The American Association of Individual Investors (AAII) Journal recently interviewed William P. Bengen for the article “Insights on Using the 4% Withdrawal Rule From Its Creator.”
Bengen is responsible for creating the 4% rule (now 4.5%) which suggests that at age 65 a retiree can withdraw 4% of their portfolio, adjust that dollar amount up by inflation each year, and have sufficient assets in their portfolio to last their lifetime.
Bengen’s original study suggested that a 4.2% withdrawal strategy would have lasted at least 30 years even in the worst historical markets. The “worst” historical market is of course retiring in October of 1968. A retiree at the end of 1968 has to survive not just the double digit inflation of the 1970s, but also the The Baby Bear Market of 1966, The Double Bottom Bear Market of 1970, The Golden Bear Market of 1973, and Volker’s Bear Market of 1982. Retiring at the end of 1968 is the most stressful retirement stress testing that can be done.
Bengen published his research in the article “Determining Withdrawal Rates Using Historical Data” in the October 1994 issue of the Journal of Financial Planning. His analysis suggested that 4% might be a little too conservative but that 5% was too aggressive a withdrawal rate.
Begen’s article was ground breaking in its concept but impractical for an advisor trying to counsel clients.
Not every client who wants to know how much they can safely withdraw from their portfolio is exactly age 65. What is the safe withdrawal rate for age 75? What about the client who wants to retire at age 50? What about the trust fund baby who is effectively retired the day they are born? The 4% rule does not help an advisor with these questions.
And even if your client sets a safe withdraw rate at exactly age 65, how do you adjust the withdraw rate when they are age 66 and the portfolio’s return have significantly changed the account value? Do you blindly move the withdraw rate up by inflation without any regard to what happened in the markets?
And how much of a portfolio should be in fixed income and how much of a portfolio should be in equities? Without a proper portfolio mix you may not have the best chance of achieving the appropriate returns to support such withdrawal rates.
In the 2018 AAII Journal article, Bengen explains that he increased the withdrawal rate from 4.2% to 4.5% because he changed his asset allocation. The article quotes Bengen:
Originally, I only worked with two asset classes. I used U.S. large-company stocks and U.S. intermediate-term government bonds. I then added small-cap stocks. The small-cap stocks added enough of a boost in terms of return to allow the withdrawal rate to be increased. It was originally around 4.2%, actually. Including small-cap stocks raised it a little bit to about 4.5%. This shows you the importance of having a diversified portfolio during retirement.
…Retirement investors should have a very well-diversified portfolio spread out among a number of asset classes. The small-cap stock is kind of like a proxy in my research to represent all the other asset classes that retirees would normally employ in building a portfolio.
The 4% rule was one of the most widely discussed rules early in my financial planning career. Determining what constituted a safe withdrawal rate was one of the first questions I tackled. After a year and a half of study on the question, I had realized the inadequacy of the 4% rule and found a methodology which provides more useful when advising clients.
In order to advise clients, you need a methodology to compute a safe withdrawal rate for any client at any age with any amount of money and also to recommend the portfolio mix that gives that withdrawal rate the best chance of success. Those are the issues where the 4% rule needed expansion.
In our 2008 article “Maximum Safe Withdrawal Rates in Retirement,” we first published our conclusions for how to compute a safe withdrawal rate for any age. Our conclusions that at age 65 the maximum safe withdrawal rate was 4.36% fit nicely with Bengen’s conclusion that 4% was too conservative but 5% was too aggressive. Our work also suggested that at age 65 the optimum mix for a portfolio with a 4.36% withdrawal would be 75% stocks and 25% bonds. This mix is also in line with research work on optimum portfolio allocations at various ages.
But our work went on to set maximum safe withdrawal rates for every age such as a 5.35% withdrawal rate at age 75 or a 7.66% rate at age 85. If a client wants to retire at age 50, the safe withdrawal rate is just 3.64%. Currently, we use our safe withdrawal rate formulas to compute a continuous safe withdrawal rate that very gradually changes every day.
Our work also found that the traditional 60%-stock and 40%-bond portfolio so commonly recommended by commission-based agents isn’t the best asset allocation until a client is over age 78.
Our work also suggests that a client portfolio should appreciate by at least 3% over inflation over long periods of time in order to stay on track. Currently, our safe withdrawal rates are based on a lifespan of 100 years, ending at age 101. However, they are adaptable should life expectancy continue to improve. If the day ever comes when people live forever, our approach suggests limiting your withdrawal rate to 3% to maintain a perpetual portfolio.
If a client chooses to have a more conservative portfolio than might be optimal, we can also adjust our expected minimum return and our safe withdrawal rates accordingly.
Our method is also adjustable to movements in the markets. No matter how a client’s portfolio does, our method will recompute a safe withdrawal rate in light of those market movements. Yes, when markets correct it will suggest a lower safe withdrawal rate. But this is what clients want, small adjustments in light of market movements rather than ultimate failure and running out of money. Most clients try to keep their lifestyles below the maximum anyway.
Finally, our work can be used to warn clients how long their resources will last if they are spending more than their safe withdrawal rate. If a client is spending 6.22% at age 65, we can warn them that they are heading to run out of money in just 21 years. They are spending money like an 80 year old with a withdrawal rate that ends at age 101.
We believe that our technique and methodology provides a more powerful method of computing safe withdrawal rates for actual clients. Annual safe withdrawal rate calculations is just one of the many services we provide our clients.
Photo by Bonnie Kittle on Unsplash