Riding the Rails

Adam M. Grossman

“HOW MUCH CAN I withdraw from my portfolio each year?” It’s one of the most common questions that retirees ask.

In the past, I’ve talked about the 4% rule, a popular tool for addressing this question. Among the reasons it’s so popular is its simplicity: In the first year of retirement, a retiree withdraws 4% of his or her portfolio, and then that amount increases each year with inflation. If you have a $1 million portfolio, for example, you can withdraw $40,000 in the first year. It couldn’t be easier.

There is, however, a fair amount of debate about the rule. Some contend that 4% is overly generous, while others argue that it’s unnecessarily stingy. And many question the assumptions used in the original research.

Perhaps the most fundamental criticism is that the 4% rule defies human nature. Suppose you had retired in 2009, in the middle of a recession, when the stock market was depressed. If you’d set your initial withdrawal based on the value of your portfolio at that time, it would have been an artificially low number, even though that’s what the 4% rule would have dictated.

Indeed, in the 14 years since, the stock market, as measured by the S&P 500, has risen from a low of 666 to above 4,000. As a result, many retirees’ portfolios have grown substantially over the past decade. But if you’d been following the 4% rule, your withdrawals would have grown much more slowly—because withdrawals under this rule are permitted to increase only at the rate of inflation and, with the exception of the past few years, inflation has averaged some 2%.

Because of that, many view the 4% rule as more theoretical than useful. That’s why an alternative spending methodology has been gaining in popularity. It’s commonly known as the “guardrails” method.

In simple terms, guardrails are designed to be more responsive to market returns than the 4% rule, which pays no attention to market movements. Using guardrails, retirees can withdraw more from their portfolio in years when the market is strong. But in exchange for that, retirees must accept a spending cut in years when the market is particularly weak.

Because guardrails-driven spending rates are responsive to market conditions, this approach has intuitive appeal. Guardrails-based spending also typically allows for a higher initial withdrawal rate than the 4% rule.

In their research, guardrails creators Jonathan Guyton and William Klinger concluded that much higher withdrawal rates—between 5.2% and 5.6%—would be sustainable over a 40-year retirement. Instead of $40,000, or 4%, on a $1 million portfolio, guardrails would allow for between $52,000 and $56,000. This aspect of guardrails also has intuitive appeal. If retirees are willing to accept a pay cut when the market is down, they should be allowed to start out at a somewhat higher rate.

At first glance, it might seem impractical to ask retirees to cut their spending during market downturns. But proponents make two points. First, these pay cuts aren’t significant. In the standard guardrails formula, withdrawals are cut by just 10% during market downturns. Second, those who use guardrails know how the strategy works—and they know which discretionary expenses they’d trim if it’s necessary.

Another appeal of guardrails: They offer a sort of built-in early warning system. In years when the market is weak, retirees can see how close they’re getting to a potential pay cut. Assuming a $1 million starting portfolio, the lower guardrail, which would necessitate a spending cut, might be set at $800,000. If that were the case, an investor could keep his eye on the market and begin preparing for a cut if he saw his portfolio drop below, say, $900,000.

Despite these benefits, guardrails have their downsides. For starters, unlike the 4% rule, the guardrails approach is complicated. If the 4% rule is like riding a bicycle, guardrails are like a 747. To determine each year’s withdrawal rate, investors must work through a five-part framework, which includes these rules: the portfolio management rule, the inflation rule, the withdrawal rule, the capital preservation rule and the prosperity rule.

To get a sense of the complexity of guardrails, you can try this online calculator. Just set the strategy to “Guyton-Klinger.” As you’ll see, even though the calculator does the hard part, there are still about a dozen inputs.

Another downside: Retirees have to contend with much more unpredictable spending from year to year. As I noted above, guardrails will generally only require a 10% pay cut in years when the market is down. But if the market declines for multiple years in a row, as it did in 2000, 2001 and 2002, guardrails would require multiple pay cuts in a row. It’s for this reason that one critic calls guardrails a “scam” and a “horror show.”

A final criticism—one that applies to both the 4% rule and guardrails—is that they ignore an important reality: Spending isn’t linear. Research has found that most retirees’ spending follows a common pattern, with spending higher during the initial post-retirement years but generally lower later in life, as travel and other activities become harder. That’s one reason it doesn’t make sense to simply extrapolate spending from the first year of retirement. Also, retirees might have one-time expenses—a home in Florida, an RV or maybe a gift to their children—that don’t fit neatly into either of these simple spending formulas.

Where does that leave retirees? If neither the 4% rule nor the guardrails approach provides a complete solution—and the alternative, Monte Carlo analysis, is even worse—how should retirees decide on a spending rate? I have three suggestions.

First, try to build a multi-year model that incorporates both regular spending and the one-time expenses referenced above. You could do this in a spreadsheet, though I recommend financial planning software because it does a better job of estimating taxes.

Second, after building an initial model, explore variations. For example, if it looks feasible to spend $70,000 per year and to buy a $400,000 vacation home, see what it would look like if your spending were instead $100,000 or the home more expensive. This would allow you to see what general range of spending is advisable over time, making it easier to vary it from year to year within that range.

My third suggestion: Don’t accept any of these spending strategies as gospel—but don’t entirely reject them, either. William Sharpe, a recipient of the Nobel Prize in economics, has described the retirement spending puzzle as “the nastiest, hardest problem in finance.” It’s not easy, so it’s wise to attack the problem with as many tools as you can.

Each strategy has some merit. The 4% rule is a great shorthand tool because you can often do the math in your head. Guardrails, on the other hand, may be more complex, but the way it responds to changes in the market makes it more realistic. Many school endowments, it’s worth noting, use a hybrid approach: They withdraw a fixed percentage of their endowments, but that fixed percentage is often set in relation to a three-year moving average of the endowment’s value.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. Sign up for Adam’s Daily Ideas email, follow him on Twitter @AdamMGrossman and check out his earlier articles.

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