Many experts recommend that people withdraw 4% from their retirement portfolio each year in order to make their retirement savings last. This much touted advice, however, may not hold true for today’s retirees. While personal finance experts have relied on the 4% rule for years, a recent Morningstar report predicted that future retirees might have a higher chance of making their retirement savings last if they use a lower withdrawal rate.
Financial planner William Bengen first developed the 4% rule in 1994 by using historical returns of the stock market and a 30-year retirement horizon. The 4% rule dictates that people should withdraw 4% of their retirement portfolios in the first year, only adjusting for inflation each subsequent year. By using a portfolio of 50% stocks and 50% bonds, Bengen found that people with a 4% withdrawal rate had a 90% chance of success (which meant not running out of money during retirement).
Yet today’s retiree’s are facing an entirely different financial market.
While current retirees have experienced higher than expected stock market and bond returns over the past 30 years, researchers at Morningstar predict that future retirees might find themselves facing lower returns on bonds and stocks after the market’s recent stellar performance.
This could mean a future decline in the value of people’s retirement portfolios. The report recommends that retirees consider a lower withdrawal rate of 3.3% to ensure they don’t run out of money in retirement.
Though researchers suggest a lower withdrawal rate with adjustments for inflation, retirees might also consider trying a more dynamic withdrawal approach. The guardrail approach is one such method. Below, Select explains what the guardrails approach is and how it works.
What is the guardrails approach to retirement?
The guardrails approach, which was developed by financial planner Jonathan Guyton and professor William Klinger, requires that retirees change their withdrawal rate based on the performance of the market. This approach is designed to account for changes in the value of your portfolio. Your withdrawal rate will fall when the market is doing poorly or increase when it is doing well.
With the guardrails approach, people set a high guardrail and a low guardrail based on their target withdrawal rate. Therefore, when your withdrawal rate is above or below guardrails, you reduce or increase your withdrawal amount so you end up within the target withdrawal range.
“And if you think about driving your car down a road, you hit a guardrail, it does two things. It puts a ding in your car, and it changes your momentum so that instead of the momentum pushing you toward the edge of the road, it now starts to shift you back toward the middle where it’s safe,” said Guyton in a Morningstar interview.
Your guardrails are set at 20% above and below your withdrawal rate. For a target withdrawal rate of 5%, the lower guardrail is 4% and the upper guardrail is 6%. The target withdrawal range would be between 4 and 6%.
If your withdrawal rate falls outside your guardrails (after adjusting for inflation) you would take a 10% increase or reduction in your withdrawal amount. After taking the 10% adjustment, your withdrawal rate should be between the upper and lower guardrails. For example, if your retirement withdrawal rate is above 6% next year, you take the inflation-adjusted withdrawal amount and reduce it by 10% so your withdrawal rate is below 6%.
Consider what would happen in a market downturn:
- Year 1: If your portfolio is worth $1 million and your withdrawal rate is 5%, you withdraw $50,000.
- Year 2: The value of your portfolio decreases to $800,000 and your normal withdrawal of $50,000, with an adjustment for inflation, would be more than 6% of your portfolio. This means you’ve hit a guardrail. You would then take the inflation-adjusted withdrawal amount (assuming 4% inflation) of $52,000 and reduce it by 10% so you would withdraw $46,800 which would be less than 6% of your portfolio.
It’s important to note that the guardrails approach does not require that retirees cut their spending by 10% in a market downturn. Retirees often have different sources of income, such as a 401(k) or a traditional IRA. With a pre-tax retirement account like a traditional IRA and a 401(k), you do not pay taxes on your upfront contributions, but you pay taxes on the money when you withdraw it in retirement.
If you had to decrease your withdrawal amount by 10%, part of that reduction could come from the reduced amount of income tax you owe on your retirement withdrawals.
When coming up with your retirement strategy it could be prudent to consult a financial planner to help find the optimal withdrawal rate and come up with what your guardrails would be.
Saving for retirement
You’ll need to start building a retirement nest egg when you’re young in order to have savings to draw upon in retirement. First off, you should focus on maximizing your 401(k) match. Some employers offer employees matching 401(k) contributions, typically between 2 and 4% of each paycheck. Your 401(k) contributions are made pre-tax and are automatically deducted from your paycheck.
After you’ve earned your 401(k) match, you might also consider opening an individual retirement account (IRA). With an individual retirement account, you’ll have more choice in how you invest your money. An individual retirement account will typically give you the option of investing in individual stocks, bonds, mutual funds and CDs.
The two most popular retirement accounts are the Roth IRA and the traditional IRA. The major difference between a Roth IRA and a traditional IRA is how the accounts are taxed.
Contributions to a Roth IRA are taxed upfront, so the contributions can grow and be withdrawn tax-free. Contributions to a traditional IRA are not taxed until withdrawal. Roth IRAs have an income limit. In 2022 individuals making more than $144,000 and married couples filing jointly making more than $214,000 are not eligible to contribute to a Roth.
There are no income limits for traditional IRAs. Contributions to a traditional IRA are tax deductible (which means your contribution reduces your taxable income, and therefore the amount you owe in taxes) depending on your income and whether you have a retirement plan through work.
When Select analyzed over 20 different Roth IRA accounts, it found that Charles Schwab, Fidelity Investments, Ally Invest, Betterment and Wealthfront offered some of the best Roth IRAs. Select looked at which accounts had no (or a low) minimum deposit, commission-free trading of stocks and ETFs and the variety of investment options offered to find the best Roth IRAs.
Bottom line
While the 4% rule has been the preferred withdrawal retirement strategy for many years, it might be time to consider an approach that addresses the impact that market volatility can have on people’s retirement strategies. The guardrails approach is meant to do that.
By setting your guardrails 20% above and below your target withdrawal rate, you can increase or reduce your retirement withdrawal any time you find yourself spending outside of the range set by your guardrails. Though this withdrawal strategy requires more thought and effort than the 4% rule, it could make your retirement savings last longer.
