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