Warning: 4% withdrawal rate unrealistic for retirement

The idea of eschewing a 4% withdrawal rate in retirement for a plan with greater income flexibility — popular among the academic set — is becoming mainstream.
J.P. Morgan Asset Management released a white paper Thursday advocating a dynamic approach to retirement withdrawal strategies. Rather than sticking with the 4% rule, the asset manager suggests periodically tweaking withdrawal rates and asset allocations in the portfolio in response to changes in wealth, age and guaranteed lifetime income streams.
“We wanted to factor in the personal aspect of people’s retirement — the changes in circumstances and possibility,” said S. Katherine Roy, chief retirement strategist at J.P. Morgan Asset Management. “The 4% rule is great as a rule of thumb and for general guidance, but in practice it can be unrealistic in terms of how people behave.”
The 4% rule was established 20 years ago in a paper by William P. Bengen, a fee-only planner and president of Bengen Financial Services Inc., in the Journal of Financial Planning. He modeled a $1 million portfolio split 50/50 between stocks and bonds, with intermediate-term Treasuries as the fixed-income component. Mr. Bengen found that a client who started withdrawals between 1926 and 1976 could have lived off the portfolio for at least 30 years with an initial 4% withdrawal, that dollar amount ($40,000) being adjusted for inflation each year thereafter.
In 2004, he updated his research, adding small-cap stocks to the model and raising the withdrawal rate to 4.5%.
But the market tumult of the 2000s, plus today’s low interest rates, have stirred discussions among academics and practitioners: Perhaps the 4% rule isn’t the best idea when stock market returns are volatile and bonds are faring poorly?
The researchers at J.P. Morgan believe they have an answer. In order to calculate a customized optimal asset allocation and withdrawal rate at each age, the J.P. Morgan Dynamic Model method weighs five factors: the individual’s preference for withdrawal magnitude and withdrawal timing; the level of wealth and lifetime income; the current age and life expectancy; market randomness and extreme events; and the dynamic nature of the retiree’s decision-making process on how to spend the money in light of market performance.
The objective is different from the 4% rule — which prioritizes protecting purchasing power through retirement, while providing inflation-adjusted income. It’s also a contrast to the required-minimum-distribution approach, which determines withdrawal amounts based on life expectancy.
“It’s trying to be as efficient with your capital as possible and not running out of money,” Ms. Roy said. Researchers are aiming to balance two conflicting priorities in retirement: lifestyle needs and longevity risk. The idea is to have retirees sufficiently prepared to take withdrawals through the remainder of their lives, while also being able to maintain their lifestyles.
Lower expected life spans due to increasing age allow retirees to raise their withdrawal rates and cut their equity allocations, according to the paper. Meanwhile, having greater lifetime income from guaranteed sources permits retirees to raise their withdrawal rates and their investment in equities. Finally, those with higher initial wealth may want to lower their withdrawal rates and raise their fixed-income allocations.
“The same percentage decline will result in a higher dollar loss for a larger portfolio compared to a smaller portfolio,” according to the paper.
As a result, a hypothetical 65-year-old couple with $1 million in retirement savings and $50,000 in lifetime income can withdraw 5.9% for the next year, with a bond allocation of 17% and the remainder in equities. At 70, the withdrawal percentage ticks up to 6.7% and goes as high as 17.5% at age 95.
Though the concept of having greater wiggle room in withdrawal strategies seems to be gaining more mainstream attention, a group of retirement income academics and practitioners have been discussing the concept long before it was cool.
Wade D. Pfau, professor of retirement income at The American College, isn’t a fan of using a fixed 4% rule. He has written about establishing an efficient frontier for retirement income and seeking a balance for retirees between meeting spending goals and having enough in financial reserves. Mr. Pfau also co-authored a paper titled “Spending Flexibility and Safe Withdrawal Rates” with Michael Finke, a professor at Texas Tech University, and Duncan Williams, a financial planner and Ph.D. candidate at Texas Tech.
Meanwhile, Jonathan Guyton, a principal at Cornerstone Wealth Advisors Inc., was among the first to declare that a dynamic withdrawal strategy in retirement is something advisers can implement with their clients. He found that a withdrawal rate around 5.5% when markets are strong and the flexibility to ratchet downward withdrawal amounts when times are tough is better than a fixed rate. Mr. Guyton covered the concept in 2004 with a paper titled “Decision Rules and Portfolio Management for Retirees: Is the ‘Safe’ Initial Withdrawal Rate Too Safe?” and again in 2006 with another paper titled “Decision Rules and Maximum Initial Withdrawal Rates.”
“I think it’s consistent with where the research is moving in terms of smarter ways to pull money from a retirement portfolio; this is a better approach of thinking about retirement income from a pool of assets,” said David Blanchett, head of retirement research for Morningstar Investment Management and an author of numerous research papers on retirement income and sustainable withdrawals.
Ms. Roy agreed.
“Our views are very much aligned,” she said of the academics who’ve written about retirement income flexibility. “From the flexibility perspective, we’re very much on the same page.”