William Bengen’s 1994 article in the Journal of Financial Planning is widely cited as a solution for estimating a sustainable withdrawal rate for an investment portfolio during retirement. The article’s celebrated conclusion is that “about four percent” is “safe.” A reasonable first approximation, but this landmark paper is now viewed as a useful but preliminary step in modeling one of the more slippery concepts in financial planning.
The so-called 4% rule isn’t wrong per se. It’s “still a great starting point,” notes Morningstar’s head of retirement research, David Blanchett. But just as Newton’s mathematical narratives represent an early if incomplete blueprint for describing the physical universe, Bengen’s research is considered a seminal effort that launched the modern age of quantitatively analyzing spending expectations in retirement. As for delivering a genuine solution, well, that’s still a work in progress and probably always will be.
The major stumbling block is a familiar nemesis: uncertainty. Future levels of market risk and return are blurry at best. Meanwhile, every retiree’s circumstances and objectives, even for those in the upper levels of the wealth spectrum, are different.
If there’s a weakness in Bengen’s paper, it’s the suggestion that there’s one spending rate for everyone throughout retirement and it’s a number that can be confidently estimated in advance. Reality is more complicated. A truly well-heeled client may be exempt from such hitches. But a certain segment of the moneyed class—particularly those with a penchant for conspicuous consumption—may still require guidance on developing reasonable expectations for spending in retirement.
Ultimately it’s all about the details. Because of different spending goals, time horizons and other factors, the optimal withdrawal rate almost certainly varies from retiree to retiree—and from year to year. Even if running out of money is a low-risk possibility for an affluent client, modeling the future can still be a productive exercise for those planning on maximizing wealth transfers to the next generation, charitable giving and other objectives beyond living comfortably.
In other words, there’s a common set of challenges whether the nest egg is $500,000 or $50 million.
“You can’t predict how long you’ll live, what the stock market will deliver or what inflation will be,” says Jason Hull of Hull Financial Planning in Fort Worth, Texas.
In other words, trying to come up with one spending rate that’s written in stone for decades, for every portfolio, is tempting fate.
David Kitces at Pinnacle Advisor Group in Columbia, Md., says that adjusting the initial spending plan through time is reasonable and necessary. “It’s still important to set the initial number,” he says, but it needn’t remain constant. Rather, the goal should be to think of a withdrawal rate a la Bengen as a floor for spending under the worst-case scenario. “No one likes to have the floor give way,” says Kitces.
He uses Bengen’s 4% rule as an initial estimate for clients. The number is adjusted for each retiree, depending on a range of factors, he explains. If you’re willing to adjust your spending through time, for example, the flexibility allows for a slightly higher withdrawal rate. The range for Pinnacle’s clients overall is in the 3.5%-to-5% range, Kitces says.
Do Rich Clients Need A ‘Safe’ Spending Rate?
A hefty dose of wealth is the optimal solution for ensuring that the assets don’t run out in retirement. Deciding if a client is safely over the financial hump, however, isn’t always cut and dry. Does a $5 million net worth suffice? Maybe, but maybe not. Much depends on expectations and the spending rate relative to assets.
“Depending on how grand the lifestyle, spending plans have to be considered for net worth below $40 million to $50 million,” says Ed Renn, a partner in the private client department at Withers Bergman. “I have wealthy clients who go on vacation and decide to buy a $10 million house where they visited.”
To wit, it’s not how much you’re worth—it’s how much you spend. Assuming that a well-to-do client doesn’t go off the deep end, the finer points of estimating safe withdrawal rates may not be relevant. How can you tell if a client has irrevocably cleared the line? One clue: If you have to ask the question for a given client, maybe estimating a reasonable withdrawal rate is worthwhile after all … especially after factoring in taxes.
The main priorities for wealthy individuals and families tend to be intelligent planning on budgeting and tax-management issues. “Tax planning can have significant impact on the withdrawal rate” for the high-net-worth set, says Phillip Christenson at Phillip James Financial, a wealth management firm in Plymouth, Minn. Given the high tax rates that usually apply to these individuals, smart tax management can effectively be the equivalent of optimizing spending rates. An intelligent approach to minimizing taxes “can extend the life of a portfolio for years.”
Yet it’s not always easy to generalize, even for wealthy clients. Renn points out that some high-net-worth individuals hold a high degree of illiquid assets, such as real estate and private equity. Portfolios stuffed with hard-to-sell holdings can create a challenge that requires a sharper focus on modeling optimal spending rates to maintain a given lifestyle and avoid forced transactions. “For clients with way too much in residential real estate, it’s a concern,” he says.
Who Moved My ShortCut?
Regardless of the size of the asset pool, there are no easy solutions for intelligently estimating a reasonable withdrawal rate. There are, however, some obvious places to start the analytical journey:
1. Annuities
Locking in an income stream with annuities is a compelling choice to provide a foundation for retirement income, according to some advisors. “The safest way to go is with an inflation-adjusted SPIA [single premium immediate annuity],” says Hull. Paying a lump sum up front in exchange for a lifetime of guaranteed payouts that are insulated against inflation risk is a “truly safe method” for generating retirement income, he asserts.
Minds will differ, of course. The main knock against these products is the requirement that investors transfer some or all of their nest egg to an insurance company up front. There are additional risks for the high-net-worth set, some advisors warn. Robert Leahy at Leahy Wealth Management, for instance, recently wrote on his blog that “the wealthy should likely never buy tax-deferred annuities” because “sheltering too much of their investment wealth before retirement often leads to a tax bomb in retirement.”