Having a plan for taking money out of your retirement accounts can help ease your worries about income when you're no longer working.
How much can I spend in retirement and not run out of money? This or similar questions are probably some of the most “googled” topics.
The “4% Withdrawal Rule” is one of the most well-known studies on this topic, originally published in 1994 by William Bengen in the Journal of Financial Planning.
His conclusion: “Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe.”
Mr. Bengen also noted that his research strongly indicates that as long as the client’s goals remain the same, there is no need to change the initial asset allocation.
Is the 4% rule accurate?
Here are a few quotes from his article: “…using the charts for a 50/50 stock/bond allocation, determine the highest withdrawal rate that satisfies the desired minimum portfolio life. For a client of age 60-65, this will usually be about 4 percent. The withdrawal dollar amount for the first year (calculated as the withdrawal percentage times the starting value of the portfolio), will be adjusted up or down for inflation every succeeding year. After the first year, the withdrawal rate is no longer used for computing the amount withdrawn; that will be computed instead from last year's withdrawal, plus an inflation factor. Should a client wish higher levels of initial withdrawals, he or she should be apprised of the risks, … An initial five-percent withdrawal rate is risky; six percent or more is "gambling." Despite advice you may have heard to the contrary, the historical record supports an allocation of between 50- percent and 75-percent stocks as the best starting allocation for a client. For most clients, it can be maintained throughout retirement, or until their investing goals change. Stock allocations below 50 percent and above 75 percent are counterproductive.” “…I believe that the balance is tilted in favor of the higher allocation, but it is the client's choice.”
In his article, Mr. Bengen did not give a confidence level for his rule. In a similar “Trinity” study, Cooley, Hubbard and Walz (1998, 20, Table 3) reported a 95% historical success rate for a 30-year horizon, a 4% withdrawal rate, and 50%-50% mix of stocks and bonds. The success rate increased to 98% when the allocation to stocks increased to 75%.
Expanding on the research presented by Mr. Bengen… One, today we have more data to review and technology allows us to test significantly larger amounts of data and scenarios. The 4% Rule was based on the data from 1926 through 1992 and missing years extrapolated at the average return rates of 10.3 percent for stocks, 5.2 for bonds, and 3.0 for inflation.
Two, a later study “The 4% Rule—At What Price?” by Jason S. Scott , William F. Sharpe , and John G. Watson, published in April 2008 concluded: “Supporting a constant spending plan using a volatile investment policy is fundamentally flawed. A retiree using a 4% rule faces spending shortfalls when risky investments underperform, may accumulate wasted surpluses when they outperform, and in any case, could likely purchase exactly the same spending distributions more cheaply”, “…show that the 4% rule’s approach to spending and investing wastes a significant portion of a retiree’s savings and is thus prima facie inefficient”.
“Many practical issues remain to be addressed before advisors can hope to create individualized retirement financial plans that maximize expected utility for investors with diverse circumstances, other sources of income, and preferences. While we still may be far away from such an ideal, there appears to be no doubt that a better approach can be found than that offered by combinations of desired constant real spending and risky investment. Despite its ubiquity, it is time to replace the 4% rule with approaches better grounded in fundamental economic analysis.”
A flexible approach to withdrawals and income in retirement
At OCWM we believe that spending throughout retirement is not likely to be constant, and that the retiree’s goals will change over the years. Following a “rule of thumb” is usually not very efficient and may lead to a substantial amount in “unused” assets. Life is a dynamic and always changing series of events. To achieve a better outcome for each retiree based on their goals, the amount of withdrawals should be managed annually and reviewed against a benchmark, to make sure the retiree is not “overspending”.
With our clients, we created our own benchmark that is based on the rules outlined in the study by Jonathan Guyton “Decision Rules and Maximum Initial Withdrawal Rates” published in March 2006 in the Journal of Financial Planning.
Following the rules of our dynamic withdrawal strategy is more complex than simply calculating 4% and adjusting that by inflation rate, but we believe will better serve our clients.
As Guyton concluded: “Our analysis using Monte Carlo simulations supports the conclusion that the application of a few simple but powerful decision rules can significantly increase maximum initial withdrawal rates while virtually eliminating the possibility that a “perfect storm” could cause a retiree to run out of money.” “Questions about maximum initial withdrawal rates cannot be answered with a single number because retirees have varying thresholds for their financial security and need not adhere to a one-size-fits-all set of trade-offs.”
At OCWM, we have independently tested the strategy described by Guyton based on the market data going back to 1928, assuming a 35-year retirement and concluded that the success rate for the portfolio to provide income is 99%.
Guyton’s research indicates that using the withdrawal rules described below as 65% equity portfolio, 30-year withdrawal rate with 99% confidence equals an annual withdrawal of 5.4%.
An updated, dynamic withdrawal strategy
So, what are the principles of the dynamic withdrawal strategy? First, the accounts that are used for drawing down income, should be invested 60% to 75% in equities with the remaining portion in good quality shorter term bond funds or laddered CDs.
Next, based on our observations of the market corrections and the portfolio’s behavior during those corrections, it may take 2 to 4 years for the above portfolio to complete the correction cycle. The correction cycle is measured from the peak (highest point) to its lowest point, and then back to the point of recovery.
Our goal here is to avoid one of the worst mistakes investors make, which is to sell equities during market declines (“bad times”). To avoid this, while the portfolio is in the correction cycle we will sell portions of our bond allocation to generate enough for withdrawals and allow equities to recover. The portfolio will drift from the target allocation, but we’re not going to rebalance back to target during those “bad times”. (We addressed our approach to rebalancing here).
If we assume the correction cycle lasts longer than usual, say 5 years, we must have enough in the bond allocation to withdraw income during those 5 years. If the investor is drawing 5.4% annually form their portfolio, 5.4%/y x 5 years = 27%. In this case, a portfolio with 27% in bonds and 72% in equities allows us to stick with the plan. When “bad times” are over, we will rebalance back to our target allocation and replenish our reserve of fixed income.
This comprehensive and adaptable withdrawal strategy is designed to provide consistent income in retirement, all while avoiding selling the portfolio’s equity positions at a loss. By avoiding selling at a loss, we are decreasing the chances of depleting the portfolio.
Four decision rules that must be followed:
Below you’ll find the decision rules as they are explained in our firm’s Withdrawal Policy Statement:
OCTO Capital's Withdrawal Policy Statement
Among other risks, there is always the possibility that the equity market will decline early in your retirement. Since 1980, for example, the S&P 500 has experienced average annual declines from a peak to a trough approaching 14%, with declines of roughly twice that degree occurring on an average of every five to six years. We've agreed that, in order to reduce a chance of you outliving your savings, we will adhere to the Safe-Spending Policy.
Withdrawal Income Goals:
- Receive annual withdrawals (WDs) beginning now and continuing throughout your lifetimes
- Increase your future WDs to help offset lost purchasing power from inflation
- Minimize the chance that you could outlive your assets
- Minimize undesired changes to your regular monthly income
- Structure the sources of your withdrawals to maximize long-term after-tax wealth where possible
Initial withdrawal rate ___% (set individually for each client)
Ongoing Annual Withdrawal Amounts:
To maintain the long-term sustainability of your lifestyle and withdrawal objectives, your withdrawal amount will increase by the prior year’s inflation rate, unless:
A) you decide instead to keep your withdrawal amount the same in some years.
B) next year’s WD amount would make your WD Rate more than 6.5%. If so, next year’s WD amount is reduced by 10% from what it would have been with the inflation adjustment.
C) next year’s WD amount would make your WD Rate less than 4.3%. If so, next year’s WD amount is increased by 10% from what it would have been with the inflation adjustment.
D) neither B nor C applies, but the prior year’s investment return was negative. If so, your WD amount remains the same as it was the prior year.
Sources of Withdrawal:
All interest and dividend distributions are taken in Cash and held in your investment account(s). Capital gain distributions are reinvested in IRA accounts and held in Cash for after-tax accounts. Following years with positive returns that cause an equity category to exceed its target allocation, the excess amount is sold and reinvested in Cash or Fixed Income to fund future WDs.
Yearly WDs are funded from equities when markets are favorable and from fixed income when they are not, using this priority:
2) Selling Fixed Income assets;
3) Selling Equity assets in descending order of the prior year’s performance.
No WDs are funded by selling an Equity asset after a negative return year as long as Cash or Fixed Income assets are able to fund that year’s WD amount."
It is our goal to help clients achieve a better investing experience and make sure their goals are fully funded without the risk of outliving once assets.
If you are interested in learning more about our dynamic withdrawal strategy and how it might benefit your retirement, we would love to answer any questions you might have. You can contact us here, and a member from our team will get back with you as soon as possible.
If you are interested in seeing if the Dimensional approach and evidence-based investing could benefit your portfolio, we are offering a free test drive of our Financial and Retirement Planning Portal, offered at no cost and no obligation. You can click here to learn more, or contact us here.
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