The 4% rule is dead: Morningstar study

The withdrawal rate debate — that is, what is the best percentage to pull from retirement savings each year — has been heating up, especially as interest rates have been near zero. Although the 4% rule, first noted by Bill Bengen in 1994, has been a standard recommendation, that number has come under more scrutiny of late.

Bengen used a 30-year time horizon, starting in 1926, to demonstrate why the 4% rule worked. He assumed a portfolio holding 50% stocks and 50% fixed income securities.

Using those same assumptions, three Morningstar researchers found that the 4% rule may “no longer be feasible.” Christine Benz, director of personal finance and retirement planning; Jeff Ptak, chief ratings officer; and John Rekenthaler, vice president and director of research, outline their reasoning in a recent paper, The State of Retirement Income: Safe Withdrawal Rates.

“Because of the confluence of low starting yields on bonds and equity valuations that are high relative to historical norms, retirees are unlikely to receive returns that match those in the past. Using forward-looking estimates for investment performance and inflation, Morningstar estimates that the standard rule of thumb should be lowered to 3.3% from 4%,” they state in the paper.

That said, “this should not be interpreted as recommending a withdrawal rate of 3.3%,” they say, adding that their conventions underlying their calculation were “conservative.”

In the study, they presumed:

• A time horizon that exceeds most retirees’ expected life spans.
• Fully adjusting all withdrawals for the effect of inflation.
• A fixed withdrawal schedule that does not react to changes in investment markets,
• A high projected success rate for the plan (90%).

The paper demonstrates that “by adjusting one or more of those levers, current retirees can safely withdraw a significantly higher amount that the 3.3% initial projection might suggest.”

A caveat, of course: “Many of today’s retirees will have to be more resourceful to support their income needs.”

Portfolio strategies

Some portfolio strategies that retirees can employ to expand portfolio payouts include relaxing these assumptions and adopting a more flexible spending approach, the paper states.

Retirees can safely “sustain higher withdrawals, with a 4.5% starting real withdrawal rate achievable under some scenarios,” the authors write.

Strategies that improve the ability for higher withdrawal rates include the following:

• Equity-heavy allocations, which tend to support higher lifetime withdrawal rates under flexible spending methods.
• A 50% stocks/50% bonds portfolio, which consistently outperforms one that is all fixed income when tested on a rolling 30-year time period.

Nonportfolio strategies

Of course, there are “nonportfolio” strategies to maximize retirement income, the paper states. These include the following:

Delay retirement. “The simplest way to achieve a higher withdrawal rate is to work longer and retire later,” the authors state.

This reduces the time horizon of retirement and allows the retiree to increase the size of their portfolio and have a longer compounding period.

Calibrate/reduce expenses. Several factors influence how much a retiree needs to withdraw.

One is level of wealth: While 75%-80% is “considered a reasonable rule of thumb for income replacement,” wealthier retirees may need to replace a smaller share of income, according to the paper.

Spending habits also change throughout retirement, Morningstar says: Early in retirement, spending is higher, while it slows in the middle of retirement and rises again toward the end, largely due to health care needs. That said, this pattern differs for each retiree.

Health care and long-term care coverage. The authors state that as spending tends to rise in later retirement due to health care needs, it actually “provides more of an opportunity to tailor withdrawals to a retiree’s situation.”

That means that those with “ironclad healthcare and long-term-care plans” that cover out-of-pocket spending wouldn’t need to spend more later in life.

Retirees self-funding these needs should have on average two years’ worth of long-term care spending set aside.

Maximize Social Security. Delaying Social Security “provides a lifetime stream of income that is unaffected by market conditions,” the authors state.

Maximize pension payments. Pensions for those who receive them can be taken as an annuity or as a lump sum.

Key to the annuity-like payment is health of the pension. For those with well-funded pensions, longevity is on their side.

Annuitize. Several annuity types are available, including deferred annuities, which begin later in retirement, and immediate income annuities, which begin the income stream right away.

The various annuity types may help retirees determine their withdrawal rates as well.

Nonportfolio cash flow sources. These may include property rentals or royalties or even reverse mortgages. Retirement expert Wade Pfau calls these “buffer assets,” the authors write, as “they are most advantageous in periods when pulling from a portfolio is a bad idea because the holdings are depressed.”

Determining withdrawal rate

The paper concludes with steps for determining withdrawal rates. These are:

1. Set a retirement date. This helps determine a withdrawal rate percentage.
2. Calculate in-retirement cash flow needs.
3. Assess cash flow from nonportfolio income sources to meet fixed expenses.
4. Calibrate withdrawal percentage and system. “If that amount is at the high end of the safe withdrawal rates … (the mid-3% range for a balanced portfolio), that argues for a flexible approach to withdrawals,” the authors state. However, if it is 3.5% or lower, “a fixed real withdrawal system is more defensive.”
5. Identify withdrawal sequence (account type) and system for sourcing. Establish a framework for withdrawals taking into account the retiree’s variation in annual spending and anticipated tax picture on a year-to-year basis through retirement, the paper states. Typically, take required minimum distributions from tax-deferred accounts, then taxable withdrawals followed by tax-deferred withdrawals.
6. Allocate assets appropriately given the amount and source of spending.