level—typically 70%. This number could be even lower depending on specific client circumstances and your personal risk tolerance.
Research on the subject in comparing a risk-based framework would show that in a period of market volatility, such as the Global Financial Crisis – a risk-based approach might reduce base planned spending by 3%. However, using Guyton’s more aggressive spending cuts guardrails, the same spending would have been reduced by 28%! Yet, the result is similar, the retiree does not run out of money.
Unlike Guyton’s fixed thresholds, this method allows for more nuanced adjustments, minimizing drastic income cuts in bear markets while maintaining sustainability. Additionally, as retirees age, their time horizon shortens, which also influences withdrawal strategies.
The Bottom Line
Using any rules-based, evidence-backed withdrawal strategy is a great starting point. Writing down what you’ll do when, is a key component of a blueprint for success. However, the outcome of these strategies can vary significantly.
Like many things in our lives, retirement income strategies are ever evolving. And I’d argue for the better. With the use of technology and access to data, we can better understand and model how to stretch our retirement dollars even further.
Your retirement is too important to be left to back-of-the-napkin math. Our goal is to use the most advanced techniques and software to ensure your money lasts as long as you do—while also helping you enjoy it along the way.
