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Forget the 4% Rule. Why Retirees Need to Rethink Their Withdrawal Strategy.

Chiara Vercesi / Sail Ho Studio

Remember that 4% rule? Inflation and lower returns means that it may be more like 3.3%—or even lower. But the better move for retirees just might be to scrap the old rule entirely and take a more dynamic approach.

Rules of thumb help make an abstract and complicated process easier. The 4% rule was never meant as a one-size-fits-all solution, but with so many people endeavoring to turn their life savings into a paycheck in retirement, the rule has become entrenched in the zeitgeist. And, not surprisingly, its limitations are widely misunderstood: Based on actuarial tables and thousands of market-return scenarios, the rule determined that a heterosexual, same-age couple that retired at 65, withdrew 4% from their nest egg in the first year and then adjusted that amount for inflation every year after, had a high likelihood of not outliving their money, as long as they made no changes to that plan or their portfolio for the rest of their lives.

This is not a realistic look at retirement.

Academics and the financial-services industry have long grappled with how to help retirees with the withdrawal calculus. Finding the right withdrawal rate is even more crucial for today’s retirees: Previous generations could live off portfolio income when bonds yielded 4% to 5%. Today, yields on 10-year bonds are closer to 1.5%, and negative after factoring in inflation. Relying on more stocks isn’t likely to make up the difference, because a dozen-year bull market means that future stock returns aren’t likely to match those of the past. Some retirement researchers worry that near-term stock returns could be just half of the 10% projections that historical average returns would suggest.

That leaves retirees and near-retirees in a tough spot. Morningstar looked at withdrawal rates for various allocation mixes that ensured a 90% chance of not running out of money over rolling 30-year periods from 1930 to 1990. An all-cash portfolio meant that retirees could safely withdraw only 1.4% to 2.5%; investing entirely in stocks allowed for a withdrawal rate of anywhere from 3.2% to 6.5%, depending on market volatility and when that volatility hits someone’s retirement. Historically speaking, taking less risk with a more balanced portfolio was the smart move: Investors were able to withdraw 3.7% to 6% with much less worry of volatility derailing their plans.

Going forward from here, though, is another story. Based on Morningstar’s research, the projected starting safe withdrawal rate for the next 30 years is 2.7% for those with money in their mattresses and 2.9% for people with everything in stocks. The highest safe withdrawal rate is 3.3% for portfolios with 40% to 60% in stocks—well below the historical “safe” withdrawal rate of 4%. But even that may be misguided. “If you retire now or soon, this fixed withdrawal rate just can’t apply to you. There is too much uncertainty about inflation and possibility of a market drop,” says David Blanchett, who heads retirement research at QMA, the quant unit of PGIM.

Researchers are increasingly favoring a more flexible retirement strategy—long seen as anathema—in part to contend with the market’s vagaries, but also based on research around retirees’ spending patterns.

A shift from the 4% rule also allows for more customization. Women, for example, may need a more conservative withdrawal rate, given their longer life expectancies, higher healthcare costs, and typically lower Social Security benefits—a result of career breaks for caregiving and the wage gap, says Indya Yulli, managing director at registered investment advisory firm Beacon Pointe Advisors.

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If 3.3% of your portfolio doesn’t sound like enough to live on, you may be tempted to load up on stocks in hopes of increasing the size of your portfolio, but that could backfire. Looking at a series of prospective withdrawal rates, methods, and allocation mixes—over rolling periods in a 30-year stretch—the range of withdrawal rates wasn’t that wide even when retirees opted for a heavy equity mix. Too much in stocks adds volatility, potentially hitting at retirees’ most vulnerable time in their early years of retirement.

Want a higher withdrawal rate? More fixed sources of income—a pension, Social Security, or even a fixed-income annuity to cover basic expenses—could allow for a more variable and higher withdrawal rate for the discretionary items.

Retirees willing to have a withdrawal plan that allows for some swings in the amount of money at their disposal each year could withdraw as much as 6% to start, as long as they are prepared to halve that if the market veers. This may not be as tough a behavioral change as it seems: Research shows that people adjust if their portfolio is at risk of being depleted faster than expected, suggesting that retirees may be able to stomach more flexibility than the conventional wisdom held. Wealthier people, of course, are better able to tolerate variable strategies, since a bad year could mean cutting back on discretionary spending rather than on necessities like rent or housing costs.

Based on Morningstar’s analysis, there were two approaches—both of which result in variability in income from year to year—that allow for higher withdrawal rates.

One is an iteration of the minimum distributions that the Internal Revenue Service requires at age 72 from tax-advantaged accounts like individual retirement accounts and 401(k) plans. Assuming a 21-year life expectancy at the beginning of the withdrawal period, Morningstar found this translated to an average 4.76% starting safe withdrawal—or 3% if all the money was in cash and as much as 6.6% if everything was in stocks. The reason: It factors in both portfolio value and life expectancy, which means that it’s impossible to run out of money—though it also means less left at the end for heirs.

Another popular approach that can lead to a higher rate was popularized by financial planner Jonathan Guyton. It essentially gives retirees a “raise” when their portfolio has done well and calls for them to pull back when it has taken a hit. If the starting withdrawal rate was 4% of $1 million, or $40,000, and the portfolio increased to $1.4 million in the second year, the retiree could take $40,000 plus an inflation adjustment—let’s assume the average annual rate of 3%—for a total of $41,200.

That amount—$41,200—is just 2.9% of the enlarged portfolio. Since it’s less than the starting 4% withdrawal, the retiree gets a 10% raise over what she would have typically collected, pocketing $45,320. If the market took a hit, she would take a 10% cut. For example, if in the second year of retirement that $1 million portfolio shrank to $700,000, the retiree would reduce the inflation-adjusted $41,200 she would have normally pulled in the second year by 10%, taking out $37,080. As someone gets further into retirement, they can start reducing the haircut, since the biggest risk is getting hit by a market downturn early on.

The other factor that retirees need to focus on now is asset allocation. If the prior rule of thumb was 100 minus your age for stock allocations—so a 70-year-old has 30% in stocks—Blanchett says the better calculation today may be subtracting one’s age from 120. Now that 70-year-old has about half of her assets in stocks.

Advisors are also reassessing bonds. Whereas roughly half of a bond allocation in the past may have been parked in municipal bonds or core fixed income, Beacon Pointe’s Yulli is taking some of that allocation and putting it into private credit or direct real estate investments in multifamily housing, medical offices, or industrial warehouses that should hold up decently if the economy slows and better withstand inflationary pressures and higher rates than bonds. Traditional core fixed income is now down to just about a third of the bond allocation, rather than half, with short-term bonds and Treasury inflation-protected securities rounding out the nonstock portfolio as a hedge against higher rates.

The more flexible approaches work better for those with substantial nest eggs, since reductions in withdrawal rates may mean less discretionary spending but won’t hurt their ability to fund necessities. Those who retired from careers that paid bonuses or were dependent on commissions may be more comfortable with the variability that comes with a dynamic withdrawal. This approach also works best for people not looking to leave large bequests. Those who can stomach the flexibility and want to leave money to their heirs can carve out the bequest and use the withdrawal approach on the rest.

Life comes with twists and turns. Retirement is no different—and flexibility creates resilience.

Write to Reshma Kapadia at [email protected]

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