I sat in the passenger seat as we swept around a corner. My friend, Pat, was driving. I was 20 years old. Pat was 31. But he was more like a giant kid with a grown-up’s income, credit cards and a taste for fast cars.
He drove a black Porsche Carrera. His friend, George, followed us in his 3-Series BMW. As we hit a more open road, Pat floored the Porsche. I didn’t think George could keep up. But within seconds, George flew past. I later learned that he had rigged his car to use nitrous oxide.
You’ve probably never altered your car to boost its performance. But I’m guessing you wouldn’t mind boosting your future retirement income. There are two ways to do that. You could simply save more money and build a bigger portfolio. Or, you could think a bit like George and put your portfolio on the juice.
Let’s start with a traditional approach. Most financial advisors recommend the 4 percent rule. Bill Bengen, a former financial planner, was the man behind the method. After back-testing a variety of scenarios, he found that retirees could withdraw an inflation-adjusted 4 percent of their portfolio each year. His studies showed that the money should last a 30-year retirement.
For example, in the first year of retirement, somebody with $500,000 would sell $20,000. In the second year of retirement, they would give themselves a raise to cover the rising cost of living. If inflation were 3 percent, the retiree would withdraw $20,600 during their second year of retirement.
In 2010, researchers Philip L. Cooley, Carl M. Hubbard and Daniel T. Walz published Portfolio Success Rates: Where To Draw The Line in the Journal of Financial Planning. They backtested a variety of portfolio allocations and withdrawal rates between 1926 and 2009. The table below shows some of their data. For example, they found that a portfolio with 75 percent stocks and 25 percent bonds had a 96 percent chance of lasting for 30 years if a retiree withdrew an inflation-adjusted 4 percent per year. If they withdrew an inflation-adjusted 9 percent per year, the odds of the money lasting a 30-year retirement dropped to 55 percent.
Where To Draw The Line Withdrawal Rates And Portfolio Allocations For A 30-Year Retirement
|75% Stocks/25% Bonds|
|Odds Of The Money Lasting 30 Years||100%||96%||67%||96%||91%||69%||55%|
|50% Stocks/50% Bonds|
|Odds Of The Money Lasting 30 Years||100%||100%||100%||98%||85%||53%||27%|
|Source: Portfolio Success Rates: Where To Draw The Line: Journal of Financial Planning|
Critics of the 4 percent rule, however, remind me of the old joke about how much money the dead guy left. He left everything. In most cases, retirees that follow the 4 percent rule might end up leaving their heirs with more than they expect.
That led researchers to ask, “Can we safely withdraw more than 4 percent?” The answer might be yes. One such strategy was created by Jonathan Guyton. It was later refined by Guyton and William J. Klinger. They described it in their 2006 research paper, Decision Rules and Maximum Initial Withdrawal Rates. The researchers say investors could withdraw an initial 5.2 to 5.6 percent of a retiree’s portfolio value each year. That might not sound like much of an increase. But 5.2 percent is an initial spending boost that’s 30 percent above Bengen’s 4 percent rule.
Guyton and Klinger’s backtests assumed two test periods: 1928-2004 and 1973-2004. The first test period began on the eve of history’s biggest stock market crash (1929-1930).
The second coincided with “the perfect storm.” Inflation was high and the markets were set to plunge into the 1973-1974 Bear Market.
Guyton and Klinger’s strategy works best for portfolios with at least 65 percent in equities. But it requires a lot of engine tuning. Let’s assume that someone retires with $500,000. They decide to withdraw 5 percent ($25,000) from their first retirement year. During their second retirement year, the retiree would withdraw more money to cover that year’s inflation.
Let’s assume they withdraw $26,000. The money would be removed from the account in the following order of importance. The researchers call this their PMR (Portfolio Management Rule).
- Withdrawals come from the equity class that exceeds its goal allocation.
If that doesn’t cover the $26,000 required, Guyton and Klinger recommend the following withdrawals in this specific order.
- Overweight fixed income
- Withdrawals from fixed income
- Withdrawals from equities
To increase the odds that investors won’t run out of money, the researchers suggest that withdrawals aren’t increased during years when the portfolio doesn’t make a profit. For example, if the second year’s withdrawal were $26,000 and the portfolio were to drop in value during the third year, the investor would withdraw $26,000, without an adjustment for inflation.
Guyton and Klinger also say withdrawals shouldn’t exceed 20 percent more than the initial withdrawal rate. For example, if the initial withdrawal rate were 5 percent per year, investors wouldn’t withdraw more than 6 percent of their total portfolio value in any given year (6 is 20% greater than 5). This means retirees would get a “pay cut” from time to time. The reseachers call this their CPR Rule (Capital Preservation Rule).
For example, if the investor withdrew $26,000 one year, and their portfolio value dropped from $500,000 to $400,000 the following year, withdrawing $26,000 again would constitute 6.5 percent of the portfolio’s total value. But this would break the CPR Rule. To increase the odds of the investor not running out of money, the retiree would be have to cap their withdrawal at 6 percent of their porfolio’s value. In this case, that would be $24,000 ($24,000 is 6% of $400,000).
Finally, the researchers have a PR (Prosperity Rule). It allows retirees to withdraw more money during high performance years. Assume an investor’s portfolio increased from $400,000 to $650,000 the following year. If the investor withdraws $24,000 again (as in the previous example) that would only be 3.6 percent of the portfolio’s total value. That’s 28 percent below the initial 5 percent withdrawal rate. Guyton and Klinger say that when the amount withdrawn would be 20 percent below the initial withdrawal rate, the investor boosts their withdrawal by 10 percent.
Yes, this is complicated. But it’s simply skimming more off the portfolio during strong years and a little less during weak market years. Overall, it’s supposed to provide retirees with greater overall income.
It doesn’t provide a hands-free solution, such as AssetBuilder’s Abri.
But for those who want to tinker, it might increase a portfolio’s income producing horsepower.
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.