Morningstar has recalculated its annual safe withdrawal rate that current retirees would need if they want their portfolios to last 30 years. The number is now back in line where many other academics put it: at 4%. Yet in Morningstar’s methodology, that’s actually a modest increase from last year’s 3.8% rate, thanks to lower long-term inflation estimates and better bond yields, the research firm said.
The new rate assumed that 20% to 40% of a retiree’s portfolio was invested in equities, and the remainder in bonds and cash. This allocation resulted in a 90% probability of success, Morningstar said.
Should the portfolio hold a higher level of equities, the firm found that the safe withdrawal rate dropped, but the rest of the portfolio was worth more at the end of 30 years. For example, a portfolio 70% invested in equities had a starting safe withdrawal rate of 3.8% and an ending balance almost twice as large as the base-case portfolio.
“Although conservative portfolios modestly improve the starting safe withdrawal rates, they do so at the cost of potential future wealth,” the report stated. “Portfolios with equity weights between 20% and 40% supported the highest starting safe withdrawal percentage, but they also recorded lower median balances at year 30 than did portfolios with more equity exposure.”
Research from the report, called “The State of Retirement Income: 2023,” looked at how different dynamic withdrawal strategies affected the safe withdrawal rate. In particular, Morningstar compared four spending methods that bring some variability into retirees’ spending to evaluate if they could improve on the 4% rate. In the first method, the retiree did not take inflation adjustments following an annual portfolio loss. The second method was a required minimum distribution strategy where the portfolio was divided by life expectancy. The third method involved guardrails that give a retiree a raise when the portfolio was up and cut back when the portfolio was down. And the fourth involved declines in spending from the beginning of retirement to the end.
Based on the starting safe withdrawal rate, a guardrails strategy was the clear winner, as retirees employing this approach could safely withdraw 5.2%, although at the end of the retirement window the ending balance of the portfolio would be among the lowest of the options.
John Rekenthaler, Morningstar’s director of research, said that regardless of which dynamic strategy an investor chose, using some form of guaranteed income to cover needs and then using portfolio withdrawals to cover discretionary expenses protects against down markets while increasing options in up markets.
“The best approach would be to split up the portfolio, get some part of it devoted to guaranteed income, and then be flexible with the remaining portion,” said Rekenthaler. “The way to get higher withdrawal rates over time during retirement is to be flexible and to respond to market movements.”
With guardrails, that flexibility would start with that 5.2% safe withdrawal rate, adjusted annually based on portfolio performance and the previous withdrawal percentage. If the market is trending upward and all criteria are met, the retiree would get a 10% increase on top of the inflation-adjusted previous year’s withdrawal. But if the market is dropping and the reverse happens, the retiree would cut the annual withdrawal by 10%.
However, should a client use guardrails and increase equity holdings to 60% to 70% in the portfolio, the starting withdrawal rate would jump to 5.5%.