As we all know, saving for retirement requires hard work and discipline. But spending intelligently once one is in retirement can be equally challenging. Indeed, one of the most critical decisions retirees face is determining how much to withdraw from their investment portfolios—or more specifically, determining a sustainable withdrawal rate that reduces their risk of depleting their assets during their lifetime. This can be a balancing act: Most don’t want to go too far in the other direction and withdraw too little, thus forsaking well-deserved enjoyment during their golden years.
This piece examines two of the more common methods of calculating a sustainable withdrawal rate, along with a variation, and elaborates upon my preferred approach. The key takeaway: Like investing, spending during one’s retirement entails managing inherent uncertainty, as retirees don’t know how long they’ll live or what their actual future spending needs will be (such as health care expenditures), not to mention future market returns. As such, maintaining flexibility—while erring on the side of caution—is paramount.
Before I begin, please note that the methods outlined here rely on a total return approach, as it may be quite challenging for a retiree to make ends meet by withdrawing interest and dividends only. Furthermore, shifting portfolios too much toward higher-yielding, income-oriented investments could produce a less diversified portfolio, thus resulting, ironically, in too much risk.
A total return approach, on the other hand, relies on cash flow from dividends, interest, and the prudent trimming of principal as required; what is imperative, of course, is that principal is tapped at a sustainable rate.
The 4% Rule
Perhaps the most well-known sustainable withdrawal method is referred to as the “4% rule.” According to this guideline, an individual planning on a 30-year retirement and holding a balanced, diversified portfolio can safely withdraw up to 4% of his or her investment assets during the first year of retirement and then adjust that withdrawal amount every year thereafter for inflation. Safely, in this case, means with a high probability of not depleting one’s assets over the 30-year period.
Here is a quick example of how this method works: Let’s assume a couple retires with a $1 million investment portfolio. According to the 4% rule, they should be able to withdraw $40,000 in their first year of retirement and then adjust this $40,000 amount each year by the annual rate of inflation. If the rate of inflation was 3% over the first year, they would increase their withdrawal in year 2 to $41,200 ($40,000 × 1.03 = $41,200).
The 4% rule is based on a seminal paper published in 1994 by financial advisor William Bengen.1 Using historical market and inflation data from 1926 to 1976, Bengen concluded that, even during severe market and economic environments, no historical case existed where a 4% withdrawal, adjusted annually for inflation, depleted a retirement portfolio in fewer than 33 years. Perhaps surprisingly to some, the most precarious period that this method withstood was not the Great Depression; rather, it was the late 1960s and early 1970s, when retirees encountered a double whammy of poor market returns and high inflation, the latter of which systematically led to higher withdrawal amounts, thus putting additional stress on the portfolio corpus.
Other studies over the years have generally affirmed the 4% rule. Indeed, in 2020, Bengen published an update to his own initial work, with the benefit of an even longer historical data set.2 He found that an even a slightly higher withdrawal rate of 4.5% was sustainable over a 30-year period. However, unlike his 1994 study, in which historical stock market returns were based solely on U.S. large company stocks, Bengen incorporated a blend of both U.S. large company and U.S. small company stocks in his revised analysis.
While adhering to the 4% rule on a balanced portfolio could result in a predictable cash stream that keeps pace with inflation, there are a few important caveats. First, Bengen’s study was based on historical returns and inflation rates, and while history may be our only guide to the future, we all know that “past performance is no guarantee of future results.” Second, while 30 years may still be a reasonable time period over which to measure a sustainable withdrawal rate, some retirements can extend longer, which is not a minor consideration in light of rising life expectancies. Third, Bengen’s analysis tested static allocations that were rebalanced annually; in the real world many investors change their allocations over time—namely, adding more fixed-income investments as they grow older.
However, the major drawback of the 4% rule is that it is fundamentally disconnected from how the underlying portfolio actually performs. In other words, it insists on a fixed, inflation-adjusted withdrawal amount, even though the assets supporting this withdrawal can fluctuate, sometimes significantly. This fixed withdrawal could be particularly harmful for individuals unlucky enough to experience a sustained market downturn during the early years of their retirement, as they would be forced to spend a larger percentage of their portfolio value to support the same constant dollar spending level, thus increasing their chances of eventual asset depletion. Of course, the opposite holds true as well: A string of better-than-expected returns could lead a retiree to unnecessarily crimp his or her lifestyle and leave behind a larger estate than intended. (With that said, I believe retirees are better served by protecting themselves against the former, possibly more damaging risk.)
Constant-Percentage Method
Although less frequently cited than the 4% rule, another common withdrawal framework is the constant-percentage method. With this approach, rather than taking a fixed dollar amount that grows with inflation, a retiree withdraws the same constant percentage annually from his or her portfolio.
If the couple in the prior example, with a $1 million nest egg, were to apply a constant-percentage withdrawal rate of 4%, they would withdraw $40,000 in the first year. At the start of the second year, they would budget 4% of whatever their portfolio balance was at that time. If the portfolio had grown to $1.1 million, they would plan to withdraw $44,000; if the portfolio had decreased to $900,000, they would budget a $36,000 withdrawal.
I generally prefer this method because it not only is easy to execute but also increases the chance that one’s portfolio will last throughout one’s lifetime. Indeed, in theory, the portfolio should never be depleted, although it could drop to values that would be insufficient to support the desired spending levels. Most importantly, though, unlike the 4% method, this approach leads to a spending stream that is directly related to the actual year-to-year performance of the investment portfolio. And although annual withdrawals are not automatically increased for inflation, this method ultimately relies on long-term portfolio growth as an adjustment for inflation over time.
The downside of the constant-percentage method is a lumpier, less predictable stream of income than the 4% rule, because the dollar amount withdrawn will fluctuate from year to year (sometimes by a wide margin) as the value of the underlying portfolio changes. Therefore, retirees need to be prepared to spend less when the market is weak. However, this does not necessarily suggest that one should spend the windfalls that occur in stronger markets. Indeed, retirees may want to consider reinvesting some of these excess returns to help support future needs. Admittedly, this approach may work best for someone with relatively low fixed expenses or year-to-year flexibility in spending.
A Hybrid Approach
To harness the benefits of both of the methods discussed above while addressing some of their drawbacks, several hybrid variations have emerged. Generally, these variations impose several decision rules or spending caps based on how portfolio assets subsequently perform. The key idea behind these strategies is to balance the need for retirement income with the need to preserve capital over the long term.
For instance, Vanguard has proposed a so-called “dynamic spending rule” that entails calculating each year’s spending by taking a stated percentage of the prior year-end’s real (inflation-adjusted) portfolio balance but capping the amount taken with both a ceiling and floor.3 These caps are determined by applying chosen ceiling and floor percentages to the previous year’s real spending amount. In Vanguard’s research, they used a 5% ceiling (increase) and a 1.5% floor (decrease)—so in other words, real spending would never decrease by more than 1.5% or increase by more than 5% from the prior year.
The portfolio tested by Vanguard under these ceiling and floor parameters had an initial withdrawal rate of 5% and a globally diversified 50% stock/50% bond allocation, which was rebalanced annually.4 Ten thousand forward-looking simulations were run using a 35-year time horizon, 5 years longer than the 4% guideline emanating from Bengen’s study. The results had a success rate of 86%—in other words, in 86% of the 10,000 simulations, assets were not depleted over the 35-year period. This compared to a 55% success rate for the constant-dollar method (5% initial withdrawal amount, adjusted annually thereafter for inflation) and a 100% success rate for the constant-percentage method (5% withdrawal annually). Importantly, though, as Vanguard noted, the constant-percentage method’s higher probability of success came with a tradeoff, reinforcing what I stated earlier: greater volatility in annual real spending.
The Real Life of Retirees
Although alternative approaches with various decision rules might seem compelling, implementing them in the real world could prove a bit cumbersome, not to mention unrealistic. That said, many of the retirees I have worked with over the years have essentially adopted a de facto hybrid approach, albeit one that is more fluid. For instance, during severe market downturns, my experience suggests that most retirees naturally scale back their discretionary expenditures, rather than spending a predetermined percentage of their assets. And conversely, during robust markets, I have often encouraged clients to enjoy some of the windfall but not to go hog-wild, and instead reserve some of the excess as a cushion for less-cooperative market conditions.
It also bears mentioning that sustainable withdrawal strategies in the real world are not just about how much you take out, but how you take it out—that is, from which account(s). In most cases, there are taxes to pay, and many retirees have a variety of tax buckets, such as taxable accounts and tax-sheltered retirement vehicles. Determining the most tax-advantageous order in which to tap assets will increase the likelihood that your money will last longer. Generally speaking, after you have satisfied any required minimum distributions, it is optimal to take withdrawals from taxable accounts, as this helps preserve the tax deferral of funds in tax-advantaged portfolios such as IRAs, as well as tax-free compounding in Roth IRAs and health savings accounts (HSAs). There are exceptions, however, such as an interim period when one is in an abnormally low tax bracket. As such, it often makes sense to also confer with your tax professional to ensure that funds are being withdrawn in the most tax-efficient manner.
Striking the Balance
In the end, retirement portfolios need to be optimized to be reliable; indeed, what is the point of working so hard to prepare for retirement if you do not enjoy retirement once it comes? To be sure, planning for tomorrow is also crucial, as circumstances—both personal and global—are constantly in flux, and retirement itself can last decades. Importantly, risk cannot be avoided; it can only be managed. And the best way to manage risk is to focus first on factors that can be controlled. This relates not only to allocating portfolios in a way that stacks the financial odds in your favor, but also to tailoring personalized, sustainable withdrawal strategies that are responsive to your circumstances.
1 William Bengen, “Determining Withdrawal Rates Using Historical Data,” Journal of Financial Planning, October 1994.
2 William Bengen, “Choosing the Highest Safe Withdrawal Rate at Retirement,” Financial Advisor Magazine, October 2020.
3 Colleen M. Jaconetti et al., From Assets to Income: A Goals-Based Approach to Retirement Spending, The Vanguard Group, April 2020.
4 The stock portfolio consisted of 60% U.S. stocks and 40% international stocks, and the bond portfolio consisted of 70% U.S. bonds and 30% international bonds.
Abramson Financial Planning, LLC does not warrant the accuracy of the materials provided herein. Although the information provided is from sources we believe to be reliable, we do not guarantee the accuracy or timeliness of any information for any particular purpose. This information is for information purposes and does not constitute a recommendation for the purchase or sale of securities. Individual investment decisions should be made on the basis of each investor’s financial condition, suitability, and risk tolerance. Investments may be volatile and can involve the loss of principal. Past performance is no guarantee of future returns. Abramson Financial Planning’s employees may trade for their own accounts in any of the securities of issuers mentioned herein or in related investments. Abramson Financial Planning does not undertake to provide clients with tax, legal, or accounting advice, and clients are admonished to consult their own attorneys and accountants for determining the tax, legal, and accounting consequences of investments made on their behalf.