Four Flexible 4% Rule Alternatives for 'Safe' Retirement Income

A few weeks ago, Morningstar published its annual State of Retirement Income report for 2023, finding that new retirees hoping to use a “safe” fixed real withdrawal strategy for managing retirement income can plan to withdraw 4% of their portfolio’s value in the first year of retirement.

In the analysis, a trio of Morningstar researchers including Christine Benz, director of personal finance and retirement planning, show that a starting withdrawal rate of 4% delivers a 90% success rate over a 30-year time horizon for new retirees — even while accounting for inflation.

A few days after the report’s release, Benz hosted her Morningstar colleagues and report co-authors Amy Arnott and John Rekenthaler in an extended episode of The Long View podcast. In the episode, the trio dug into their research findings and broke down the data for practicing financial advisors.

The topline 4% “safe spending” finding is an important result, according to the group, especially when considering that the safe spending figures for 2022 and 2021 were 3.8% and 3.3%, respectively. This steady increase over time owes largely to higher fixed income yields, Benz explains, along with lower long-term inflation estimates.

But perhaps the most important part of the research update, the authors suggest, is the detailed section that considers four distinct flexible withdrawal approaches. As the authors argue, rigid spending frameworks and binary success probability metrics can be important reference points for advisors and retirees, but they aren’t an actual retirement plan.

In the real world, retirees’ spending needs and preferences change over time, and very few people actually follow a rigid annual pattern. For this reason, the researchers contend, financial advisors should take pains to study up on the growing variety of retirement spending approaches that are being developed in both academic and professional settings.

By helping clients see the need for flexibility and by coaching them through the potential income fluctuations they can expect, advisors can help them retire with more confidence and peace of mind — all while boosting their anticipated probability of success.

Skip Inflation Adjustments

As Arnott explains, the first flexible spending strategy considered in the paper is also the simplest.

“One would be a very simple approach where, any time you have an annual portfolio loss, you skip the inflation adjustment when you make withdrawals the next year,” Arnott says. “So, it’s very simple, but you are making some adjustments to your spending, which can really help support a higher withdrawal rate over time.”

As the report explains, this might seem like only a modest step, but the cuts in real spending, while small on an individual basis, are cumulative.

“That is, the effects of such cuts ripple into the future, as these changes permanently reduce the retiree’s spending pattern,” the report states.

With this approach, a starting withdrawal rate of 4.4% is “safe,” Arnott points out, meaning it will succeed over a 30-year time horizon 90 out of 100 times. The average safe annual withdrawal is about 4.1%, and the median result for a $1 million starting portfolio sees the retiree end the initial 30-year retirement period with a higher $1.4 million balance.

Follow RMDs

The second flexible approach considered in the report is the required minimum distribution method.

“This is the same framework that anyone who is required to make minimum distributions from a 401(k) or an IRA is familiar with,” Arnott explains. “It’s basically just taking the portfolio value divided by life expectancy, and we use the standard life expectancy table from the IRS and assume a 30-year retirement time horizon.”

As Arnott notes, this method is “inherently safe,” because retirees are always taking a percentage of the remaining balance, which means they never run out of money. However, because it is based on two variables — life expectancy and portfolio value — any given individual can have a lot of variability in cash flows from year to year, which may be very undesirable for some.

While changes in life expectancy are gradual, Arnott adds, the fact that the remaining portfolio value can change significantly from year to year adds substantial volatility to cash flows.

These quirks mean this flexible withdrawal method can expect to have the highest average annual withdrawal, at 5.4%, but it also has far and away the highest 30-year cash flow standard deviation and the second-lowest median ending balance ($200,000).

Dynamic Guardrails

As the paper notes, the flexible “guardrails” method was originally developed by financial planner Jonathan Guyton and computer scientist William Klinger.

The method sets an initial withdrawal percentage, then adjusts subsequent withdrawals annually based on portfolio performance and the previous withdrawal percentage. As Arnott explains, the guardrails attempt to deliver “sufficient but not overly high” raises in upward-trending markets while adjusting downward after market losses.

In upward-trending markets, in which the portfolio performs well and the new withdrawal percentage (adjusted for inflation) falls below 20% of its initial level, the withdrawal increases by the inflation adjustment plus another 10%.

The paper presents a “simple example” in which the starting withdrawal percentage is 4% of $1 million, or $40,000. If the portfolio increases to $1.4 million at the beginning of Year 2, the retiree could automatically take $40,000 plus an inflation adjustment — or very nearly $41,000, based on a 2.42% inflation rate.

“Dividing that amount by the current balance of $1.4 million tests for the percentage,” Arnott explains, noting that the guardrails apply during down markets, too.

Specifically, the retiree cuts spending by 10% if the new withdrawal rate (adjusted for inflation) is 20% above its initial level.

For retirees in the real world, the guardrails method features the highest beginning safe withdrawal rate, at 5.4%, and a sizable median ending balance of $800,000 — but it also has a much higher 30-year cash flow standard deviation relative to the traditional fixed approach.

Reduce Spending in Line With Historical Data

As Arnott points out, this approach is a new method tested this year.

“Last year, we looked at what would happen if retirees adjusted their withdrawals by 1 percentage point less than the annual inflation rate,” Arnott recalls. “This year, we refined that a little bit more by looking at specific data on how much retirees actually spend at different stages of their life.”

Specifically, the researchers drew on a paper that was published by the Employee Benefits Research Institute, which looked at actual spending patterns.

“They surveyed a bunch of people in retirement at different stages of life over an eight-year period to get empirical data on how people actually spend,” Arnott explains. “They actually found that inflation-adjusted household spending has historically fallen by about 19% from age 65 to 75, and then continues falling from 75 to 85 and 85 to 95.”

To reflect this, the Morningstar researchers assume that inflation-adjusted spending decreased each year by about 1.9 percentage points between 65 and 75, then by 1.5 percentage points between 75 and 85, and finally by 1.8 percentage points between 85 and 95.

This method, the authors find, is attractive for its higher 5% initial safe spending rate and a high median ending balance of $1.4 million, but it features a lower average annual withdrawal of 3.9%.

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