We’ve been overwhelmed by the thoughtful conversation generated from our recent blog post, The 4% spending rule, 20 years later. With so many insightful questions we wanted to share key highlights that address the tenor of our conversations with advisors and their clients.

If you missed, The 4% spending rule, 20 years later, you can find part one, here. Also, our recent podcast, A dynamic approach to retirement spending, dives deeper into the topic.

Why run withdrawal rate analysis assuming an 85% success rate?

As noted in the blog and accompanying research, we use an 85% success rate as a watermark to determine portfolio longevity. What this means is that in 85% of the scenarios, the retiree was left with at least $1 at the end of the planning horizon.

Is this an outcome retirees want to plan for? Most likely not. But many practitioners use a range of 80‒90% success rates to determine portfolio durability. Using a lower rate may seem appealing because it allows for greater spending during retirement, but it could result in a much greater risk of running out of money later in retirement.

On the other hand, using a success rate closer to 100% could mean that your client could end up with an unintended portfolio surplus when your client dies, which may sound desirable but could mean they miss out on some fun while they’re alive.

The key is to run scenarios to get a sense of what the portfolio sensitivity looks like at different spending levels and then reach a spot they’re comfortable with. And be sure to revisit it every few years.

How do taxes factor into the 4% rule (or any spending rule, for that matter)?

Most research on sustainable withdrawal rates, including Vanguard’s, looks at spending in aggregate. So this means that your client’s need to consider income taxes as a line item in your client’s total expense figure (or in the case of withdrawal rate, it’s part of that figure rather than added to it).

If your client’s tax picture isn’t certain, consider their prior year’s tax return as a start, and encourage them to make modifications to their spending based on the current year. One example is if they’re starting to take RMDs from their tax-deferred retirement accounts.

Because these distributions will be subject to income taxes, the “gross” amount your clients withdraw from their portfolio may be quite a bit higher then what they “net.” Of course, the higher their tax rate, the less they have to spend.

It seems that there’s an advantage in terms of portfolio longevity from having an aggressive versus a moderate asset allocation. Can you explain?

Really, the difference is not that significant, and in shorter time horizons, can actually result in a lower sustainable withdrawal rate. Over the longer-term, having a more aggressive portfolio may seem like an obvious choice when comparing the success rates.

However, what may seem like an advantage over more-conservative portfolios is merely a reflection of the generally accepted relationship that exists between risk and return over long time horizons (30-plus years), and is not as evident over shorter periods.

Investors require more return for investing in riskier or more-volatile asset classes, such as stocks, and less return from less-risky asset classes, such as bonds.

While I would expect these relationships to persist into the future, it’s important to remember that more-aggressive portfolios have a much greater risk of loss in the short term, which could cause investors to question, or abandon, their investment plan.

The historical performance of an aggressive portfolio certainly looks desirable versus a moderate or conservative one. However, as the figure below demonstrates, there is significant short-term risk in such a portfolio. In achieving the higher returns for the period, an investor would have lost close to 35% of overall portfolio value in at least one year.

This type of loss may be too difficult for many retirees to stomach, regardless of what stage of retirement they’re in. For example, if a retiree faces a bear market early in retirement and doesn’t recalibrate spending, this can severely impact the long-term durability of the portfolio.

On the other hand, if a bear market occurs later in retirement, this could significantly decrease the amount the retiree can spend during a phase in retirement when expenses may be fixed or increasing (such as dealing with healthcare costs). In addition, managing the behavioral aspects of such a loss can be extremely challenging.

On the flip side, being too conservative presents other risks, such as not keeping up with inflation, or not growing the portfolio to meet long-term spending needs.

Maria Bruno_4% part 2_Blog chart_01

Given that future market returns are unknown and uncontrollable, instead of relying on the markets to reach investment goals, a more conservative approach may be more reliable, with adjustments to how much is spent from the portfolio over time.

With today’s current bond yields, and assuming moderated stock returns over the next decade, how can a 4% withdrawal rate be feasible?

This has been a popular topic of conversation for the past few years and the reason we incorporate current market and economic conditions into our long-term projections. Given the low-interest-rate environment, it’s become increasingly difficult for investors to generate enough income from just interest on their bond funds or stock fund dividends.

Those who are unwilling or unable to cut their spending have two options: They can increase their portfolios’ exposure to higher-yielding investments, or they can spend from the total return on their portfolio, which includes not only the income or yield but also the capital appreciation.

The first option introduces one or more additional risks to the portfolio (duration, credit, decreased diversification, and/or volatility), which an investor may not realize and which can be very tax-inefficient.

Instead, investors should consider the second option: a total-return approach, which has advantages over an income-only method. Rather than concentrate on certain securities, market segments, or industry sectors to increase yield, a total-return approach allows for better diversification. It can also be much more tax-efficient relative to an income-only strategy. All this leads to a potential for longer lifespan for the portfolio.

While it may be difficult to spend from income of the portfolio alone, using a total-return approach, and spending from the capital appreciation of a balanced portfolio, as needed, can be a good starting point for balanced investors seeking to sustain a 4% inflation-adjusted withdrawal program.

Case in point: The income return on a globally diversified moderate portfolio was 2.6% for 2014, while the total return was 7.1%.¹ So if someone’s target spending rate was around 4%, this could have been met last year by the balanced portfolio through income and capital appreciation. While this certainly won’t be the case every year, it does illustrate the concept of investing for total return versus income.

I can’t help but reiterate that flexibility during retirement remains paramount. Regardless of where your clients are in their investing journey, being broadly diversified, having realistic expectations about the markets, and keeping an eye on investment costs and taxes really are tried and true best practices for all of us to embrace.

I’d like to thank my colleagues, Michael DiJoseph and Yan Zilbering, for their contributions to this research.

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1 Moderate allocation is 50% stocks/50% bonds. Stock allocation is composed of 70% U.S./30% international. Bond allocation is composed of 80% U.S/20% international.

Notes:

Please remember that all investments involve some risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your account.

There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income.

When taking withdrawals from an IRA before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax.

Diversification does not ensure a profit or protect against a loss in a declining market.