Retirees: Here's How to Tweak the 4% Rule to Protect Your Nest Egg

Summary

In this episode of Investing Insights, host Ivana Hampton discusses the evolving landscape of retirement withdrawal strategies with Morningstar Inc.'s portfolio strategist, Amy Arnot. As markets change, so too do the strategies for withdrawal, with a current safe rate slightly lowered to 3.7%. They explore methods to ensure retirees neither overspend nor underspend, focusing on new dynamic strategies like the forego inflation method and the spending ending ratio. They also touch upon annuities, Social Security, and the future direction of retirement research.

Highlights

• Morningstar's research indicates the starting safe withdrawal rate is now 3.7% due to changing market conditions 📉
• Dynamic strategies like forego inflation and the RMD method can improve sustainable withdrawal rates 💡
• The newly introduced spending ending ratio aids in balancing spending with potential bequeathments ⚖️
• Exploring the pros and cons of delaying Social Security can maximize benefits 📈
• Immediate and deferred annuities offer guaranteed income, helping to mitigate longevity risk 🛡️

Key Takeaways

• The safe withdrawal rate has slightly decreased to 3.7% due to lower market return assumptions 📉
• Dynamic withdrawal strategies can increase the starting safe withdrawal rate up to 5.1% 💪
• New metric, the spending ending ratio, helps retirees balance lifetime spending with legacy goals ⚖️
• Immediate annuities provide guaranteed income, which is ideal for those wary of market risks 💰
• The right strategy can assist retirees in achieving their goals, whether spending it all or leaving a legacy 🌟

Overview

The world of retirement withdrawal strategies is changing as market conditions fluctuate. Ivana Hampton hosts Amy Arnot from Morningstar Inc., who shares insights into why the once classic 4% withdrawal rule has been adjusted to 3.7%. Market return assumptions and economic landscapes have redefined safe withdrawal rates, requiring adaptive strategies for future retirees.

Amy introduces an array of flexible withdrawal methods designed to optimize retirees' experience in drawing down their savings. Techniques such as the forego inflation strategy or RMD method can significantly enhance withdrawal rates. Furthermore, the newly launched 'spending ending ratio' assists retirees in making informed decisions about balancing current spending with legacy potential.

Aside from withdrawal strategies, Ivana and Amy delve into the role of annuities and the pivotal timing of claiming Social Security. Immediate annuities provide peace of mind with guaranteed income, while deferred annuities offer longevity risk mitigation. Future research focuses on incorporating variable inflation rates, tax strategies, and enriching guaranteed income guidance for retirees.

Chapters

• 00:00 - 01:00: Introduction and Overview of Safe Withdrawal Research The chapter discusses the changing financial landscape new retirees may face compared to previous generations. It highlights that Morningstar researchers have recently examined and adjusted the safe withdrawal rate for retirees, noting that it's slightly decreased from the previous year. The chapter features an interview with Amy Arnot, a portfolio strategist from Morningstar Inc, to explore the reasons behind these changes.
• 01:00 - 02:30: Challenges in Estimating Safe Withdrawal Rates This chapter explores the challenges in estimating safe withdrawal rates for retirement income. It introduces a new metric aimed at helping individuals determine whether they are spending too little or too much in retirement. The discussion includes insights from Amy and her co-authors who recently published a report on the state of retirement income. The main goal of their research is to estimate safe withdrawal amounts, distinguishing their approach from other studies focused on retirement income strategies.
• 02:30 - 04:00: Difference from Historical Market Data Approaches This chapter discusses the complexities involved in determining how to withdraw from a retirement portfolio effectively. It highlights that while saving for retirement is relatively straightforward if approached early and consistently, the challenge lies in converting the accumulated portfolio into sustainable retirement income. The discussion centers on the difficulty and importance of making this transition successfully.
• 04:00 - 05:00: Current Safe Withdrawal Rate Findings The chapter discusses the complexities of determining a safe withdrawal rate during retirement. It highlights the common concern of outliving one's savings versus the risk of underspending. The discussion emphasizes the need to find a balance between spending enough to enjoy retirement, engaging in hobbies and travel, without spending too aggressively and risking financial constraints later in life.
• 05:00 - 06:30: Market Conditions Influencing Withdrawal Rates This chapter discusses how market conditions impact withdrawal rates, particularly focusing on retirement strategies. It compares the traditional approaches based on historical market data, dating back to William Bengen's 1994 study, which analyzed data from as far back as 1926, to determine sustainable withdrawal rates for retirees.
• 06:30 - 09:30: Exploration of Flexible Withdrawal Strategies The chapter discusses the exploration of flexible withdrawal strategies, highlighting the limitations of past data analysis and introducing a more forward-looking approach using market estimates for future returns. The rationale behind the 4% rule is critiqued, and alternative strategies are considered based on potential future market conditions.
• 09:30 - 11:00: Introduction of the Spending Ending Ratio The chapter introduces the concept of the 'Spending Ending Ratio,' starting with a base case of 3.7%. The base case calculation is explained as the foundation of research aimed at creating a consistent retirement income. It begins with a specific withdrawal rate, like 4%, applied to the starting portfolio, aiming to ensure a stable income throughout retirement.
• 11:00 - 13:00: Strategies for Leaving a Legacy The chapter discusses strategies for leaving a legacy focused on financial planning. It introduces the concept of portfolio withdrawal in retirement and explains the approach of withdrawing a fixed dollar amount each year, adjusted for inflation. The importance of maintaining a steady spending amount and the cautious approach of aiming for a high probability of success are emphasized. The chapter also highlights the use of a Monte Carlo analysis to evaluate retirement plans by looking at a thousand different random simulations to ensure financial stability.
• 13:00 - 16:00: Strategies for Spending It All The chapter explores the concept of a safe withdrawal rate for retirement funds. It emphasizes the importance of ensuring that the chosen withdrawal strategy succeeds in a high percentage of scenarios, particularly focusing on a 90% success rate across multiple trials. Additionally, the discussion assumes a long retirement period of 30 years, highlighting both the hopes and challenges associated with planning for such an extended time frame.
• 16:00 - 18:30: Considerations for Delaying Social Security The chapter discusses the reasons for delaying social security benefits for individuals approaching retirement age, specifically 65 or 67. It emphasizes the importance of using conservative estimates for market returns when planning for retirement. It suggests that there should be a buffer or cushion built into the financial planning to account for unforeseen circumstances, ensuring that if things do not go as expected, the individual is still financially secure. It highlights the significance of considering potential market volatility and life expectancy when deciding the timing of social security withdrawals.
• 18:30 - 23:00: Understanding Annuities for Retirement The chapter provides insights into annuities as a tool for retirement planning. It begins with a discussion on how annuity rates have fluctuated over time, particularly noting a decrease from 4% in the previous report. This fluctuation is attributed to the assumptions made about market returns. The chapter highlights the strong performance of equity markets in 2023 and 2024, where returns reached approximately 25% each year. This robust market performance has implications for annuity rates and the considerations individuals should have when planning for retirement. The narrative underscores the importance of understanding market trends and their impact on annuity products.
• 23:00 - 25:30: Research and Future Focus Areas The chapter highlights the exceptional performance of stocks over the past 15 years, marking it as the best period since 1970. However, due to the strong market performance, current stock valuations are relatively high. This could potentially lead to lower future returns, prompting a reduction in return assumptions for stocks.
• 25:30 - 27:00: Conclusion In the final chapter titled 'Conclusion', the discussion focuses on various financial insights and strategies based on market trends from 2024. With lower bond yields due to three rate cuts last year, future returns are expected to diminish. However, the chapter also highlights several flexible or dynamic withdrawal strategies that can enhance the starting withdrawal rate. The key strategies explored in the paper enable better financial planning and management in light of changing economic scenarios.

Retirees: Here's How to Tweak the 4% Rule to Protect Your Nest Egg Transcription

• 00:00 - 00:30 [Music] welcome to Investing Insights i'm your host Ivana Hampton new retirees might enter a different environment than their predecessors the economy or market might have changed slightly or dramatically morning Star researchers have investigated and identified their latest starting safe withdrawal rate here's a hint it's slightly lower than the previous year i asked Morning Star Inc portfolio strategist Amy Arnot why we
• 00:30 - 01:00 also talked about a new metric that can help people figure out if they're spending too little or too much here's our conversation welcome back to the podcast Amy thanks it's great to be here now you and your co-authors recently published your annual report on the state of retirement income can you talk about the main goal of this research and how it's different from other research that look at retirement income strategies well the main goal with this research was to try to estimate how much can you safely
• 01:00 - 01:30 withdraw from your portfolio during retirement and this is a difficult question to figure out um and actually probably one of the most difficult questions that people will ever face during their financial lives you know if you're saving for retirement it's pretty straightforward as long as you start early and you're consistent about it but when it comes to taking your retirement portfolio and figuring out how to turn that into a paycheck for yourself that
• 01:30 - 02:00 gets more much more complicated so you know the the danger is a lot of people are worried about possibly running out of money during retirement but on the other hand a lot of people actually end up underspending um so there's sort of a balance between you want to make sure that you're spending enough so that you can enjoy your retirement and um enjoy hobbies and travel that kind of thing but not spend too aggressively so that you might have to cut back later in life
• 02:00 - 02:30 um the way this research is different from other research out there is most retirement withdrawal research is traditionally based on looking at historical market data so this started out with William Bangan with his landmark paper in 1994 which was based on looking at market data going back to 1926 and figuring out what's the highest withdrawal rate you could have made that would have survived you wouldn't have
• 02:30 - 03:00 depleted the portfolio in every past period and so that's the origin of the 4% rule that so many people are already familiar with um when we started doing this re research we decided that instead of looking at past data we would do something more forward-looking using market estimates for possible future returns so that's the main way this is different from other research the latest starting safe withdrawal rate for the
• 03:00 - 03:30 base case is 3.7% can you talk about how you all calculated that number and why it's a conservative estimate yeah so the base case is the really the foundation of where all of our research starts and it assumes that you want to create sort of a steady paycheck equivalent throughout retirement so it assumes that you take a certain withdrawal rate say 4% and apply that to your starting portfolio balance
• 03:30 - 04:00 that becomes your first year portfolio withdrawal and then each year after that you're adjusting that dollar amount for inflation so you're basically keeping a steady spending amount and never changing it um the reason it's conservative um one reason is we're looking for a very high probability of success so we use something called a Monte Carlo analysis where do we're looking at a thousand different random
• 04:00 - 04:30 paths of returns and then we're looking for a safe withdrawal rate that succeeds or that doesn't run out of money in 900 of those trials so it's very high threshold for success um secondly we're um looking for a very long time horizon we're assuming a 30-year retirement period which you know we all probably hope that we'll be able to live 30 years in retirement but unfortunately not
• 04:30 - 05:00 everyone is going to make it to age 65 or 67 and finally we're using conservative estimates for market returns um so especially you know we want to make sure to build in sort of a buffer so that we're not assuming the best case scenario but we want to make sure there's a little bit of a cushion built into the numbers in case things don't go as well as expected and those all seem important the starting safe withdrawal
• 05:00 - 05:30 rate has fluctuated over the years um in the previous report it was 4% why did it tick down it really comes down to the assumptions that we used for market returns and if you think about how the market has done in 2023 and 2024 we both uh in both years we saw equity market returns of about 25% so very strong market performance recently and even if you go
• 05:30 - 06:00 back looking at the past 15 years it's actually the best 15-year period for stocks that we've seen going back to 1970 so because of that strong market performance we now have a situation where valuations are relatively high on stocks which leads to the possibility that maybe future returns could be a bit lower so we reduced our return return assumptions for stocks and across
• 06:00 - 06:30 different sub asset classes and then also on the bond side since we had three rate cuts last year during 2024 bond yields are lower which again you know suggests that future returns are probably also going to be a bit lower now you also explored various flexible or dynamic withdrawal strategies and those can often lift the starting right withdrawal rate can you summarize some of the key ones that you and your team looked at in the paper
• 06:30 - 07:00 yeah so um one thing we looked at is the forego inflation method which is a very simple approach where anytime the portfolio value is down in a given year you don't give yourself a a raise to account for inflation the next year so it's very simple um but because those inflation adjustments kind of ripple throughout the 30-year retirement period it it does actually make a pretty big improvement in the sustainable
• 07:00 - 07:30 withdrawal rate uh we also looked at a method that we call the RMD method a lot of you know retirees are probably familiar with the required minimum distributions that they have to take from tax deferred retirement accounts and it's basically calculated based on the portfolio value divided by life expectancy um and again that's something that allows you to start out with potentially a higher withdrawal rate
• 07:30 - 08:00 than the base case uh we also looked at something that we call actual spending which is based on some interesting research that has been done um looking at how people actually spend during retirement so it's the University of Michigan and the Department of of Aging send surveys to people who are retired and then follow up with the same people over time to look at their spending patterns and what they found is that spending tends to decline even in
• 08:00 - 08:30 inflation adjustment terms by about 2% per year during retirement and then finally we also looked at something called the guard rails method which was originally developed by Jonathan Gton and Bill Clinger and it's based on the idea that you you test the dollar amount that you're planning to withdraw each year and if that withdrawal rate um is over a certain percentage then you cut
• 08:30 - 09:00 back a little bit on your spending if it's under a certain percentage you increase your spending so you know sort of like visualizing guard rails on a highway it's a way of keeping you on the path and making sure you're not veering too far off in either direction and so these four methods um as you said they all can lift the starting safe withdrawal rate um and the amount ranges from 4.2% 2% for the forego inflation
• 09:00 - 09:30 method all the way up to 5.1% for withdraw for guardrails it seems like a retiree can find one that works for them and go forth so the team also rolled out a new metric called the spending ending ratio can you explain how it can help people yeah I think this is a really helpful metric and it's based on looking at the dollar value of the total dollar of value that we estimate that you can
• 09:30 - 10:00 spend during the whole retirement period and then the dollar value of that we estimate for how much you might have left over and then comparing those two things in percentage terms and I think this is a really helpful way of helping people think through what their priorities are and do they want to lean one way or the other now the ratio can help people calibrate their spending or whether they want to prioritize lifetime spending or having some money left over
• 10:00 - 10:30 what strategies could they pursue if they want to leave legacy money yeah so um a lot of people really like the idea of leaving a legacy behind for their family members or charity so one approach would be you could carve out a separate pool of assets and kind of keep that off to the side and not use that for portfolio withdrawals at all you could also use one of the methods that start that ends up with a higher ending
• 10:30 - 11:00 value like the for like the base case or the forego inflation method um but I was would also encourage people in addition to think about thinking about legacy to also thinking about giving while you're still alive and you know there's this this expression that I really like called is that goes it's better to give with a warm hand than a cold one and I think this really goes to the idea that if you're able to give to people or
• 11:00 - 11:30 causes that are important to you during your lifetime you can get some emotional benefit from that and I would also argue that even if you're giving smaller amounts during your lifetime it can often have a bigger impact if you're able to do that at certain key milestones during someone's life so helping out with education for a family member or helping pay for a wedding or down payment on a house or maybe planning a nice trip for the extended
• 11:30 - 12:00 family these are all things that can um you know help sort of build a legacy while you're still around those are great examples and you can see and be a part of those moments right so some future retirees Amy they say they're going to spend it all they're not leaving anything what strategies can help them reach their goal yeah so a lot of people have probably heard of this book called Die with Zero by Bill Perkins and the idea is instead of
• 12:00 - 12:30 trying to save every single last penny and end up with as much as you can when you pass away that you really focus on spending mindfully and intentionally on things that are important to you during your lifetime so for people who want to pursue that approach one thing you could do is build a tips ladder where you're buying Treasury inflation protected securities with different maturity dates and then spending each rung of the
• 12:30 - 13:00 ladder as it matures to support your living expenses that tends to be a very efficient way of drawing down assets during retirement um another approach would be the RMD method which again is portfolio value divided by life expectancy and because your life expectancy is getting a little bit shorter each year your spending tends to increase a little bit in percentage terms each year and that also tends to be a pretty efficient way of spending
• 13:00 - 13:30 down assets during your lifetime many seniors depend on guaranteed income like social security and when to claim can be a really big decision so I hear now the full retirement age sits around 67 but 70 is when you can get like the maximum amount of benefits what are the pros and cons of delaying social security yeah so the big advantage to delaying social security until age 70 as you mentioned is you can get much higher benefits the benefit amount actually increases from
• 13:30 - 14:00 uh 67 to 70 goes up by 24% so if you were expecting a monthly payment from Social Security of say $2,000 a month you could see that actually bump up to more like $2,500 a month so some of the ways that you could potentially delay social security one would be if you're in good health and you enjoy your job you could continue working and that way you don't have a need for social
• 14:00 - 14:30 security and you might also be able to continue saving for retirement a lot of people also like to use rental income as a way of kind of covering spending during those gap years between when you retire and when you start taking social security or some people might also have a spouse who's still working and you know be able to use that income to cover their living expenses um but a fort unfortunately a lot of people don't have any of those options and actually a lot
• 14:30 - 15:00 of people end up retiring um significantly before age 67 so more like age 62 so in that situation if you want to delay social security you would um have to take withdrawals out of your portfolio to cover your living expenses and when you're taking money out of the portfolio that means there's less money in the portfolio to grow over time so
• 15:00 - 15:30 you could end up with a smaller value at the end of retirement if that's something that's important to you um another drawback behind waiting to claim social security is if you don't have a long lifespan you might actually end up with smaller total payments during your lifetime so the break even age is about 83 so if you wait to delay social security until age 70 as long as you live to age 83 or later you'll come end
• 15:30 - 16:00 up you know breaking even and then coming out ahead but if you do pass away before then you would your total payments would be lower so immediate and deferred annuities could help someone avoid outliving their money what type of retiree might want to consider an annuity yeah so an immediate annuity would be when you um are interested in in starting payments as soon as possible
• 16:00 - 16:30 and some people who might want to look at an immediate annuity would be um people who don't have a lot of assets to work with and are worried about running out of money during retirement um so when you buy an annuity you're basically taking money out of your portfolio and giving it to the insurance company in exchange for a guaranteed stream of monthly income and because you're pooling your longevity risk with other people who also have insurance contracts
• 16:30 - 17:00 with the with the insurance company that monthly income amount can end up being significantly higher than what you might be able to withdraw from your portfolio so for example if you bought an immediate annuity for $100,000 you might be able to get guaranteed income of $6 or $7,000 a year for as long as you're living um other people who might want to consider one of these annuities would be
• 17:00 - 17:30 people who aren't comfortable taking market risk and you know just want to have guaranteed income and don't want to mess around with trying to figure out how their portfolio is doing or how much they can safely safely withdraw and then the third person who might want to consider one of these annuities would be someone who has who's concerned about longevity risk so for example if you have a lot of family members who have lived well into their 90s or later or if
• 17:30 - 18:00 you're a very healthy person and you think you might have a longer than average lifespan an annuity can be a good way to protect yourself from that type of longevity risk now deferred annuities postpone payouts for maybe a decade or more and that can push up monthly or yearly payments compared to immediate annuities can you talk about the risk and rewards sure so on the risk side you know like any type of annuity normally a
• 18:00 - 18:30 deferred annuity is not inflationadjusted so you are running the risk of losing some purchasing power over time especially if you're deferring the payments for 10 or 20 years down the road another risk is the financial health of the insurer so you want to make sure that you are comfortable with the credit quality of the insurer and the company is going to be around 10 or 20 years down the road on the positive
• 18:30 - 19:00 side as you mentioned by deferring the annuity you can often get significantly higher payouts so for example if you bought an annuity at age 67 and waited until 85 to start collecting the payouts those payment amounts could actually be double what they would have been at age 67 um and again I think another positive with deferred annuities is it's can be a
• 19:00 - 19:30 very good way to hedge against longevity risk because for example if you're deferring until age 85 you don't have to worry about how long you're going to live after that point because you have that guaranteed stream of income so some peace of mind right exactly so what areas are the you and a team thinking about focusing on in the next report yeah so one thing I really like about this report is we publish it once a year and we try to expand it a little bit
• 19:30 - 20:00 each year um so some of the things that we're thinking about for next year one would be looking at more of a variable inflation rate right now our data kind of assumes a flat inflation rate during retirement um but as we all know inflation can bump around a bit from year to year um we're also interested in looking at the impact of taxes and strategies that people can use to minimize the tax impact of portfolio
• 20:00 - 20:30 withdrawals a third area would be um looking at additional flexible spending strategies like maybe a fixed percentage approach where you're taking a certain c certain percentage like 5% and then applying that to the portfolio balance a year each year to figure out your portfolio withdrawal amount and finally uh we're interested in looking at guaranteed income strategies in more detail and giving people more guidance
• 20:30 - 21:00 on how they can combine different sources of guaranteed income with the various withdrawal strategies that we look into in the paper i'm looking forward to reading about all of it when it comes out thank you Amy for coming to the table and discussing this important retirement research thanks it's always great to talk to you that wraps up this week's episode thanks for watching and making this show part of your day subscribe to Morning Star's YouTube channel to see new videos about investment ideas market trends and
• 21:00 - 21:30 analyst insights thanks to senior video producer Jake Van Kersonen associate multimedia editor Jessica Bevel and digital communications specialist Kumuini Nala i'm Ivana Hampton lead multimedia editor Morning Star take care [Music]