Managing withdrawal rates in retirement is like mastering a high-risk balancing act: on one hand, if you spend too much too quickly, you will run out of money – not good! However, if you’re too conservative in your withdrawal strategy, much of the work you did and sacrifices you made to prepare for your ideal retirement will have been for naught. So, the $64,000 question becomes: what is a safe withdrawal rate for my retirement?
HCM has developed a customized guardrail method where initial withdrawal rates are established based on all of your planning variables, reviewed annually, and adjusted either up or down based on updated statistical success rates of your individual planning scenarios. This process relies on more than simple inflation rates or asset allocation assumptions (utilized in the 4% Rule described below) that may no longer be appropriate for your situation. Instead, the HCM Guardrail process establishes a more flexible maximum withdrawal rate that adjusts as your financial goals change over time. When used in conjunction with HCM's Safety Net™, planned distributions are typically smooth and predictable. For example, if you start in year 1 with a hypothetical $1 million portfolio and a 95% plan success rate, you might choose to withdraw $50,000 from your retirement assets. Next year, based on updated planning for your family’s goals, current market conditions, inflation assumptions, etc., your planned withdrawal amount would be reviewed and updated to determine appropriate actions, if it makes sense to hold steady, increase withdrawals, or reduce distributions for a period.
Following the HCM approach allows clients to utilize the planning process to take advantage of the power of compounding by making small, nearly imperceptible adjustments to the plan over long periods of time. For example, an article put forward by financial researcher Derek Tharp posits that simply foregoing an inflation increase when market returns are negative can increase a safe withdrawal rate 5 times more than cutting spending by 20% for several years after a substantial market decline.
Popular Withdrawal Rate Calculation Methods
You are probably already thinking, I know, I know, “4%! Of course!” If you are, you’re not alone. The idea of the Safe Withdrawal Rate was coined by William Bengen, who in 1994 published the paper “Determining Withdrawal Rates Using Historical Data,” which showed that a retiree with assets split between stocks and bonds at 50%-50% to 75%-25%, taking a 4% withdrawal their first year of retirement and then increasing for inflation every year after that would have resulted in a 30 year portfolio longevity during the historical period he examined, even in the worst-case scenario, using market returns from 1926 to 1975.
As an example, let’s say you have $1 million saved for retirement, invested across equities and fixed income assets as Bengen specified. Your first year in retirement, you’d withdraw 4% * $1,000,000 = $40,000 to live on, along with Social Security and any pensions or other assets you may have. This income would need to cover all your living needs as well as any tax obligation on that income. The next year, if inflation increases by 3%, you’d withdraw $41,200 and so on throughout your retirement. By accounting for inflation in your withdrawal, you’re providing for yourself the same purchasing power as you had in year 1 of your retirement.
An interesting insight from the paper is the extreme sensitivity of portfolio longevity to the withdrawal rate. Moving just 1% in either direction causes a massive swing in the expected duration of the portfolio. With a 3% withdrawal rate, the portfolio could last another 15-20 years, allowing the retiree to live up to five decades in retirement. On the other hand, at 5% the portfolio’s longevity drops to less than 20 years. This means that, once established, the retiree should never increase withdrawals beyond the rate of inflation. There is no extra money for vacations or new cars if it can’t be taken out of the annual distribution.
Limitations of the Safe Withdrawal Rate Method
As with any theoretical model, there are caveats to consider. The assumptions are quite rigid: maintain the same asset allocation your entire retirement, as well as maintain the same income every year (save for inflation). The model assumes that the retiree’s portfolio is fully invested, with nothing in cash or cash equivalents. The rule assumes an average market performance of 10.3% stock return, a 5.2% bond return, and a 3% inflation rate. Based on the current elevated valuations in both stocks and bonds, it is unlikely that either asset class will achieve these levels of returns over the balance of this cycle. Finally, it’s built on the assumption that you’ll be retired for 30 years and no more.
Many of these assumptions may have been valid in 1994, but the world has changed considerably since then. For one, life expectancies have increased, with the average person living a full two years longer after reaching 65 in 2019 than they did in 1994. This greatly increases the odds of a retiree living past 30 years in retirement. Alternatively, many people are choosing to work during what were traditionally considered retirement years, increasing their income and allowing for greater potential withdrawals during retirement. Also, most retirees’ spending patterns aren’t constant across time. For example, spending is usually higher at the beginning of retirement when you’re travelling, getting used to your new life, and doing all the things you wanted to do but couldn’t find time for during for the last 40+ years. These are examples of the types of planning assumptions that the HCM approach is designed to consider.
Finally, there are the market performance assumptions; the stock return, as measured by the S&P 500, has slightly outperformed the 4% rule paper assumption: 10.44% since 1995. Similarly, inflation is slightly less than what Bengen assumed at 2.15% since 1995. However, while a 5.2% bond return tracks closely to history, that’s likely not going to be the case going forward. Since the COVID outbreak and subsequent economic impacts, interest rates have been forced to near zero, and the Fed Chairman has confirmed the Fed’s plans to keep them near zero until at least 2023. This means that interest from CD’s and bonds won’t be contributing very much to your retirement income, likely decreasing the safe 4% withdrawal rate to some lower amount for the foreseeable future.
Alternatives to the 4% Withdrawal Rate Method
As mentioned above, a drawback of the 4% is its rigidity. The model assumes you’ll take out the same income, adjusted for inflation, every year of your retirement, regardless of your family’s needs and what the economy and markets do. Most people don’t like to plan their retirements this way. Coupling this with the fact that the financial terrain has changed dramatically from when the 4% rule was discovered in the mid-90s, it seems like variable withdrawal strategies make a lot of sense. This, of course, is the foundation of the HCM Guardrail approach described above.
There are different ways to implement variable withdrawal rate methods, with the most prominent being decision rule methods. These methods start from a similar place as the 4% rule, but then adjust the withdrawal amount based on changing circumstances. One of the simpler decision rule methods, also coined by Bengen, is a fixed percentage withdrawal, where you always withdraw X% of your savings each year. With this method, it’s impossible to run out of money in retirement, as you’re always adjusting the total amount you’re spending to reflect your current nest-egg’s value. One negative by-product of this approach is that your income becomes much less predictable. The biggest problem with this purely computational method is the unnecessary pain it can inflict. If the market experiences a 30% bear, you would need to cut you spending immediately by the same amount until the market had recovered. This can be a tough pill to take if you were about to pay the final installment on next year’s cruise.
A possible solution is to apply a weighted average of both methods to achieve a mix of somewhat more reliable income and also ensuring that some amount of savings will last throughout retirement.
What’s the Right Withdrawal Rate?
As you may have guessed by now, we like the HCM Guardrail approach as it is flexible and can adapt to your family’s changing objectives. However, it does require regular updates. With the simpler rules-based approaches, there is no one-size-fits-all answer to this question. You need to find the best withdrawal rate for your family and your plans in retirement. This is going to be based on a number of factors:
- How long do you plan to be retired?
- How will you invest your portfolio?
- How confident do you want to be that your money will last?
There are a lot of tradeoffs to be made in retirement planning: some folks like a high risk/high reward strategy, while others prefer to play it more conservatively. Some people want to take every step possible to ensure they don’t outlive their savings, while others might be comfortable taking on more risk later in life if it means doing what they’ve always wanted to do now. When talking through your plan with one of our Wealth Advisors, we offer our wisdom and experience to help you select the path best suited for your individual journey.
| Mike Hengehold, CPA/PFS MST RICP®
Mike is the Founder and President of HCM Wealth Advisors. Over the last 30 years, he’s provided financial planning guidance to a myriad of families to help them realize their financial dreams. Mike is an avid homebrewer and animal lover, and when he’s not at work you can often find him on the golf course working on his short game.