This Spending Strategy Outperforms 4% Rule, With a Catch

What You Need to Know

A growing body of research shows that dynamic withdrawal strategies deliver more wealth than traditional fixed-percentage approaches.
The greater potential wealth accumulation comes with the potential for high variability in annual income.
Stock-heavy portfolios tend to have bigger swings in annual cash flows when using these strategies, Morningstar’s Christine Benz says.

The use of variable retirement income spending strategies that go beyond traditional fixed-withdrawal methods, such as the ubiquitous 4% rule, is becoming increasingly common, thanks mainly to the fact that such dynamic strategies can generate significant additional lifetime wealth.

However, as noted in a new analysis published on Morningstar’s website by Christine Benz, director of personal finance, these dynamic withdrawal strategies come with an important catch that advisors must emphasize with their clients during the income planning process. Failing to do so could lead to substantial client confusion and consternation.

The catch? A relatively high level of variability in the anticipated annual income stream a client will be able to enjoy. Such variability can be hard for clients to stomach if they have not been adequately coached about the way dynamic spending strategies work — particular about how they seek to allow higher spending overall at the cost of the client potentially needing to weather some low-income years when the markets struggle.

This issue is especially prevalent when an advisor embraces what is coming to be called the “guardrails” approach to retirement income, Benz warns.

The Facts About Spending Guardrails

Stated simply, the guardrails approach to retirement income attempts to deliver adequate “but not overly high” raises for retirees during 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%,” Benz explains.

In the new analysis, Benz offers an example with “easy numbers” to help demonstrate the point, in which the starting withdrawal percentage for a theoretical retiree is 4% of $1 million, or $40,000.

If the portfolio increases to $1.4 million at the beginning of the second year of retirement, the retiree could start by taking the normal $40,000 plus a normal inflation adjustment. This would be, say, $41,136 in base income for year two if one assumed a 2.84% inflation rate.

The advisor could then divide that amount by the current balance — $1.4 million — in order to “test” the percentage for a potential adjustment either up or down. In this case, thanks to the positive market performance, the base case of $41,136 is just 2.9% of $1.4 million.

“As that 2.9% figure is 27% less than the starting percentage of 4%, the retiree qualifies for an upward adjustment of 10%,” Benz explains. “The new withdrawal amount becomes $45,256 — or the scheduled amount of $41,136 plus the additional 10% of $4,120.”

Obviously, the guardrails must apply during down markets, too.