How to Set Your Retirement Withdrawal Rate
Why calculating your spending rate isn't a one-and-done project.
Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Baby boomers are retiring in droves. But many of them are no doubt wondering about how much they can safely spend in retirement. Joining me today to discuss the topic is Christine Benz. Christine is Morningstar's director of personal finance and retirement planning.
Nice to see you, Christine. Thanks for being here.
Christine Benz: Hi, Susan. It's great to see you.
Dziubinski: Christine, you say that it may be counterintuitive, but the starting point to actually figuring out what your portfolio withdrawal rate should be actually doesn't start with withdrawal rates or even your portfolio. Let's delve into that.
Benz: That's right. The name of the game is to see if you can reduce the demands you'll be placing on your portfolio in retirement. So, you want to start by looking at what you expect your expenses will be like in retirement and how they might change over your retirement years. And then you want to take a look at all of the nonportfolio sources of income that you might be able to draw upon. So, for a lot of people, that's Social Security; for some people, that's a pension; some people may have some sort of an annuity that is providing them with ongoing cash flows or rental properties or even working income. So, you want to tally up all of those nonportfolio sources of income. And ideally, you can find some sort of a match between your nondiscretionary expenses, your fixed expenses, and nonportfolio sources. And then that will give you a lot more wiggle room and ability to be flexible when it comes to your actual portfolio withdrawals.
Dziubinski: What's the next step in the process?
Benz: The next step is to look at the amount that you will need to spend from your portfolio, and you want to take a look at whether that is sustainable over your time horizon. So, a lot of people may be familiar with what's called "the 4% guideline." That means that your year-one withdrawal is 4% or less of your total portfolio balance in the first year of retirement. We recently did some research at Morningstar where we actually looked at whether starting withdrawals--because the near-term market environment is likely to be constrained--we looked at whether starting withdrawals should in fact be lower. And we concluded that for people with balanced portfolios and a 30-year time horizon who want to have a 90% certainty of not running out of money, we argued that they should set their withdrawal rate even lower at 3.3%.
Dziubinski: Let's talk a little bit about time horizon and what role that plays here--for people who think that they might live longer than 30 years and have that long of a retirement versus those investors who maybe don't expect to have a retirement that would span as long as three decades.
Benz: Yeah, it's such an important dimension of this, Susan. So, I would say for young retirees, so for people who think that they might be retired for 40 years, for example, they'd want to set the bar even lower. So, we did look at different time horizons within our research. We concluded that people who have, say, a 40-year time horizon should actually target less than 3%, so in the realm of the high 2% initially in retirement. On the other hand, people who have shorter time horizons, so maybe you are someone who's 75, and you're just now thinking about "what is a sustainable withdrawal rate," well, we found that people with shorter time horizon, shorter life expectancies can take more. And it's all quite intuitive, but we found that people who have a 20-year time horizon could take close to 5% initially.
Dziubinski: Now, one logical response to this might be that, "OK, well, what if I increase my equity exposure given that stocks have historically outperformed bonds over very long periods of time?" Would that give an investor any lift in their portfolio withdrawal rate if they would in fact steer a little bit more toward equities?
Benz: It sure seems like it ought to, because we have historically seen equities have much higher returns than bonds. The problem is is that a person with a really equity-heavy portfolio does face higher sequence-of-return risk. And so, the risk is that someone embarks on retirement with a very heavy equity allocation and then encounters a bad equity market right out of the box. That's sort of the worst-case scenario. So, while increasing equity allocations does have the potential to enlarge lifetime withdrawals, it also introduces more uncertainty than most retirees would find desirable. So, unfortunately, jacking up equity exposure really isn't a panacea.
Dziubinski: Christine, this 3.3% number that you cited relates to a system of fixed real withdrawals. So, what does that mean? And are there other alternatives that investors can be thinking about that might allow them to pursue a higher withdrawal rate in retirement?
Benz: You're right, it's a very specific system of thinking about in-retirement withdrawals. It basically means that someone is seeking a high level of certainty in terms of his or her cash flows in retirement. So, to use that 3.3% number, let's say someone has a $1 million portfolio, that would mean that they could take $33,000 of that portfolio in year one, and then they would just inflation-adjust that dollar amount every year thereafter. In reality, we know that a lot of retirees don't necessarily spend that way. We know that spending is often pretty variable in retiree households. And we also know that oftentimes it does tend to trend down a little bit in the middle years and even into the later years of retirement, and then it may elevate a little bit in the very late years of retirement for uninsured healthcare expenses.
So, for someone who does not need a certain cash flow, I would say that they absolutely ought to experiment with some of the more flexible systems. And the beauty of having a more flexible withdrawal system in retirement is that you're able to tether your withdrawals to what's actually going on in your portfolio. So, in a bad equity environment, you would take less; in a better environment, in a year like 2020 or 2021, when the market is really good, you can give yourself a raise. So, for people who are willing to be flexible, we found that starting withdrawals could be higher and lifetime withdrawals were also higher. So, it's something to explore, certainly.
Dziubinski: Of the flexible strategies that a retiree might consider pursuing, are there are certain strategies that you prefer over others for most investors?
Benz: There are a range of these flexible strategies. People can read the details in our paper. One really simple tweak to that fixed real withdrawal strategy would simply be to forgo inflation adjustments in years after your portfolio has had a losing year. So, that's a simple adjustment. My view is that it's a pretty livable adjustment that does elevate the starting withdrawal amount that would be sustainable and also helps lift lifetime withdrawals a little bit. Another strategy that we explored was pioneered by financial planner Jonathan Guyton and William J. Klinger, who's a computer scientist. That strategy is a little bit more complex, but that is a strategy that--because it does require the retiree to make ongoing course corrections--it's really quite efficient. It leads the retiree to consume his or her portfolio during the lifetime. And for retirees who do have that desire to kind of maximize their quality of life during retirement, that's a strategy that I would urge people to explore. It's called the "guardrail strategy."
Dziubinski: And then, lastly, Christine, how often should retirees revisit their withdrawal strategies, their withdrawal rates?
Benz: I don't think you need to overdo it. I think doing a good once annual check-in should be plenty. And as a part of that check-in, you can do an overall portfolio checkup. So, you can check your cash balance to make sure that you have enough reserves on hand for the next couple of years. You can do a little bit of tax management. If you're someone who is subject to RMDs, check out whether you're meeting your RMDs and spend some time on portfolio maintenance. But I think a good once annual review is plenty for this.
Dziubinski: Christine, thank you for your time today to discuss this important topic, because none of us wants to run out of money in retirement.
Benz: That's right, Susan. Thank you so much.
Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.