Forget the 4% rule? Why retirees need a new 'safe' withdrawal rate

A new Morningstar report found that the safe starting withdrawal rate for retirees from a balanced portfolio has risen in the past year and investigates a variety of withdrawal strategies to determine how well various approaches serve retirees.

The research, which is contained in Morningstar’s “The State of Retirement Income: 2022,” determined that a starting withdrawal rate of 3.8% is safe for a balanced portfolio using an approach of fixed real withdrawals – up from 3.3% in 2021’s report. The rate is based on a 90% likelihood of not running out of funds and a 30-year time horizon.

According to Morningstar, higher bond- and equity-return expectations than last year helped to create upward pressure on starting safe withdrawal rates while inflation countered with downward pressure. Morningstar’s model used a 2.21% average annualized inflation assumption over a 30-year period in its 2021 research, but that figure climbed to 2.84% for the 2022 report.

Morningstar used higher return assumptions for this year’s study than in 2021, citing lowered equity valuations and increased bond yields from the broad-market selloff seen in 2022.

“Thanks to the higher return assumptions, the projected safe withdrawal rates are meaningfully closer to the oft-cited 4% rule of thumb for retirement withdrawals than was the case in our 2021 research,” according to the study.

Still, keeping starting withdrawals below 4% could be “unwelcome” to retirees in the face of the reduced values of their portfolios, according to the report’s authors. With that in mind, Morningstar also considered five alternative withdrawal strategies with more flexible approaches than the fixed withdrawal system that is the report’s “base case.” In these scenarios, retirees would vary their withdrawal amounts each year to take advantage of the financial conditions of the moment, particularly taking lower withdrawals in weaker market environments and higher ones in very strong environments.

Related: The 4% rule is dead: Morningstar study

“Flexible strategies are effective because they help to prevent retirees from overspending in periods of portfolio/market weakness, while giving them a raise in strong portfolio/market environments,” according to the report. “Adjusting withdrawal rates based on portfolio performance can also help ensure that retirees consume their portfolios efficiently. For retirees with no interest in leaving a legacy, for example, but who instead aim to maximize consumption during their own lifetimes, flexible strategies provide opportunities for spending increases when market performance is strong.”

Trade-offs associated with withdrawal adjustments include potential swings in standards of living that some retirees may prefer to avoid, according to Morningstar.

“The fixed real withdrawal system that serves as this paper’s base case nicely addresses a retiree’s desire to have stable portfolio cash flows, much like a paycheck in retirement,” Morningstar’s report noted. “But taking fixed real withdrawals is inefficient because it fails to link consumption to portfolio values. If the starting withdrawal is too low and the portfolio outperforms expectations, the retiree will leave behind a large sum, which may not be a goal. If, on the other hand, the initial withdrawal is too high, the retiree will consume too much too early and risk running out prematurely and/or having to engage in dramatic belt-tightening later in life.”

5 widely-used withdrawal strategies

Morningstar picked five widely used flexible strategies to consider as alternatives. One method was forgoing inflation adjustments following years in which the portfolio declines in value. Method two involved sticking to required minimum distributions. The third method is known as “guardrails,” and it incorporates variability based on market performance with an upper boundary on how much is distributed in good markets and a lower boundary for down markets. The fourth method calls for 10% reductions in distributions following annual portfolio losses. The fifth method – the “inflation haircut” approach – involves a fixed real withdrawal system with inflation adjustments that are one percentage point less than the actual inflation rate.

Guardrails had the highest starting withdrawal rate across all portfolio distributions studied – from 0% to 100% equity, peaking at 5.5% for 70% and 80% equity portfolios. Similarly, the required minimum distribution method had the highest lifetime withdrawal rate across each portfolio distribution, reaching a maximum of 8.1% in a 100% equity portfolio. However, Morningstar’s report points out that both guardrails and required minimum distribution come with higher deviations of withdrawal rates than the other methods, leading to the kind of unpredictability many retirees avoid, the report says. Meanwhile, the method that calls for forgoing inflation adjustments for withdrawals after portfolio losses and the method that relies on 10% reductions in withdrawals in years that follow annual portfolio losses lead to much less volatility in year-to-year spending changes, according to the report.

In conclusion, the report authors conclude that the guardrails system “does the best job of enlarging payouts in a safe and livable way.” Meanwhile, a fixed withdrawal system that reduces spending after a losing year, either by forgoing inflation or cutting spending by 10%, offers a simple, straightforward approach that produces higher lifetime withdrawals than a fixed real withdrawal method without adding significant cash flow volatility.