Financial Insights

New Year, New You, New Withdrawal Rate

Many people look forward to the fresh start a New Year can bring.  Some set resolutions focusing on eliminating bad habits like smoking, avoiding junk food, or reducing screen time.  Others aim for self-improvement, like eating healthier, going to the gym more often, or reading more books.  Some even contemplate significant lifestyle changes to turn the page after a difficult year or simply because they’re ready for a new challenge.  As we plan for the New Year and what we hope to achieve, we should also take some time to review our financial goals, which may involve setting a budget and spending rate for those living off their investment accounts.

For retirees or those new to retirement, uncertainty about how much they can spend from their investments can create anxiety, especially after a year where markets or economic factors like inflation had a negative impact.  This is when many clients ask about a safe portfolio withdrawal amount, hoping for a clear and confident answer.

Seeking solutions for calculating a safe portfolio withdrawal rate isn’t a new concept in the financial planning industry.  In the early 1990s, advisor William Bengen published a study in the U.S. Journal of Financial Planning that led to the “4% Rule”, which is a simple rule of thumb for estimating how long your investment portfolio might last.  He examined different withdrawal rates over potential starting retirement years (1926 – 1976) using historical returns for a portfolio of stocks and bonds.  With a 50% stock and 50% bond portfolio, he found that withdrawing 4% of your initial investment each year, adjusted for inflation, usually allowed the portfolio last at least 50 years.  The worst-case scenario was around 30 years (starting retirement in 1976).  If you increased the withdrawal rate to 5%, the chance of the portfolio being depleted over a shorter time period, even as little as 20 years, went up.  On the other hand, a withdrawal rate of 3.5% per year meant the portfolio always lasted at least 50 years.  This conservative approach helped to address Sequence of Return Risk, which is essentially bad timing where you need to take portfolio distributions in the initial/early years of retirement and the markets are down at the same time.

A few key planning variables aren’t considered when applying the 4% rule in real life:

The study aimed to test portfolio longevity, not considering how much money was left over in circumstances with very high success rates.  Multiple asset allocations beyond 50% equities / 50% fixed income were tested, and those with higher equity allocations provided similar success rates and more “wealth creation”.   In fact, a 75% allocation to stocks included a scenario where a plan ended with four times the initial starting amount.  It’s impractical to think someone would want to leave this much life on the table as time went on, and this surplus capital came into focus.

The 4% rule is inflexible, assuming that the same spending rate adjusted for inflation remains constant over the life of a plan. Life isn’t linear, so one-time additional expense needs, for both good (extra vacation or luxury purchase) or bad (extreme health event) reasons, were not accounted for.  In the scenario where a plan was set to quadruple the initial starting value of capital, why wouldn’t the spending rate increase?

The study also did not account for potential income tax obligations. The tax location of the portfolio matters, as income realized from tax-deferred retirement accounts and after-tax brokerage accounts can be subject to different tax rates.

So, does that mean that we should actually look at higher initial spending rates, especially for those of us willing to take on more equity risk? Maybe double the rule of thumb to withdraw an 8% rate like one financial planning pundit controversially claimed towards the end of last year?

The reality is that an 8% distribution rate could work in cases where someone has a very short time horizon and isn’t concerned about leaving a legacy to family or charity or where the markets are up significantly in the initial years of your retirement.  It most likely does not work for most people and where long-term average market rates of return apply, but financial planning has evolved over the last 30+ years to better address the issue of a safe withdrawal rate.

Morningstar, a financial services and investment research firm, updates their study on safe withdrawal rates annually.  It concluded this past November that, thanks to rising interest rates leading to stronger fixed income yields, 4% is the highest safe withdrawal rate again after lower withdrawal rates were projected over the two years prior.  The updated analysis also looked at more practical withdrawal strategies, including the concept of Dynamic Withdrawal Strategies, which involves adjusting how much you can withdraw each year.  In tough markets, you take out less and in strong markets you might be able to take out more.  This flexible approach usually allows for higher withdrawal rates over time.  It helps prevent over-withdrawing when the market is down and gives you a bit of a raise when it’s doing well.  Here are some examples of different types of dynamic withdrawal strategies based on timing:

Practically speaking, retirement spending tends to gradually decrease during retirement.  As you age in retirement, people tend to do less and therefore need less income until the later-stage years when there is an increase in spending for long-term care or other medical expenses. This pattern of gradually reducing expenses that then increase later looks like an actual “smile” when plotted on a chart. This strategy accounts for increased spending later in life but allows for a higher initial withdrawal rate.

There are multiple phases of retirement.  Spending patterns start off high at the onset of retirement, or the Go-Go Years, and then tend to decline as people slow down.  Assumed spending can be reduced in phases to account for the Slow-Go Years and then again towards the end of a plan, or sometimes referred to as the No-Go Years. This strategy supports the thought that life is not linear, and in reality, we’ll want to spend earlier when we are younger/healthier since we most likely won’t be able to be as active in the later stages of life.

The Guardrails method, created by financial planner Jonathan Guyton and computer scientist William Klinger between 2004-2006, allows retirement spending to fluctuate with market performance for the specified timeframe.  Each year, it adjusts withdrawals based on how well your investments are doing and the previous withdrawal percentage.  The goal is to give you raises when the market is doing well but also lower withdrawals after market losses, aiming for a balance. This method allows for higher initial withdrawal rates but adheres to strict rules to make it work.  Decision rules include when to adjust spending up to account for inflation and how to take distributions from your investments ( dividends and interest first) when markets dictate lowering your withdrawal percentage.  Planners are testing alternatives or variations to the Guardrails method due to concerns that large changes in withdrawal rates from year to year based on market performance (2022 vs. 2023) might be difficult for clients to adjust to.

As with most Rules of Thumb, the 4% withdrawal rule is a general principle that works for predicting a safe withdrawal rate based on average long-term market rates of return.  But when it comes to your retirement, you may not be comfortable with being mostly correct.

The best way to confirm your safe withdrawal rate is by working with your ACM Wealth Advisor.  Planning how to withdraw money in retirement can be tricky and there are multiple considerations depending on your particular circumstances.  These include how flexible you think you can be with your spending versus a preference for a steady income, whether you want to withdraw as much as possible versus any plans to leave a legacy for your heirs or anyone else, and how much of your regular living expenses are covered by sources aside from your investments, like social security, a pension, or other income sources.

As part of your annual review with ACM Wealth advisor, it’s imperative to review your withdrawal strategy and know what changes you can make to stay the course towards a successful retirement.

The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

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