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Retirement Planning > Spending in Retirement > Income Planning

Use This Metric to Improve on the 4% Rule, Planner Says

By John Manganaro

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What You Need to Know

  • A growing complaint about the 4% retirement spending rule is its rigidity and lack of context.
  • Leading financial planners know they can do better for their clients by helping them to optimize and regularly update their spending plan. 
  • One powerful means of doing so is to introduce 'magnitude of failure' metrics and the concept of dynamic income guardrails. 

Financial planners who focus on retirement income increasingly voice skepticism about the traditional 4% safe withdrawal rule popularized by research originally conceived of and executed nearly three decades ago by Bill Bengen.

The rule suggests a given client in retirement should add up all of their investments and simply plan to withdraw 4% of their total wealth during their first year of retirement. The withdrawal amount is then adjusted annually to account for inflation.

According to Bengen’s original analysis, based on a now-popular statistical technique known as Monte Carlo simulations, this spending pattern is virtually guaranteed to leave a client with sufficient assets to navigate a 30-year retirement, even one during which the markets perform poorly by a historical standard.

That simple safety “guarantee” is what has driven the rule’s popularity.

Yet financial planners know they can do a lot better for clients, helping them to optimize their spending plan in retirement based on their unique and evolving personal goals, risk tolerance and market conditions.

One way they are doing so is by bringing forward an important metric beyond simple probabilities of success and failure: the magnitude of failure.

Bringing this metric into the planning effort allows advisors and their clients to move beyond binary planning strategies and to embrace a new degree of flexibility in the planning process, one that can help their clients maximize spending in retirement while protecting them from the worst-case scenario of retirement bankruptcy.

Why Magnitude of Failure Matters

Oscar Vives, a wealth planner at PNC Wealth Management, recently gave a presentation during a webinar hosted by the Investments and Wealth Institute, during which he dug into the weakness of the traditional 4% withdrawal rule and how it can be complemented by newer planning insights and techniques.

As Vives explained, when reporting binary Monte Carlo results to a client framed around probability of success, anything less than 100% can sound scary. For example, for a client with a 75% probability of success at a given starting spending amount, the notion of failing one out of every four times simply does not sound acceptable to many people.

Vives says it is crucial, however, to think carefully about what a 75% success result in a Monte Carlo simulation actually implies. While on the one hand this metric suggests one in four projected retirement scenarios will “fail,” this metric alone actually tells a client nothing about how severe that failure is.

For example, if 90% of the client’s required future income is expected to come from guaranteed sources, such as a pension and Social Security, then “failure” in such a scenario really just means running 10% short of one’s stated goal. This isn’t an ideal scenario, Vives notes, but it’s far from a catastrophe.

“This is where the whole concept of the magnitude of failure comes into play,” Vives explains. “By giving clients a better sense of how much risk they are really running with a spending plan, we can help them feel more confident and spend more, especially when we pair this perspective with the concept of using pre-defined spending guardrails. That’s really a powerful approach.”

How Retirement Spending Guardrails Work

According to Vives, the real power of the magnitude of failure metric is that it points advisors and clients away from binary projections and towards what many consider to be the new, emerging best practice for structuring “safe” retirement income: using retirement income guardrails.

Vives used a theoretical client example to explain the ins and outs of the approach.

“For example, one can envision a planning scenario with a $1 million client portfolio and a 5% starting withdrawal rate, and this might give them a Monte Carlo success projection of 70% or 75%,” Vives explains. “Just doing some quick math, that starts us out with a $50,000 per year distribution.”

As part of this plan, Vives says, the advisor and the client can set spending guardrails at 20% above and below this initial withdrawal rate — i.e., 6% withdrawals on the high side and 4% on the low side.

“So, as we go along, the portfolio value naturally fluctuates over time based on the withdrawals and market returns,” Vives says. “For example, let’s assume that at the end of year one, the portfolio has grown well and reached to $1.25 million even after the withdrawals, thanks to some strong equity market returns.”

If that happens, the starting 5% withdrawal rate moves to below 4%.

“Thus, we have hit that ‘good’ guardrail, which lets us know we can increase our withdrawal by 10% for year two, to $55,000,” Vives says. “On the other hand, if the market had dropped a similar amount, the withdrawal rate for the following year would be higher than 6%. In that case, we hit the ‘bad’ guardrail and this triggers a 10% spending cut to get the portfolio back on a sustainable path.”

As Vives emphasizes, this approach is far more grounded in the real world than a rote fixed withdrawal rate. It also allows the client to adjust over time if they happen to have higher or lower spending than anticipated during a given part of their retirement journey.

“Notably, on a year-to-year basis, a given client is unlikely to hit these guardrails,” Vives points out. “So, what do we do? Well, we can still follow the inflation rule.”

Essentially, if a client sees positive returns but doesn’t hit the good guardrail, they can increase their distribution to address some or all of the inflation experienced during the year. On the flip side, if the portfolio goes down and the withdrawal rate the following year is higher than where the client started, then they should freeze the distribution and accept that they have fallen behind inflation.

“This is just a great framework to use in practice because, by using these guardrails, you can help clients have greater peace of mind,” Vives says. “You can help them anticipate exactly what changes to withdrawals might need to be made in the future, whether up or down, and why.”

Advisors can even use this planning framework to help some clients retire sooner than the traditional binary-style projections would suggest is prudent.

“Again, by bringing in the magnitude of failure concept and by being flexible with withdrawals, the starting numbers can look a lot better for a given client,” Vives says. “If they accept the flexibility, they can often retire earlier than expected.”

Credit: Adobe Stock 

John Manganaro

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