Rethinking Retirement Spending Rules: A Market‑Based Approach

Starting portfolio yields may be a better guide to optimal spending than knowledge of future market returns.

Determining a feasible rate of spending in retirement ranks among the most vexing challenges in finance. Too many variables are unknowable: How long will an individual live? How will markets perform? What unexpected spending needs will arise? We believe portfolio yields may help determine feasible spending.

Rules of thumb – such as “the 4% rule” for annual withdrawals advanced by William Bengen in the 1990s – offer convenient solutions that seek to maximize consumption without undue risk of running out of money. Bengen updated his rule to 4.5% in 2006, noting the “safe withdrawal rate” can vary depending on taxes and other factors.

Morningstar in November said a prudent annual withdrawal rate is 4%, up from 3.3% two years ago and 3.8% last year. Higher bond yields help explain the increase, which is based on a common retirement portfolio allocation of 40% stocks and 60% bonds. Other strategies include adjusting the withdrawal rate based on the performance of the investment portfolio; altering the rate based on mortality risks; and determining a “safe withdrawal rate” based on Monte Carlo simulations.

A problem with these approaches is that they are based on past performance and assumptions about the evolution of markets, interest rates, longevity, and spending patterns over several decades in retirement. And these assumptions need regular updating.

However helpful these rules of thumb may be, retirees appear to largely ignore them. Wary of running out of money, nearly 60% of retirees plan to spend little of their savings or even grow balances.1