In 1994, a financial planner named William Bengen published an article that would take the retirement planning industry by storm. The paper had a simple yet powerful idea — using average returns and inflation in retirement planning can mislead retirees with disastrous results. Instead, use the ups and downs of actual, historical data.
The conclusion Bengen reached was that for a 30-year retirement, retirees could take an initial withdrawal of about 4% of their savings. Each year thereafter, they could adjust the amount by the rate of inflation. Based on historical data, he concluded that this approach would survive any 30-year retirement since 1926. Subsequent research has confirmed these results dating back to just after the Civil War.
And the 4% Rule was born. Today, it’s used by those in the FIRE movement —Financial Independence, Retire Early — to calculate when they can retire. It’s debated among financial planners, with some claiming that the rule overstates or understates how much a retiree can spend. And countless academic papers have evaluated the rule from every conceivable angle.
What many don’t know, however, is that the 4% Rule is just one of many retirement withdrawal strategies. I would go a step further and say there are better options for many retirees. Here are five alternatives to the 4% Rule worth considering.
1. Spending Guardrails
One little known shortcoming of the 4% Rule is it usually leaves retirees with more money at death than when they retired. In some cases, retirees have six times their starting amount after 30 years. Why? Because the 4% Rule is derived from the absolute worst time to retire based on historical data — 1966. Most of the time, the safe initial withdrawal rate is higher than 4%, sometimes much higher. One way to address this problem is with spending guardrails.
The idea is to set upper and lower limits to the amount one withdraws each year. For example, a retiree using a constant dollar approach (which is what the 4% Rule is) might start with a 5% initial withdrawal rate. If adjusted for inflation each year, historical analysis tells us this approach will fail about 20% of the time. To address this, one can set a lower guardrail of 4% and an upper guardrail of 6%.
Each year the retiree would adjust the prior year’s withdrawal by inflation. Before withdrawing the money, however, the person would calculate the percentage of the total portfolio the withdraw represents. If it amounts to more than the 6% upper guardrail, the retiree would reduce the amount to the upper limit. If it’s less than the lower guardrail of 4%, the person could increase the withdrawal to the lower guardrail.
Guardrails were popularized by Jonathan Guyton and William Klinger, who devised what is known as the Guyton-Klinger withdrawal strategy.
2. Bogleheads’ Variable Percentage Withdrawal Strategy
The 4% Rule is classified as a constant dollar approach due to the annual inflation adjustments. Spending remains the same throughout retirement on an after-inflation basis. In contrast, the Bogleheads Variable Percentage Withdrawal strategy does not adjust spending by inflation. Instead, it uses several factors to determine the withdrawal percentage for each year of retirement:
- Age
- Asset Allocation
- Portfolio Balance
The retiree uses a chart prepared by the author of this strategy, which can be found here. This withdrawal strategy has several pros and cons.
On the plus side, it’s nearly impossible to run out of money. That’s due in part because the strategy is based on market returns. It also takes into account a retiree’s asset allocation to fine-tune the withdrawal amounts. Finally, it enables retirees to start with a higher initial withdrawal rate.
On the downside, the approach can result in volatile spending following big swings in the market. If one were to retire into a bear market with high inflation, spending on an inflation-adjusted basis could go down significantly. Finally, it can result in retirees having more spending money later in retirement when they are less likely to spend it. Of course, that’s often the case with the 4% Rule as well.
3. Yale Spending Rule
Similar to retirees, an endowment must address the competing goals of providing current income to the institution while growing the endowment fund, or at least not decreasing it on an inflation-adjusted basis. This can be difficult when the market is down or inflation spikes.
To address both of these goals, Yale and other institutions have implemented a unique spending policy. At a high level, each year, the distributions from the endowment are calculated as follows:
- 70% of the amount of the total distributions from the previous year, adjusted for inflation;
- 30% of the average of the funds balance over the past three years, multiplied by a set spending rate (typically around 5%).
Note that the result is a combination of the constant dollar approach followed by the 4% Rule and a variable spending rule using market values. A retiree could change the 70/30 split above to either increase or decrease the effects inflation or the market have on spending.
This approach is also called the Tobin Spending Rule after James Tobin, recipient of the 1981 Nobel Prize in Economics. MIT followed this approach at one time.
4. The Dividend Spending Rule
While many retirees would be happy to avoid running out of money, some think more of intergenerational wealth. Here they want to know how much they can spend in their lives while leaving wealth behind for the next generation. The Yale Spending Rule might be suitable in some cases. Another approach was developed by James Garland.
Garland served as president of The Jeffrey Company from 1995 to September 2012. The Jeffrey Company dates back to 1876 when it developed a machine to mine underground coal. Eventually, the company sold its operations, and today it operates as investment manager for the benefit of descendants of the company’s original owner.
Garland’s research found the company could distribute 130% of its investments’ dividends while preserving sufficient assets to provide similar income, adjusted for inflation, to future generations. You can find his research here.
5. Spend Safely In Retirement Strategy
The final strategy is my personal favorite, and the one I believe is well-suited for many retirees. I’ve published an article on the strategy and a YouTube video. The strategy has two simple components:
- Wait to claim Social Security until you are age 70 (the lower-earning spouse for couples may claim sooner); and
- Calculate annual spending from savings based on the same formula used to determine Required Minimum Distributions.
The result is a strategy that’s very easy to apply. It partially accounts for inflation based on the Social Security benefits. It also adapts to market conditions thanks to the RMD component.
Conclusion
No withdrawal strategy is perfect. Retirees need to understand the tradeoffs of any strategy and their ability to adapt to changing economic and personal conditions. While the 4% Rule is a reasonable approach to retirement planning, one of these other approaches may prove more realistic when one actually retires.
Read the full article here