5.2% Withdrawal Rate May Make Sense: Morningstar

After touting more conservative numbers for several years, Morningstar analysts explain when higher withdrawals are in order.

By Jerilyn Klein

Suggesting that investors with a 30-year retirement horizon withdraw 4% of their retirement savings each year may not sound like a big deal. Even many consumers are familiar with the 4% rule, developed in 1994 by financial advisor William Bengen. But Morningstar analysts have begun suggesting this as a starting safe base case for investors, their highest level in three years.

And under five other dynamic spending strategies they researched, the starting safe withdrawal rates that they calculated are even higher, ranging from 4.4% to 5.2%.

A big impetus for moving the needle has been stronger fixed-income returns. When Morningstar initiated its withdrawal-rate research in 2021, with a 3.3% base-case withdrawal rate, the benchmark 10-year Treasury yield hovered around 1% or so.

“Even in the Great Depression, Treasury bond yields were not that low,” John Rekenthaler, Morningstar’s director of research, said during a webinar on January 24. The webinar focused on a report he co-authored, “The State of Retirement Income: 2023.”

Inflation is another reason Morningstar raised its base-case starting withdrawal rate to 4% late last year, from 3.8% in 2022.

“It’s kind of a good news/bad news story,” Amy Arnott, a portfolio strategist at Morningstar and a co-author of the retirement income paper, said during the webinar. Although inflation forecasts are lower now, “the problem with inflation is it’s cumulative.”

Since the beginning of 2021, the cumulative inflation rate has been 17% or 18%, she said. “If you started out with a consumption basket that was going to cost you $40,000 a year, that same basket of goods and services would now cost you more like $47,000 a year.”

Sequence of inflation is also a concern: Someone experiencing 10% inflation early in retirement will have a much higher spending rate for a long time than some who is 85, Arnott said.

Important Clarifications

One thing that advisors should be explaining clearly to their clients is how withdrawal rates work. Arnott noted there is a lot of confusion about them. “Some people think that when you say 4% that means you’re looking at 4% of each year’s portfolio value and that’s not the case,” she said. “We’re using 4% as the number that sets the initial dollar amount and then each year after that you use the previous year as a baseline and adjust the withdrawal by the amount of inflation.”

“We’re also not saying that is the right number for everyone or that you have to take 4% year in and year out,” she said. “We really think of it as a starting point and kind of a way to cross-check whether your strategy is reasonable.”

Rekenthaler and Arnott also clarified that they take a somewhat different approach than Bengen, the father of the 4% rule.

Although they borrowed his 30-year retirement horizon for calculating withdrawals, “the big difference between what we did and Bill did is he looked backward,” said Rekenthaler. “He used historic returns on stocks and bonds in performing his calculations and we’re using forward-looking estimates for the stock and bond market.”

Why does it matter? “You add one more year into the 100 years of data, [it] hardly changes,” he said. “But the forward estimates can change a lot.” These estimates come from a Morningstar team that specializes in that kind of research.

Rekenthaler also pointed out that Morningstar’s model for the base case does not assume any changes due to market behavior. “The retiree is just locked in there, again for simplification purposes,” he said. But while a fixed model is good for comparison purposes, “it doesn’t necessarily, I would think, reflect how people actually behave in real life.” So, he and his colleagues did test what could happen under different scenarios including market downturns, “which is, again, why we have a 30-page paper rather than a one-page paper,” he said.

How Much Success is Enough?

Rekenthaler and Arnott arrived at the 4% withdrawal rate by targeting a 90% success rate — when at least 900 of 1,000 trials funded specified spending amounts throughout a 30-year period.

“Back in the day, most plans were done on a 50% success rate,” said Rekenthaler, adding some perspective.

Webinar moderator Christine Benz, Morningstar’s director of personal finance and retirement planning and also a co-author of the paper, asked the panelists what they’d say to clients who say, “I want a 100% success rate, I do not want any chance of running out of funds.”

Buy Treasury inflation-protected securities (TIPS), said Rekenthaler. “They’re guaranteed by the government and they’re guaranteed to adjust in response to inflation. There’s nothing else you can do,” he said. “Even an annuity is not going to be inflation-adjusted in most cases. But although TIPS can be nicely laddered, he doesn’t recommend an all-TIPS portfolio because it’s too conservative a strategy, he said. Instead, “people can adjust. I think that’s a big takeaway from the work that we’re doing.”

Although 30 years in retirement was their base-case scenario, the analysts ran numbers for 10 to 40 years. “If you’re 84 years old, you probably aren’t planning for a 30-year time horizon,” said Rekenthaler. “Much higher withdrawal rates are permissible for someone looking out for 10 or 15 years.”

He and Arnott also examined different asset allocations and cautioned about the damage that the volatility of stocks could have on retirement portfolios. For retirees who want to ramp up their equity holdings to 60% or 70%, the suggested withdrawal rate drops to 3.8% or 3.9%, said Rekenthaler. “These are what the numbers show,” he said, “but this is an individual decision.”

Additional Withdrawal Strategies

Rekenthaler and Arnott also researched the outcomes of other strategies and determined their starting safe withdrawal rates were as follows: TIPS ladder (4.6%), forgo inflation adjustment (4.4%), RMD (4.4%), guardrails (5.2%) and actual spending (5.0%).

Like the base case, all of these scenarios are based on a 40% equity/60% fixed income portfolio over a 30-year period and a 90% success rate.

The forgo-inflation-adjustment method is just as it sounds: Investors forgo inflation adjustments following an annual portfolio loss. Instead, they keep spending flat that next year. “So even though that’s a very small change in any given year, we’ve found that it is significant in terms of how much it can boost your sustainable withdrawal rate,” said Arnott.

The RMD strategy, as advisors know, involves dividing an investor’s portfolio value by their remaining life expectancy. “It’s conservative in the sense that you’ll never spend the entire portfolio down to zero,” said Arnott.

Under the guardrails method, “Instead of taking a stable dollar amount in real terms, you are adjusting that for portfolio performance,” Arnott said. This means reducing one’s withdrawal rate after a bad year in the market and taking a larger withdrawal when the portfolio is up. The method was developed by Jonathan Guyton, a financial planner, and William Klinger, a computer scientist.

To calculate the withdrawal rate to test, divide the planned withdrawal rate by the portfolio value. If the calculated withdrawal rate, adjusted for inflation, is more than 20% above its initial level, then you would perhaps ratchet down your spending, said Arnott, but if it’s 20% below its initial level, you’d ratchet up spending. “Under the guardrails method, you’re able to take advantage of the volatility of stocks,” she said.

The fourth method Arnott and Rekenthaler tested this year, for the first time, considered how retirees actually spend over the retirement lifecycle. They looked at research from the Employee Benefits Research Institute (EBRI), which tracked the expenses of a group of retirees over eight years. EBRI sent the retirees surveys to fill out that broke out their spending by category.

“Spending does tend to decline pretty significantly as you get older,” said Arnott, commenting on the data. During its testing, Morningstar reduced annual spending rates by 1.5% to 1.9%.

Golden-Year Considerations

Of course, seniors fortunate to be healthy and active into their 80s and 90s may retain high spending levels if they’re able to vacation and engage in other entertainment, said Arnott. Those in poor health can also face a significant uptick in spending during their later years.

From what Arnott observed, “There was definitely an increase in spending on healthcare and medical costs as you get older, but that was offset by lower spending in other categories – things like transportation, entertainment.”

Staying Safe

Advisors can also help clients consider sequence-of-inflation risk and sequence-of-return risk. “If you are someone who was unfortunate enough to retire at the beginning of 2022 and have seen your portfolio value go down a lot and you’ve seen your costs go up because of inflation, you probably want to be pretty conservative at this point and try to course-correct to account for that,” said Arnott.

Rekenthaler is trying to focus on the positive trends of a rising market, more attractive interest rates and tempering inflation. “It is happier news than when we started these [State of Retirement Income] papers” in 2021, he said.

When asked about the high cost of long-term care, which Arnott noted can run more than $100,000 a year, she said one approach that makes sense to her is carving out a separate pool of assets that are specifically allocated to long-term-care.

“If you have the peace of mind knowing that you have a separate pool of assets to deal with that potential issue, then you would probably be more comfortable with spending from your regular portfolio,” she said.

Benz said the best-case scenario would be not needing the long-term-care fund and instead passing it to heirs, charity or whatever the case might be. “Or you might decide to spend it yourself,” said Arnott — to which Benz responded, “Or you live to 105.”

Jerilyn Klein is editorial director of Rethinking65

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