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Is 3.3% the New 4.0%?

Recent Morningstar research shows that the 4% standard for in-retirement withdrawals may be a bit too aggressive.

Christine Benz 23 November, 2021 | 5:58AM Susan Dziubinski
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Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. The 4% guideline has been used as a baseline for setting in-retirement withdrawal amounts. But is it too aggressive? Joining me today to discuss some new research on the topic is Christine Benz. Christine is director of personal finance and retirement planning for Morningstar.

Hi, Christine. Nice to see you today.

Christine Benz: Hi, Susan. Great to see you.

Dziubinski: Let's start out by talking a little bit about this 4% guideline. What are the assumptions behind that?

Benz: One of the key ones is that it assumes you take out 4% of your balance in year one of retirement, and then you are inflation-adjusting that dollar amount thereafter, I think sometimes people hear 4%, and they think it means that we're saying to take 4% out in perpetuity. In reality it assumes that you want a somewhat stable standard of living in retirement. So, you're taking out that initial amount, and then inflation-adjusting that dollar amount thereafter. There are also some conservative assumptions around time horizons. It assumes 25- to 30-year time horizon. It also assumes a balanced portfolio, so you need to have fairly significant equity exposure. But this is the general strategy that has been stress-tested over a lot of market environments. I still think it's a decent starting point when looking at your nest egg and determining whether you have enough to retire. It's an OK starting point. But our research pointed to, for people who want to be conservative, that they may want to be a little bit more careful if they're using a 4%-style withdrawal system.

Dziubinski: Your team did some new research that looked at forward-looking return estimates when figuring out if this 4% withdrawal rate is really the best place to start. Where did you get those return estimates? And what did they say?

Benz: We turned to our colleagues at Morningstar Investment Management, they do capital markets assumptions for various asset classes over various time periods. We looked at their 30-year forward-looking projections. With U.S. equities, the range was anywhere from roughly 10% for small-cap value stocks to roughly 6% for U.S. large-cap growth. For bonds, the return assumptions were lower, so in the neighborhood of 2% to 4% over the next 30 years for fixed-income investments. And then in terms of an inflation rate, we used a 2.2% inflation rate, we are all seeing higher inflation right now. And inflation indeed might be higher over the next 30 years. But we used a fairly low 2.2% inflation rate to help simulate what a withdrawal rate might look like going forward, what would be safe for people just embarking on retirement.

Dziubinski: Using these forward looking return assumptions and inflation assumptions, you found that 4% might be a little aggressive. But there are some caveats to that.

Benz: Right. We settled on a 3.3% starting withdrawal rate. So, for people with 50% equity exposure, 50% fixed income exposure, and a 30-year time horizon who want a 90% degree of certainty of not running out of funds over their retirement time horizon and want that fixed real withdrawal system, we settled on 3.3% as a safe starting point. But one key thing that we explored in the paper was if retirees are willing to be a little bit flexible in terms of some of these assumptions, how they can lift that withdrawal rate quite substantially. We wouldn't want people to walk away from this and feel that they're hopeless or be worried about taking a withdrawal rate higher than 3.3%. If they're willing to, I would say fiddle with the levers a little bit, they're able to lift the withdrawal rate. So, for example, if they're willing to settle for a lower degree of certainty in the 80% range, they can get closer to 4%. Or if they're willing to be variable in their withdrawals. If they're willing to tether their withdrawals to whatever's going on in their portfolio and in the market, that's another great way to lift lifetime withdrawals.

We spent a lot of time in the paper looking at some of the variable systems. We settled on a few systems as being attractive for retirees who want to try to lift their lifetime withdrawals. One easy one is to simply forgo an inflation adjustment after a year in which your portfolio has had losses. That showed some aptitude to lift lifetime withdrawals. And then another potential strategy that someone could use is what's called the guardrail strategy. This was developed by financial planner Jonathan Guyton and William Klinger, who's a computer scientist. It's a more complicated set of rules regarding withdrawals, but it very much aligns the retiree's withdrawals with what's going on in the portfolio, and therefore it maximizes lifetime withdrawals. So, my overall point would be that retirees have some tools in their tool kits to help enlarge lifetime withdrawals.

Dziubinski: And then for pre-retirees today, before they start thinking about withdrawal-rate considerations, you think there are a couple things that they really need to consider before that. What are they?

Benz: I do. One is to think about the timing of retirement. So, if you're able to delay retirement by even 18 months or a couple of years, that can be really impactful in terms of enlarging your lifetime withdrawals. I would also take close stock of how you expect to spend in retirement and think about how your spending might change in retirement, you might say not at all, I expect to just keep doing what I'm doing. But many people do make some tweaks to their spending as they embark on retirement. I would go forward and create a budget where you actually get quite granular--in year one of retirement my spending will look like this, in year seven I think we'll need to buy a new car--I'd get quite specific in terms of forecasting spending. And then, finally, being really thoughtful about your nonportfolio sources of cash flow is a great way to improve the health of your overall plan. So, if you can look hard at Social Security-claiming strategies try to calibrate the optimal time to claim Social Security so as to maximize your lifetime benefit. If you're lucky enough to have a pension, being thoughtful about what sort of pension benefits you claim.

And also thinking about whether some sort of an annuity might make sense as a portion of your plan. I know that a lot of retirees' hackles immediately go up when they hear annuity, and here I'm talking about a very basic-vanilla annuity type with very low costs. But if you have a product such as that, and you can align it with what you expect your basic living expenses to be, if you can align those nonportfolio sources of income with your basic spending, that's a great way to alleviate the demands on your portfolio. I think you'll have to worry less about withdrawal rates because you've thought about these other nonportfolio elements first and foremost.

Dziubinski: Well, Christine, thank you for your time today. This is exciting new research for Morningstar. And what's great about it too is no one has to be locked into any particular rate. It's great to know that you have these levers that you can think about and perhaps play around with that'll give you what you need in retirement.

Benz: Thanks so much, Susan. It's great to see you.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thanks for tuning in.

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About Author

Christine Benz

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz.

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