DR Podcast 046: 4% Retirement Withdrawal Rule--An Interview with Vanguard's Maria Bruno and Colleen Jaconetti

What do retirement planning professionals from Vanguard have to say about retirement topics like the 4% rule? In today’s podcast I interview two investment analysts at Vanguard with over 35 years of combined experience – Maria Bruno, CFP and Colleen Jaconetti, CFP. We talk about everything from the 4% rule to portfolio balancing issues to annuities for retirees who want guaranteed income.

Maria and Colleen are true retirement experts who have run studies and written about retirement planning for years. Be sure to check out the resources from Vanguard that I link to at the end of the article. So, without further ado, here’s the transcript from the interview:

Rob: Maria and Colleen, welcome to the show.

Colleen: Thank you, Rob.

Maria: Thank you.

Rob: I’m thrilled to have you both here to talk about retirement and retirement investing and spending. Before we jump into it though, can you guys just give me a little bit of your background. Maria, perhaps we can start with you?

Maria: Sure. I am a Senior Investment Analyst with Vanguard’s Investment Strategy Group. I am also a certified financial planning professional. I’ve worked with financial planning clients for well over a decade. I’ve been in the financial services industry for over 20 years. But a lot of the work I’ve been doing has been around financial planning strategies, particularly with retirement planning and retirement strategies.

Rob: Great. Colleen?

Colleen: Yes. I too, am a Senior Investment Analyst with Vanguard’s Investment Strategy Group. I’ve been with Vanguard for over 15 years. I’m also a certified financial planner, as well as a certified public accountant. My primary focus has really been working on the advice methodology at Vanguard, specifically focusing on retirement income.

Rob: You two are the perfect folks to talk to about retirement and, again, I’m thankful for your time.

I get a lot of questions from listeners on the topics we’re going to cover. Obviously they’re very important topics for folks’ financial future as they near retirement and enter retirement, so let me just jump right into it.

4% Rule of Retirement Spending

I want to begin with a very popular ‘rule of thumb,’ and that’s the 4 percent rule of retirement spending. Can you guys sort of start off by describing for us just what that is?

Maria: Sure. The four-percent spending rule is really a rule of thumb, and there’s been a lot of researchers who have done work on this—Vanguard included. Both Colleen and myself have done work on this.

What it’s set out to do is, it’s set out to be a guideline for individuals who are starting out in retirement, to give them a framework in terms of what a sustainable portfolio spending rate could be throughout retirement. So, there are a couple factors that come into play, one being asset allocation.

Most of the studies out there, including ours, assume a balanced portfolio anywhere from 40 to 60 percent equities. And what we do is run simulations. In our situation we do Monte Carlo simulations, and we look at different risk return horizons. And 4 percent seems to be a good starting point to give a strong likelihood for the portfolio not being depleted over a 30-year time horizon.

So, I think when we talk about the 4 percent spending rule, two factors come into play which are paramount. For instance, the asset allocation and the other one is the time horizon. I bring that up because I think there is a lot of focus on the 4 percent spending rule of thumb, but you need to keep in mind the time horizons.

For instance, if you have someone who’s starting out retirement much earlier, say in their 50s, then they would want to err on the conservative side and maybe have a lower initial withdrawal rate of about three percent. On the flipside, someone who is in advanced retirement, maybe in their 80s shouldn’t necessarily be tied into a 4 percent spending rule. So there is flexibility around that.

I think we’ll use that term a lot during today’s discussion, but it’s meant as a starting point. There’s been a lot of interest in this figure in today’s environment because of the low-yield environment and recent global financial crisis as well, so there’s a lot of interest in this figure.

It is a rule of thumb. We at Vanguard do believe it’s still a viable starting point, but there are a lot of factors that come into play when thinking about that figure.

Rob: Okay. Let me put some actual dollars on this. Let’s say someone had a portfolio for retirement of $1 million. Under the 4 percent rule, in year one of retirement they could withdraw $40,000?

Colleen: Right, so the way it would work is it’s a dollar inflated adjusted formula so in the situation of a million dollars, the initial spend would be $40,000, and then you would adjust that spending rate every year thereafter for inflation. That’s one of the cautious areas of this rule of thumb. It’s meant to provide a predictable income stream throughout retirement because it’s inflation adjusted. Rather predictable.

But what it doesn’t do is it does not look at market performance, so it totally ignores the portfolio value. And that’s where the tail risk is— or the real concern around this type of spending strategy because, theoretically, someone could be increasing their spending throughout retirement, but if they incur a sustained bear market, particularly in the early stages of retirement, that’s when the portfolio runs the risk of being depleted prematurely.

Rob: Right, right. That’s the key point. The 4 percent rule determines your initial withdrawal in year one. But as you say, that’s under this ‘rule of thumb.’ There’s no rule that says a retiree has to follow this. But if you were, you would adjust your withdrawals and presumably increase them each year by the rate of inflation.

And if I understand what you’re saying, the tail-risk, as I think you described it, is you could be increasing your withdrawals at a time when the market is down 10, 20, 30, 40 percent in a year. So your portfolio balance is going down significantly while the amount you’re taking out is still ratcheting up a little bit each year. And that can create the risk that you run out of money during retirement. Is that the idea?

Colleen: Right. So the global financial crisis for instance: if that was sustained and someone had not altered their spending, what they thought was 4 percent could potentially be 6 percent. And clearly, a portfolio that’s meant to last for 30 plus years could not sustain a 6 percent withdrawal rate. So it is important to do a cross-check against the portfolio just to validate that.

Percent of Portfolio Spending Methodology

Colleen:On the flipside there is also a ‘percent of portfolio spending’ method which is exactly that – where you take the portfolio, say, every year, and if your spending rate is 4 percent you would adjust [annually]. You would take 4 percent of the prior year-end balance every year and presumably spend that. Now technically you could never run out of money because it’s a percent portfolio. Although the dollar amount could get much smaller over time.

What the trade off there is: it results in a very volatile year-to-year withdrawal strategy because it’s very contingent upon market performance. That’s another method, but that too comes with the trade off of having volatile income where many retirees wouldn’t be able to live with that type of volatility. And when I say volatility, I mean the income stream.

Rob: Right, so under that approach to the 4 percent rule, rather than starting out with a dollar amount that’s equal to 4 percent and adjusting for inflation each year going forward, you simply take, let’s assume 4 percent. You simply take 4 percent of your portfolio each and every year.

So if it happens to be a pretty good year like 2013, you’re presumably going to withdraw a lot more than you did the previous year because the market— at least the S&P 500 was up whatever— 32 percent, I guess. But in a down year like 2008, 2009 time period you could end up taking out a lot less, so you have a lot of volatility in your spending from year to year.

Colleen: Right. And that’s where we think retirees will have trouble. The upside is great because you have a surplus. It’s those years when the market is not performing well, then you might need to ratchet down that income. And that’s where retirees may have trouble with strictly following this type of method.

Hybrid 4% Rule with a Spending Ceiling and Floor

Rob: Right. Well, Colleen, I think you’ve written about a third alternative which is a percentage portfolio such as you’ve just described, but you’ve put in place a ceiling and floor. Do I have that right? And can you explain how that would work?

Colleen: Sure. We kind of dubbed this the hybrid method where we take the two methods—the positive parts of these two strategies. Each area was a 4 percent of the portfolio. You could actually increase it up to about 5 percent, due to the fact that you are actually having some flexibility with your spending.

So you would take a percent of the prior year’s end-balance and make sure it falls within the ceiling and the floor. You’d put a range on it. The reason why the range is helpful is because if you had a really good year and say the market was up 33 percent, you would cap the amount of spending. The amount you’re spending would increase so that in other years when the market goes down, you wouldn’t have to cut your spending as much. It helps with the predictability of the income stream and not having as extreme highs or lows as far as the spending amounts each year.

Rob: In the research you’ve done, are there any sort of guidelines you can give us as to what the ceiling and floor amounts should be? I take it those are percentages?

Colleen: They are percentages. It’s the year-over-year in real spending so what we’re trying to do there is keep the spending numbers within a range. We would say, each year the spending would not increase by more than 5 percent. So if the market was up 15 [percent], you would increase your spending from year one to year two by 5 percent, and that extra 10 percent of return would go into the portfolio.

And that way your year-over-year spending would not go down by more than 2 1/2 percent. But if the market was down 5 percent or 10 percent you would actually only be cutting your spending by 2 1/2 percent. When you’re thinking about that it is important to realize it’s the year-over- year change in real spending.

Rob: Okay. It sounds like the idea there is to combine the first two approaches, the traditional 4 percent rule where you adjust for inflation and combine that with the ceiling and floor so you get the advantages of both and you minimize the downside of each, even though nothing’s perfect, it puts in place perimeters that make the volatility from year to year a little less painful.

Colleen: Yes, exactly. And if you look at it: if you have a zero ceiling and a zero floor, you essentially have dollar plus inflation. If you went out for more of a 10 percent ceiling and a 10 percent floor, it would be very unlikely the ceiling and floor would kick in, so essentially you’d have a percent portfolio. It’s somewhere in between there that the ceiling and floor would really kick in.

Rob: Right, right. One question: I don’t know if it was you or Maria, but you alluded to the fact that bond and dividend yields are low. But I’m curious: for those in retirement, nearing retirement, or even those decades away who are trying to plan for how much they need to save—with the low yields that we’re seeing now, does that have any impact on this 4 percent rule and how folks should plan for retirement?

Maria: I would say it doesn’t really impact how you should plan for retirement because we believe in following more of a ‘total return’ approach. We don’t focus only on the income. If an investor is in retirement, they should not let the yield or the cash flow from their portfolio dictate how much they can spend.

For instance, in 2013, the yield from a 50 percent stock, 50 percent bond portfolio was only 2 percent, but the total return of the portfolio was actually about 15 1/2 percent. What we would say is, once you spend that 2 1/2 percent, you should maybe dip into the 13 percent to meet your spending needs as opposed to changing the composition of your portfolio to get that yield number to be higher.

Rob: Let me break that down a little bit to make sure I’m following you. Obviously with bonds, when you talk about yield you’re talking about the interest payments that an investor receives.

Maria: Correct.

Rob: I take it for stocks then, when you say yield we’re talking about the dividend payments they receive, whether it’s from an individual stock or even a mutual fund?

Maria: Yes.

Rob: Okay, so for a 50/50 split— 50 percent bonds, 50 percent stocks was this based on last year with a 2 1/2 percent yield?

Maria: Yes. And that’s been coming down since 1960 through the current years. In each of the last five to seven years the yield on 50/50 has been well below the 4 percent.

Rob: I was reading one of your articles… I think Colleen, you wrote it but I may have that wrong. I think it was back in 2007. In the article there were yields. I know the 100 percent bond portfolio had a yield of—I want to say 4 1/2 percent. Of course this was 2007 and I thought, “Man, I’d love to have bond yields at 4 1/2 percent right now.” It’s unbelievably low.

Colleen: Yes, it is.

Rob: So when you talk about a total return approach, you’re saying, “Don’t focus just on interest from bonds or the dividends from stocks. Look at a total return which would include capital appreciation.”

Colleen: Exactly.

Rob: The value of stocks going up.

Colleen: Correct. And what that really does for you is, a lot of people who are looking at their portfolio trying to figure out how to meet their income needs. If they only focus on the income, they might change their portfolio to overweight dividend paying stocks or high-yield bonds and maybe give up some diversification and increase the risk on the portfolio. In their fear of not spending from principal, they can actually make changes to their portfolio that could put their principal at higher risk than simply spending from it.

Rob: So for the total return approach, you really have to have a significant portion of your assets in stocks?

Colleen: Well, we would say a balanced portfolio, so at least 50 percent in stocks. For a younger retiree with a longer time horizon—let’s say a 20 to 40 year time horizon, 50 percent stock allocation could be very reasonable.

Rob: Okay, so the thought is, you’re more aggressive early in life in your 20s, 30s, 40s. Then as you get closer and closer to retirement, you tend to put more in bonds and less in equities. But you’re thinking that a balanced approach— again, it’s going to vary from person-to-person, I know there’s no one ‘right answer’ – but you think a 50/50 split between stocks and bonds is a good rule of thumb or starting point for those in retirement?

Colleen: Sure. I would say even between 40 to 60 percent in stocks, just because it’s important over long-term horizons to have some of that growth on the equity side of the portfolio to pay for inflation as well as grow to support the spending needs over time.

U-Shaped Glide Path

Rob: Let me ask you about this. I’d read an article in CNN. It was an interview of Michael Kitces. He had done some research suggesting that in the first few years of retirement you really should be conservative because how your portfolio performs in, let’s say the first 5 to 10 years, is critical to whether or not your portfolio will be enough to provide for your retirement.

He suggests starting with more bonds than stocks early on, and as you get a number of years into retirement the time risk minimizes somewhat— obviously your time in retirement goes down, then you can start to get a little more aggressive in your asset allocation and actually move more into equities. I’ve never heard of that approach before, and I’m curious whether you’re familiar with that and what are your thoughts?

Maria: Yes, Rob. Actually, we do get this question periodically. Sometimes it’s referred to as a U-shaped glide path in that during your accumulation years you’re more aggressive. Then as you enter retirement you move more conservatively, say 20 to 40 percent equity, but then you ratchet that back up to 40 to 80 percent equity later in retirement. The notion there is that the advocates will say that this should provide for higher success rates, but it also reduces the probability and the magnitude of the failure of those— the probability of losses.

Now you can think about that. But if you think about that intuitively and you think about retirees, basically what this does is shifts the sequence of returns risk from the beginning of retirement to later in retirement. It can create some pretty serious market risk scenarios for some retirees. It would be very difficult to address these types of market risk scenarios with someone who may be in their 80’s or 90’s.

Earlier in retirement, if you’re facing these types of bear markets for instance, you have the ability to adjust. You can adjust by doing some work part-time or consulting or maybe cut back on discretionary-type expenses. But in advanced retirement it becomes very difficult to manage this type of tail risk.

If you can envision 2008 where a 70 percent portfolio lost maybe about 20, 25 percent, if you’re having a discussion as a financial planner working with a client who is in their 80’s— it’s very difficult to deal with that situation versus someone who may be balanced in 30 percent equity for instance. And in 2008 they would have lost less than 10 percent of their portfolio value. So in our opinion, it really shifts this return risk towards the late stage of retirement in a period where it’s difficult for retirees to be able to adjust to that.

Rob: That actually is a good point. I think we tend to think of retirement as one chunk of time— you’re either working or you’re retired. The reality is, retirement at age 65 is going to look a lot different than retirement at 90 – both in terms of your spending needs and, as you said, your ability to adjust.

Presumably, at 65 you’re going to have more options to adjust to a difficult market for example than you will when you’re 85. Again, every circumstance is different but I think it is one of the mistakes is thinking of retirement as being all the same when it’s not. In fact, your spending requirements will likely change significantly over a 30 or 40 year retirement span. Would you agree with that?

Colleen: Yes, absolutely. And I think it’s a good practice for people who are entering retirement or early retirement to really look at their spending from both a discretionary and non-discretionary standpoint. Non-discretionary are things that you need to spend [money on] like food, housing, income taxes, healthcare costs. Whereas discretionary [spending is for] things like leisure and travel. Things shift over time.

Perhaps somebody early in retirement might have more goals in terms of travel and leisure, so their discretionary funds might constitute a greater percentage of their overall spending. But as you advance into later retirement, what is often seen is that the discretionary expenses go down but the non-discretionary – typically related to healthcare costs – may go up.

So there is fluidity there, and I think by looking at the expenses with discretionary and non-discretionary can give a retiree a good sense of where they may be able to make adjustments if they need to.

Rob: Another thing is—and I guess it’s my own personal view on investing – is that I was concerned about this U-shaped approach. You called it sequence risk, I think. The risk that you’re going to have bad years in the first few years of retirement.

Would you agree that is a real concern? If you have bad market years in the first couple of years in retirement does it have an impact on your success rate in that your money will be insufficient for your years of retirement?

Colleen: Yes, absolutely. And the other thing to keep in mind is at Vanguard we really advocate for all investors, regardless of what life stage they’re in to really focus on some things they can control. Though we can’t control the market, we can control our asset allocation and making sure we do portfolio management tactics such as rebalancing that asset allocation. So we basically will manage the risk profile of the portfolio.

Also, investment costs. We’ve talked about a lot of simulations and research here, but we need to overlay real-life considerations in terms of costs— costs being investment costs, as well as taxes. So focus on the things you can control as an investor because it’ll make you much better equipped to deal with the things that you can’t control.

None of this is ‘once and done.’ Once you’ve spent your spending target in your asset allocation, it’s very important to revisit that at least every few years, if not to adjust the asset allocation, but at a minimum to rebalance that periodically.

Rob: Let me cover both of those. On the portfolio construction, you think that Michael Kitces’s approach is making changes to your asset allocation during your retirement years. Putting that aside though, apart from rebalancing, which changes your actual asset allocation but doesn’t change your plan, you’re conforming your actual investment with your plan when you rebalance, right?

Do you think there’s a need to actually change your asset allocation during your retirement years?

Colleen: Really, we would say life changes would drive those allocations, so I would consider retirement a life change where you should at least look at the asset allocation and see if you would like to become more conservative due to the fact that you no longer have income coming in.

A lot of people up until retirement may have thought, “Okay, if I did lose my end-of-market I could replace it with my salary.” So there may be a point in time where people should take a few moments to think about the fact that, given they will no longer have income, will they want to become more conservative? And not necessarily would they have to— it’s just a consideration.

Then throughout retirement investors may decide to become more conservative as their time horizon shrinks. So, as Maria was talking about before, you may not be able to recover from a 30 percent loss or a 20 percent loss. Sometimes through time, investors may say they would prefer to become more conservative as their time horizon decreases.

Rob: It’s interesting on the conservative and aggressive because that discussion is always stocks versus bonds, although. – and maybe I follow Warren Buffet too closely – but there are other risks besides volatility, right?

For example, the risks that you won’t increase the purchasing power of your capital, which is a huge risk for bonds—at least in my view. Although, as you say, when you’re in retirement and your time horizon is getting shorter and shorter, there may be other considerations that trump that. There may be times when you want to adjust your asset allocation, and that certainly makes sense.

Investment Costs and the 4% Rule

RobYou mentioned investment costs. I’m curious. How do investment costs affect the 4 percent rule, whichever version of it one follows, and the likelihood of success—the likelihood that you’ll have enough money during your retirement. Is there a relationship between that and investment costs?

Maria: Absolutely. When we run our simulations and we put out there that you can spend 4 percent over a 30-year horizon of a 50/50, that assumes you pay all costs and taxes from that 4 percent. Depending on how you want to look at it, that would really mean you could spend something closer to 3 3/4 percent or 3 1/2 percent, depending on whether all of your assets are in a tax-deferred account where you pay ordinary income tax on them or tax-free accounts.

So the amount of investment costs and taxes is a dollar-for-dollar reduction in the actual spending for investors.

Rob: Okay. Let me play devil’s advocate and focus on the costs for a second. I get this question a lot. The cost of a fund really isn’t the issue. Whether it’s a low-cost Vanguard fund at 15, 20 basis points or whatever it might be, versus 100 basis points or more for an actively managed fund, that’s the wrong thing to focus on. What you should focus on is your after-cost returns. And if you have a mutual fund that’s charging you one percent or 1 1/2 percent but it’s beating those low-cost Vanguard funds, isn’t that really what you should focus on, and aren’t those the funds that you should be buying – focusing on after-cost return and not the expense ratio? What would you say to that?

Maria: I would say you should absolutely focus on after-cost returns and if they know in advance which returns, which funds will provide the highest after-cost returns then that would be ideal. The problem is no one really knows that in advance. And actively managed funds as a whole— after you take costs into account do not—there’s no predictability as far as whether those would provide higher after-cost returns.

Rob: Yeah, that’s great. You know, I cringe at those articles that you read where they talk about funds that have beat the indexes over 10 years. I think that’s an easy article to write when you’re looking in the rear-view mirror, but how about the 10 funds you think are going to beat it in the next 10 or 20 years? That’s a much harder article to write.

Colleen: Yes, and we’ve actually done a lot of work looking into which funds actually remain in the top quartile going forward and things like that. It’s very rare that actively managed funds will consistently stay in the top quartile in top 20, 30 or 40 year time period.

Annuities

Rob: Before I let you go— and I do appreciate your time with us today. It’s been very, very helpful and I’m thrilled to have you on the show, but I’m curious about annuities. You know, we talk about people wanting to get more conservative. I guess one very conservative approach would be some sort of fixed annuity. Just at a high level, how would that play into retirement planning and spending? And for those who do have annuities, should that affect the asset allocation for the rest of the investments they have?

Colleen: That’s a two-pronged question Rob, and they’re both very good points. I think I can touch upon how at Vanguard we believe annuities come into the financial planning picture, if at all, for retirees. We really focus on if a retiree is looking for a guarantee, an assurance. Because, again, annuities are— and when we say annuities we are talking about income annuities. Whether they’re immediate income annuities or deferred annuities or longevity insurance, they guarantee against longevity risks.

The question is, as a retiree you can do this in one of two ways: you can insure it by purchasing an income annuity to help manage that longevity risk, or you can do it with a portfolio of assets. Both are doable. The question is, do you want that peace of mind that additional guarantee that annuities can provide? Because they come at a cost, the insurance and the cost of the guarantee.

We don’t believe there’s an optimal annuity ratio for retirees out there. There’s a trade off. Certainly the more of your liquid portfolio assets you use to purchase guaranteed income, the less liquidity there would be from the portfolio later in retirement when, potentially, it might be needed.

If we’re talking to retirees and having that discussion, we would encourage them to think about it in terms of what the absolute floor is – the minimum level of guarantee you feel you need above and beyond other sources of guaranteed income you have as a retiree— first being Social Security. Social Security is an income annuity, and it’s the safest income annuity out there because it’s backed by the US government. That is the first source of guaranteed income.

But the question is, as a retiree, do you want an additional level of guarantee beyond that? And that’s where income annuities can come into the picture.

Rob: Okay. Am I correct that the low interest environment we’re in makes annuities more expensive, or am I thinking about that the wrong way? I confess, I’m not at a point yet that I’ve had to worry about purchasing annuities or even consider whether it’s the right decision for me and my family, but does the interest rate environment make annuities more expensive?

Colleen: It can. But there’s a point and counter-point to all of this. The question is, is it any more expensive relative to what? Usually that’s the argument there. Trying to time annuities is a futile effort. What, as a retiree—what might be a viable strategy would be essentially dollar cost averaging into annuities. And what I mean there is essentially buying a couple deferred annuities.

For instance, if you’re worried about the interest rate environment, and if you think interest rates may go up then you may be interested in locking in a higher payout or buying an annuity today versus a year or two, three, four down the road. You can start where the purchase is at, but I think it’s more important to think about whether you want the guarantee and when do you want the guarantee to start? I think that should be the first course of action for someone who is thinking about it versus the time to purchase the annuity.

But certainly the current interest rate environment will impact calculations that go into the payment schedule for annuities. Absolutely.

Rob: Okay, I can appreciate that. Obviously we could spend an entire show on annuities, and maybe I’ll be able to convince you guys to come back and talk about annuities sometime in the future. Let’s throw out one more question before we bring this episode to a close.

That is: do you have any favorite book on retirement or retirement planning that you’ve read, that you’ve liked, [and] that you think those listening might be able to benefit from? I know I’m kind of throwing that out there. Some interviewees that I talk to don’t have any recommendation, and that’s okay. But if you have any that you think are really good that would help folks, we’d love to hear them.

Maria: You know Rob, I don’t know whether there is a book per se. I think there’s a lot of good information out today via the web. And rather than be biased towards one particular book, I think there’s some very good personal finance columnists that tend to take different types of views, points and counter-points. The personal finance magazines could be a really good start for retirees as well.

Rather than me mentioning one book I’d actually encourage someone who is thinking about this actually looking into some of the personal finance magazines that are out there.

Rob: Okay.

Colleen: If I could just add to that. On Vanguard.com, Maria and I have done a lot of work. There are a lot of papers and presentations and webcasts on there that if someone is interested in reading more about it, we’ve probably covered a lot of these topics there.

Rob: I’ll link to those in the show notes. And of course there’s the Vanguard Blog too. Well listen Maria and Colleen, I really appreciate your time today. Thank you so much.

Colleen: Thank you, Rob.

Maria: Thank you.

Well, there you go. I hope you enjoyed the interview. I think Maria and Colleen did a great job of laying out a lot of issues—there’s a lot of stuff in that interview. But if you have questions, shoot me an email at [email protected]

And here are some great resources from Vanguard on the topics we discussed today:

• Vanguard’s Framework for Constructing a Diversified Portfolio
• Revisiting the 4% Spending Rule
• A More Dynamic Approach to Spending for Investors in Retirement
• Annuities and Your Retirement Portfolio