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IT’S CHALLENGING TO GO from saving during our working years to spending in retirement. Our solution: Use a modified version of the 4% rule.
Financial planner William Bengen was the first person to articulate the 4% rule. He wanted to know how much people could withdraw from their investments each year and still not run out of money. Through extensive back-testing, he found that if folks withdrew 4% in the first year, and thereafter increased this amount each year for inflation, in almost all cases they wouldn’t run out of money over a 30-year retirement.
With Bengen’s 4% rule, the amount withdrawn is driven only by the initial portfolio value and subsequent inflation. History suggests this approach should be okay despite sequence-of-return risk—the danger that the financial markets perform poorly during the years immediately after a person retires. Still, folks who retire and keep taking out an inflation-adjusted 4% do run some risk of running out of money.
I believe it’s reasonable to increase spending when the markets are doing well, while also cutting back when markets perform poorly. Bengen’s model doesn’t incorporate this. Vanguard Group developed a withdrawal method which does. I have read its guide several times and, I must confess, I still don’t understand it.
What to do? For my wife and me, I had three criteria for our retirement withdrawal strategy. First, it should be simple, something I can use when I’m 90 years old. Second, the approach should be responsive to market returns. Finally, it should be financially conservative, meaning there’s reasonable certainty we won’t run out of money before we die.
A withdrawal each year that’s simply 4% of the prior year-end balance—without the inflation adjustment in Bengen’s approach—meets these three objectives. With such a plan, a person would never run out of money. Each year, you always leave 96% of your portfolio invested. And it’s certainly simple. But a major drawback is that the amount withdrawn each year fluctuates widely because market returns are so erratic.
That’s why I nixed the idea of simply withdrawing 4% of our prior year-end balance. Instead, I’ve made two modifications, which I have found to be extremely helpful.
First, rather than using last year’s Dec. 31 balance, I apply a percentage to a three-year rolling average of year-end balances. It allows for significant spending increases only if there have been sustained market gains, while cutbacks are only required if there’s a prolonged bear market. Second, because I’m financially conservative, instead of 4%, I use 3%.
The upshot: We limit our annual withdrawals to no more than 3% of our average investment balance for the prior three year-ends. I believe this is a simple yet elegant solution. Because of a lifetime of frugal habits, we’re in the fortunate position that we could live on Social Security and a modest pension I receive. We use withdrawals from our nest egg primarily for gifts to individuals, contributions to charitable organizations and to fund a major overseas trip every few years.
Because we’re heavily invested in stocks and limit our withdrawals to 3%, I fully expect our investments to continue to grow. When the time comes, hopefully a decade or more away, we’ll spend what we need to for assisted living or nursing care, even if it exceeds the 3%.
We have just three investment accounts: a traditional IRA, a Roth IRA and a regular taxable investment account. Each January, I enter the year-end amounts for the three accounts in a simple spreadsheet. It totals the three accounts and calculates the three-year rolling average. The calculation could also be done by hand. If I pass away first, my wife can easily take over.
After a lifetime of saving, we initially found it unsettling to make withdrawals from our investments. But with this plan, we sleep well at night, enjoy the fruits of our earlier saving and remain confident we won’t run out of money.
Larry Sayler is the only person with a Wharton MBA who also graduated from Ringling Bros. and Barnum & Bailey’s Clown College. Earlier in his career, he served as CFO for three manufacturing and service organizations. For 16 years before his retirement, Larry taught accounting at a small Christian college in the Midwest. His brother Kenyon also writes for HumbleDollar. Check out Larry’s earlier articles.
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It would be interesting to compare your three year average withdrawal to a three year “EMA” withdrawal method. The EMA would weigh your withdrawal more towards recent gains.
I like your method, Larry. Thanks for sharing.
Nice article Larry. Another withdrawal method that I found very interesting was recently posted by Mad Fitentist (The Problem with the 4% Rule (and Why You Could Retire Even Sooner) (madfientist.com). He talks about the problem with the 4% rule and gives, I think, a good solution. He basically bases one’s withdrawal percentage on the person’s discretionary income and the stock market’s performance. His method is very interesting. It may or may not be your choice of withdrawal method, but will at least get you thinking.
I solved the withdrawal volatility by separating required expenses from discretionary expenses. Required expenses stay under 2.5% of the current portfolio balance, but the withdrawal rate is always 4%. After a market crash of 55%, a 67/33 portfolio with a 4% withdrawal rate will still provide a dollar amount greater than 2.5% of the balance prior to the crash.
I also read the Vanguard withdrawal method and found it lacking. The ceiling could be infinite and still not cause a problem, so there’s no point. The floor method is also far less effective than fixed percentage, which they themselves found to be the case. I appreciate Vanguard, but their method seemed like an overcomplicate fixed percentage method. My advice: Use a fixed percentage, have a plan for variability, and just do your best.
This is a great article, and is actually a big “duh” for me. In the past I have been on the endowment committee of 2 different non-profit organizations. One of our tasks was monitoring withdrawal rate with the objective of not depleting the endowment. Current law allows a “total return” distribution, but it is up to the organization as to what base period to use. One of the charities used a rolling 8 quarter-end average, and one used a rolling 12 quarter-end average. That’s not too much harder to calculate than Mr Saylor suggests using year-end results. Looking backwards, investment totals peaked at the end of 2021 and were lower at the end of 2022. No surprise there. But the big gains in 2021 got averaged in with the previous quarters, and the big reductions in 2022 got averaged in with their previous quarters as well. This prevented taking an unusual windfall in the unusually good year, and prevents taking a big hit on the distribution in an unusually bad year, thereby somewhat stabilizing the income to the charity. So my big “duh” is, why didn’t I think of this for my own account???
Nice article Larry.
I wonder if the (admittedly minimal) work to calculate performance over the last three years, or even adjust spending based on last year’s performance, is really necessary. It seems to me that with a sufficient cash reserve, one should be able to continue withdrawing at the initially set rate even following a down year (or three) and not sell depreciated assets to do so.
I agree that withdrawing 3% of the average of the last 3 years assets is straightforward, which is helpful.
However, I wonder if that would be an appropriate withdrawal level for all ages? For example, if you were age 95 with (presumably) relatively few years remaining, withdrawing only 3% might be too low unless your objective was primarily to leave an inheritance.
What I wrote Mr. Clements about in 2016 and I still think is appropriate, albeit slightly more complicated, is to:
I call this approach “RADAR” for Risk Adjusted Drawdown Asset Rate.
Of course, each situation will have complexities such as wanting to take out a higher asset percentage before starting to draw social security, etc. However, I think the basic principle of adjusting your asset withdrawal percentage based on your estimate of how much time you (or you and your spouse) may have remaining is sound.
Does a 95-year old have relatively few years left? In most cases, yes. But there are outliers. My grandmother passed away just a month before reaching 112. At 95, she had nearly 17 years left.