Saving for retirement is relatively straightforward: Spend less than you make and invest steadily. But, as healthcare workers get closer to retirement, we often ask- How much is enough to retire and not run out of money? To answer this question, we often utilize the 4% withdrawal rate as a guideline.

The 4% withdrawal rate was first theorized by William Bengen in 1994, and then followed up by Trinity study published in 1998. Bengen looked backward from 1925 to 1995 and tested which rate of withdrawal on a portfolio would achieve the desired result- having enough money to spend for the rest of their lives, without running out. The result was 4%.

The average inflation rate was 3% and the average growth rate on a portfolio was 7%, so withdrawing 4% was considered the safe bet to make a pot of money last forever.

But, a retiree who is close to retirement is likely to want more forward-looking data that models what might happen in the future, rather than the past. Financial planners often do this by running a Monte Carlo simulation (a type of multivariate analysis) to estimate our withdrawal rate based on our asset allocation and lifestyle goals.

Morningstar, a leading source of investment data for financial advisors, recently published their State of Retirement Spending report that applies Monte Carlo simulations on a larger scale to 1000 portfolios with different asset allocations.

This Morningstar report provides forward-looking guidance considering current and projected yields, valuation, and inflation from the Morningstar Investment Management team. They use Monte Carlo simulations to project how portfolios with different asset allocations would perform in a 30-year period.

That data is used to seek the highest possible withdrawal rate and strategy with a 90% success rate, which means that at least 900 of the 1000 trials funded the spending requirement of the retiree throughout the 30-year period without running out of money. They assume a total return approach to the portfolio meaning that the income comes not just from the income of the portfolio but may also use the starting principal of the portfolio. While they were not aiming for the highest final value of the portfolio, the ending balance for the median trials still ends up being high.

The safe withdrawal percentage they came up with this year mirrors the backward-looking recommendation of the Trinity study- 4%. This is slightly higher than last year’s projection of 3.8% largely due to the rise in bond yields. The asset allocation that produced this result was 40% equity (or stocks) and 60% cash and bonds.

The highest income came from rather conservative portfolios that had only 20-40% in equities.

That’s because the base case assumes a steep 90% success rate and assumes the investor’s spending needs are inflexible. If a retiree can adjust their spending based on market conditions, like most are, that approach can allow for higher withdrawal rates in conditions where the market is performing well, making room for giving and traveling when the market is performing well.

The Morningstar analysis tested four commonly used flexible strategies. The base case assumes the retiree’s initial withdrawal is calculated as 4% of the total value of the portfolio and an upward inflation adjustment of 3% is added to that withdrawal every subsequent year.

This strategy is quite inflexible and turns out to be inferior to the more flexible strategies that mimic real-life spending adjustments. The first flexible strategy forgoes the inflation adjustment in down markets to preserve capital during adverse conditions. This strategy cuts real spending but can allow for higher starting withdrawal rates (around 4.4 percent for a 40% equity portfolio) and results in a healthy portfolio value at the end of a 30-year retirement.

The second method ties the withdrawal to the Required Minimum Distributions (RMD) required by the IRS. The RMS method calculates the RMD as portfolio value divided by life expectancy as defined by the IRS. Because the remaining portfolio value can change significantly depending on the market conditions, there is substantial volatility to cash flows, and ends up with lower portfolio values than other methods. This method may be good for people who can cover most of their living expenses from other sources of income such as social security or pensions.

The third method is the Guardrails system, developed by Jonathan Guyton and William Klinger. This method sets an initial withdrawal percentage and then adjusts subsequent withdrawals based on portfolio performance and the previous withdrawal percentage. When the portfolio is performing well and the market is trending upwards, the withdrawal amount for that year increases by the inflation adjustment plus another 10%.

In markets that are not performing well, the retiree cuts the withdrawal by 10%. This method supports the highest starting safe withdrawal rates across most asset allocations, from 4.9-5.2%, but results in lower portfolio values at the end of the 30 years. It could be good for retirees who prioritize maximizing lifetime spending over leaving an inheritance.

The fourth model incorporates the fact that spending usually declines in later ages, assuming real spending declines at 1.9% between the years of 65 and 75, 1.5% per year between 75-85, and 1.8% per year between 85 and 95. While it doesn’t maximize lifetime withdrawal rates, it delivers higher paychecks early in retirement and provides low cash flow volatility.

The Morningstar report introduces a fifth method of portfolio management for those seeking to generate guaranteed income- a TIPS (Treasury Inflation Protected Securities) ladder.

A TIPS ladder is a self-liquidating portfolio. A 30-year ladder buys TIPS of various maturities from one year to thirty years to generate guaranteed income for a specific period and then, literally, dying with zero. They provide a 100% success rate as they are immune from inflation. At current rates, a TIPS ladder would offer a 4.6% withdrawal rate with 100% success.

But, this strategy would liquidate the portfolio at the end of 30 years. For more flexibility, another strategy is to have a TIPS ladder, with an equity kicker, to keep some leftover value in the portfolio at the end of 30 years.

Keep in mind that the data above assumes a 30-year retirement period for the traditional retiree. In a recent interview, one of the lead authors of the Morningstar report, Christine Benz, recommended a more conservative withdrawal rate for an early retiree who anticipates a longer retirement period.

While retirement spending waters can seem murky at first sight, we can be heartened that there is clear data and well-defined strategies that can help us preserve our portfolios and fund our lifestyles through retirement.

Works Cited

Arnott, Amy, et al. “Six Retirement Withdrawal Strategies that Stretch Savings.”

Morningstar, November 2023, https://www.morningstar.com/lp/the-state-of-retirement-income. Accessed 1 December 2023.

Bengen, William. “Determining Withdrawal Rates Using Historical Data.” Financial Planning Association, FPA Journal, October 1994, https://www.financialplanningassociation.org/sites/default/files/2021-04/MAR04%20Determining%20Withdrawal%20Rates%20Using%20Historical%20Data.pdf . Accessed 1st December 2023.

Cooley, Philip L., et al. “Retirement Savings: Choosing a Withdrawal Rate That is Sustainable.” American Association of Individual Investors, 1998.