The 4% guideline for retirement spending is a decent starting point when determining whether you have enough to retire. But it was developed for a worst-case scenario in the markets, and much of the time, the markets perform much better than that.
In this excerpt from my new book, How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement, I chatted with financial planner and retirement researcher Jonathan Guyton about how a dynamic spending system can help enlarge starting and lifetime withdrawals from a portfolio. Jonathan and computer scientist William Klinger developed the “guardrails” approach to retirement spending with an eye toward helping retirees enlarge their lifetime portfolio withdrawals while also putting guardrails around how high spending could go in strong markets and how much it would have to go down in bad ones.
Christine: One criticism of a 4%-style guideline—where you’re taking the same amount out of your portfolio on an inflation-adjusted basis year after year—is that it doesn’t account for the portfolio’s performance. You’re taking the same amount out by rote, regardless of how your portfolio has behaved. Why do you think it’s important to factor in the portfolio’s performance when deciding how much you can safely take out?
Jonathan: The 4% rule is a static spending rule that allows you to set it and forget it, except for those inflation adjustments. It’s designed to work even if you get a worst-case scenario. If you do get that scenario, you want to be sure that what you’re withdrawing is still going to be safe.
But the reality is, you might not get a worst-case scenario. If it’s not that bad, or if it’s even pretty good, you would like to be able to take advantage of that. It’s a little bit like driving a car: You might want to go a certain speed, but if you look around and see hazards, you can take your foot off the gas, you can tap the brakes to regulate your speed. If you said to me, “How fast would you go if you didn’t have any brakes, and you didn’t have any mirrors, you just set a speed and maintained it regardless?” I’d say that I would want to go a lot slower. A static spending rule is like the car with no brakes and no mirrors. You’re just going to take a withdrawal amount, and come hell or high water, you’re going to keep going with it. So it has to be lower. That flexibility is the key to not going as slow as you might have to under the worst possible circumstances.
Christine: The way you’re describing it is that it’s a positive, because it will allow me to kind of optimize my standard of living. I may have to tap on the brakes and take less. But if things turn out okay, or even better than okay, I may be able to take more.
Jonathan: Yes, and there’s another advantage over a static withdrawal spending rule. When things get dicey, when markets are not cooperating, when the economic indicators are troubling, the static rule’s answer to whether you should do anything differently is always no, just keep increasing your spending by the rate of inflation. At that very moment it might be important, or it might feel like it’s important, to be able to tap the brakes or take your foot off the gas. But those static spending rules come up empty. They have nothing to say about what you should do.
In financial planning, the things that feel good to do are usually not in your best interest. Saving more versus spending, for example: More saving doesn’t feel as good as more spending. But you know it’s better for your long-term financial success. Buying low doesn’t feel good, buying high feels good. But in reality it’s not.
Retirement spending is one area where your feelings line up with what’s in your best interest. Because when conditions say it would be useful to take your foot off the gas, that is exactly what you want to do. That’s empowering, and it helps your confidence.
Christine: What’s a good way to take flexible withdrawals? It sounds like the name of the game is to pay attention to what’s going on with the portfolio, but also put some parameters on how low the withdrawals can go in a bad year and how high they can go in a good year. Can you shorthand for us how such a system would work?
Jonathan: It starts with an assumption that you want to “know the score.” Imagine that you’re a manager of a sports team and you’re trying to decide what to do as the game progresses, but you have to do it without knowing the current score, or knowing how much time is left, or where you are in the match. It’s impossible.
We start with the idea that anybody who cares enough about the kind of things you’re asking about wants to know the score. Knowing the score on basic things like how much money they have, how much they need to take out, and what percentage that would be is a great place to start.
A flexibility-based system, or the guardrails-based system, says that in a normal environment, if you’re willing to be a little bit flexible—and I’ll just use the number that came out of Morningstar’s 2022 retirement income research—5.3% works as a starting withdrawal percentage.
What you then do is establish a top end and a bottom end to that. And that is simply 20% more and 20% less. These guardrails are nothing more than a range that you want to stay between. In this example, 20% above 5.3% is 6.4%, and 20% below 5.3% is 4.2%.
There’s your range, and so you go merrily along in retirement. When your portfolio value goes up in a given year, you give yourself a raise equal to inflation and then see what your withdrawal amount would be as a percentage of your portfolio. If it’s within that range, that’s all you need to know.
If it’s above 6.4%, you need to make a shift; you would knock that withdrawal back 10%. If it’s below 4.2% you get to make a different shift. You get a raise of 10%. And if it was a year where you’re within that range but your portfolio lost money, you skip the inflation raise.
Christine: Let’s go back to that 5.3% starting withdrawal that you just referenced with the guardrails system over a 30-year horizon. When we did that same research in 2022, we concluded that someone who didn’t want to make any adjustments at all would have to settle for a 3.8% starting withdrawal. Can you walk through why that flexible system lets you start out higher?
Jonathan: Remember, that fixed real withdrawal amount is designed to work even under the worst-case scenario, and it says you never get to benefit by going higher if, in fact, the market isn’t that bad.
What the guardrail system does is to say, “We expect it to be average, and if it turns out to be even better than that, we have a way to bump you up. If it turns out to be worse than that, we have a way to bump you down.”
There’s no free lunch here. If it turns out that the investment hand you get dealt in retirement is so bad economically that it is a realistic worst-case scenario, fear not. The guardrail system will knock you back down to where you should have been all the way along very quickly. You won’t like it, but it will get you there with the same chance of sustainability along the way.
Excerpted with permission of the publisher Harriman House Ltd. from How to Retire: 20 Lessons for a Happy, Successful, and Wealthy Retirement by Christine Benz. Copyright (c) MMXXIV Morningstar, Inc.
