Retirees: Here’s How to Tweak the 4% Rule to Protect Your Nest Egg

Ivanna Hampton: Welcome to Investing Insights. I’m your host, Ivanna Hampton.

New retirees might enter a different environment than their predecessors. The economy or market might have changed slightly or dramatically. Morningstar researchers have investigated and identified their latest starting safe withdrawal rate. Here’s a hint: it’s slightly lower than the previous year. I asked Morningstar Inc. portfolio strategist Amy Arnott why. We also talked about a new metric that can help people figure out if they’re spending too little or too much. Here’s our conversation.

Welcome back to the podcast, Amy.

Amy Arnott: Thanks. It’s great to be here.

How ‘The State of Retirement Income’ Report Helps Investors Know Their Safe Withdrawal Rate

Hampton: Now, you and your co-authors recently published your annual report on the state of retirement income. Can you talk about the main goal of this research and how it’s different from other research that looks at retirement income strategies?

Arnott: The main goal with this research was to try to estimate how much can you safely withdraw from your portfolio during retirement. This is a difficult question to figure out, and actually probably one of the most difficult questions that people will ever face during their financial lives. If you’re saving for retirement, it’s pretty straightforward as long as you start early and you’re consistent about it. But when it comes to taking your retirement portfolio and figuring out how to turn that into a paycheck for yourself, that gets much more complicated. So, the danger is a lot of people are worried about possibly running out of money during retirement, but on the other hand, a lot of people actually end up underspending. So, there’s sort of a balance between you want to make sure that you’re spending enough so that you can enjoy your retirement and enjoy hobbies and travel, that kind of thing, but not spend too aggressively so that you might have to cut back later in life.

The way this research is different from other research out there is most retirement withdrawal research is traditionally based on looking at historical market data. This started out with William Bengen with his landmark paper in 1994, which was based on looking at market data going back to 1926 and figuring out what’s the highest withdrawal rate you could have made that would’ve survived. You wouldn’t have depleted the portfolio in every past period. And so that’s the origin of the 4% rule that so many people are already familiar with. When we started doing this research, we decided that instead of looking at past data, we would do something more forward-looking, using market estimates for possible future returns. So that’s the main way this is different from other research.

Conservative Estimate for Starting Safe Withdrawal Rate

Hampton: The latest starting safe withdrawal rate for the base case is 3.7%. Can you talk about how you all calculated that number and why it’s a conservative estimate?

Arnott: Yeah, so the base case is really the foundation of where all of our research starts, and it assumes that you want to create sort of a steady paycheck equivalent throughout retirement. So, it assumes that you take a certain withdrawal rate, say 4%, and apply that to your starting portfolio balance. That becomes your first-year portfolio withdrawal, and then each year after that, you’re adjusting that dollar amount for inflation. So you’re basically keeping a steady spending amount and never changing it. The reason it’s conservative, one reason, is we’re looking for a very high probability of success. So we use something called a Monte Carlo analysis where we’re looking at a thousand different random paths of returns. And then we’re looking for a safe withdrawal rate that succeeds—or that doesn’t run out of money—in 900 of those trials, so it’s very high threshold for success.

Secondly, we’re looking for a very long time horizon. We’re assuming a 30-year retirement period, which we all probably hope that we’ll be able to live 30 years in retirement, but unfortunately not everyone is going to make it to age 65 or 67. And finally, we’re using conservative estimates for market returns. So, especially, we want to make sure to build in sort of a buffer so that we’re not assuming the best-case scenario, but we want to make sure there’s a little bit of a cushion built into the numbers in case things don’t go as well as expected.

Why Has the Starting Safe Withdrawal Rate Gone Down?

Hampton: And those all seem important. The starting safe withdrawal rate has fluctuated over the years. In the previous report, it was 4%. Why did it tick down?

Arnott: It really comes down to the assumptions that we used for market returns. And if you think about how the market has done in 2023 and 2024, in both years, we saw equity market returns of about 25%, so very strong market performance recently. And even if you go back looking at the past 15 years, it’s actually the best 15-year period for stocks that we’ve seen going back to 1970. So because of that strong market performance, we now have a situation where valuations are relatively high on stocks, which leads to the possibility that maybe future returns could be a bit lower. So, we reduced our return assumptions for stocks and across different subasset classes and then also on the bond side. Since we had three rate cuts last year during 2024, bond yields are lower, which again suggests that future returns are probably also going to be a bit lower.

Flexible or Dynamic Strategies to Increase the Starting Safe Withdrawal Rate

Hampton: Now, you also explored various flexible or dynamic withdrawal strategies, and those can often lift the starting withdrawal rate.

Arnott: Right.

Hampton: Can you summarize some of the key ones that you and your team looked at in the paper?

Arnott: One thing we looked at is the forgo-inflation method, which is a very simple approach where anytime the portfolio value is down in a given year, you don’t give yourself a raise to account for inflation the next year. It’s very simple, but because those inflation adjustments kind of ripple throughout the 30-year retirement period, it does actually make a pretty big improvement in the sustainable withdrawal rate.

We also looked at a method that we call the RMD method. A lot of retirees are probably familiar with the required minimum distributions that they have to take from tax-deferred retirement accounts, and it’s basically calculated based on the portfolio value divided by life expectancy. And again, that’s something that allows you to start out with potentially a higher withdrawal rate than the base case.

We also looked at something that we call actual spending, which is based on some interesting research that has been done looking at how people actually spend during retirement. So, it’s the University of Michigan and the Department of Aging send surveys to people who are retired and then follow up with the same people over time to look at their spending patterns, and what they found is that spending tends to decline even in inflation-adjustment terms by about 2% per year during retirement.

And then finally, we also looked at something called the guardrails method, which was originally developed by Jonathan Guyton and Bill Klinger. And it’s based on the idea that you test the dollar amount that you’re planning to withdraw each year, and if that withdrawal rate is over a certain percentage, then you cut back a little bit on your spending. If it’s under a certain percentage, you increase your spending. So, sort of like visualizing guardrails on a highway, it’s a way of keeping you on the path and making sure you’re not veering too far off in either direction.

So these four methods, as you said, they all can lift the starting safe withdrawal rate, and the amount ranges from 4.2% for the forgo-inflation method, all the way up to 5.1% for guardrails.

What Is the Spending-Ending Ratio?

Hampton: It seems like a retiree can find one that works for them and go forth. So, the team also rolled out a new metric called the spending-ending ratio. Can you explain how it can help people?

Arnott: I think this is a really helpful metric, and it’s based on looking at the total dollar value that we estimate that you can spend during the whole retirement period and then the dollar value that we estimate for how much you might have leftover, and then comparing those two things in percentage terms, and I think this is a really helpful way of helping people think through what their priorities are and do they want to lean one way or the other.

Retirement Spending Strategies That Leave Legacy Funds

Hampton: Now, the ratio can help people calibrate their spending or whether they want to prioritize lifetime spending or having some money left over. What strategies could they pursue if they want to leave legacy money?

Arnott: A lot of people really like the idea of leaving a legacy behind for their family members or charity. One approach would be you could carve out a separate pool of assets and keep that off to the side and not use that for portfolio withdrawals at all. You could also use one of the methods that ends up with a higher ending value, like the base case or the forgo-inflation method. But I would also encourage people, in addition to thinking about legacy, to also thinking about giving while you’re still alive. And there’s this expression that I really like that goes, “It’s better to give with a warm hand than a cold one.”

And I think this really goes to the idea that if you’re able to give to people or causes that are important to you during your lifetime, you can get some emotional benefit from that. And I would also argue that, even if you’re giving smaller amounts during your lifetime, it can often have a bigger impact if you’re able to do that at certain key milestones during someone’s life, so helping out with education for a family member or helping pay for a wedding or a down payment on a house, or maybe planning a nice trip for the extended family. These are all things that can help build a legacy while you’re still around.

Hampton: Those are great examples, and you can see and be a part of those moments.

Arnott: Right.

Strategies to Help Retirees Spend All Their Savings

Hampton: So, some future retirees, Amy, they say they’re going to spend it all. They’re not leaving anything. What strategies can help them reach their goal?

Arnott: A lot of people have probably heard of this book called Die With Zero by Bill Perkins. And the idea is instead of trying to save every single last penny and end up with as much as you can when you pass away, that you really focus on spending mindfully and intentionally on things that are important to you during your lifetime.

For people who want to pursue that approach, one thing you could do is build a TIPS ladder, where you’re buying Treasury Inflation-Protected Securities with different maturity dates, and then spending each rung of the ladder as it matures to support your living expenses. That tends to be a very efficient way of drawing down assets during retirement.

Another approach would be the RMD method, which, again, is portfolio value divided by life expectancy. And because your life expectancy is getting a little bit shorter each year, your spending tends to increase a little bit in percentage terms each year, and that also tends to be a pretty efficient way of spending down assets during your lifetime.

Should You Delay Social Security?

Hampton: Many seniors depend on guaranteed income like Social Security, and when to claim can be a really big decision, so I hear. Now, the full retirement age sits around 67, but 70 is when you can get the maximum amount of benefits. What are the pros and cons of delaying Social Security?

Arnott: The big advantage to delaying Social Security until age 70 as you mentioned, is you can get much higher benefits. The benefit amount actually increases—from 67 to 70, it goes up by 24%. So, if you were expecting a monthly payment from Social Security of say, $2,000 a month, you could see that actually bump up to more like $2,500 a month.

Some of the ways that you could potentially delay Social Security, one would be if you’re in good health and you enjoy your job, you could continue working, and that way you don’t have a need for Social Security and you might also be able to continue saving for retirement. A lot of people also like to use rental income as a way of covering spending during those gap years between when you retire and when you start taking Social Security, or some people might also have a spouse who’s still working and be able to use that income to cover their living expenses.

But unfortunately, a lot of people don’t have any of those options. And actually, a lot of people end up retiring significantly before age 67, so more like age 62. So, in that situation, if you want to delay Social Security, you would have to take withdrawals out of your portfolio to cover your living expenses. And when you’re taking money out of the portfolio, that means there’s less money in the portfolio to grow over time, so you could end up with a smaller value at the end of retirement if that’s something that’s important to you.

Another drawback behind waiting to claim Social Security is if you don’t have a long life span, you might actually end up with smaller total payments during your lifetime. The breakeven age is about 83, so if you wait to delay Social Security until age 70, as long as you live to age 83 or later, you’ll end up breaking even and then coming out ahead, but if you do pass away before then, your total payments would be lower.

What Type of Retiree Should Consider an Annuity?

Hampton: Immediate and deferred annuities could help someone avoid outliving their money. What type of retiree might want to consider an annuity?

Arnott: An immediate annuity would be when you are interested in starting payments as soon as possible. And some people who might want to look at an immediate annuity would be people who don’t have a lot of assets to work with and are worried about running out of money during retirement. When you buy an annuity, you’re basically taking money out of your portfolio and giving it to the insurance company in exchange for a guaranteed stream of monthly income, and because you’re pooling your longevity risk with other people who also have insurance contracts with the insurance company, that monthly income amount can end up being significantly higher than what you might be able to withdraw from your portfolio. So, for example, if you bought an immediate annuity for a $100,000, you might be able to get guaranteed income of $6,000 or $7,000 a year for as long as you’re living.

Other people who might want to consider one of these annuities would be people who aren’t comfortable taking market risk and just want to have guaranteed income and don’t want to mess around with trying to figure out how their portfolio is doing or how much they can safely withdraw.

And then, the third person who might want to consider one of these annuities would be someone who’s concerned about longevity risk. So, for example, if you have a lot of family members who have lived well into their 90s or later, or if you’re a very healthy person and you think you might have a longer-than-average life span, an annuity can be a good way to protect yourself from that type of longevity risk.

Pros and Cons of Deferred Annuities

Hampton: Deferred annuities postpone payouts for maybe a decade or more, and that can push up monthly or yearly payments compared to immediate annuities. Can you talk about the risk and rewards?

Arnott: On the risk side, like any type of annuity, normally, a deferred annuity is not inflation-adjusted, so you are running the risk of losing some purchasing power over time, especially if you’re deferring the payments for 10 or 20 years down the road. Another risk is the financial health of the insurer. So, you want to make sure that you are comfortable with the credit quality of the insurer, and the company is going to be around 10 or 20 years down the road.

On the positive side, as you mentioned, by deferring the annuity, you can often get significantly higher payouts. So, for example, if you bought an annuity at age 67 and waited until 85 to start collecting the payouts, those payment amounts could actually be double what they would’ve been at age 67. And again, I think another positive with deferred annuities is it can be a very good way to hedge against longevity risk because, for example, if you’re deferring until age 85, you don’t have to worry about how long you’re going to live after that point because you have that guaranteed stream of income.

Hampton: So, some peace of mind?

Arnott: Right, exactly.

What’s Next for ‘The State of Retirement Income’ Report?

Hampton: What areas are you and the team thinking about focusing on in the next report?

Arnott: One thing I really like about this report is we publish it once a year, and we try to expand it a little bit each year. Some of the things that we’re thinking about for next year, one would be looking at more of a variable inflation rate. Right now, our data kind of assumes a flat inflation rate during retirement, but as we all know, inflation can bump around a bit from year to year. We’re also interested in looking at the impact of taxes and strategies that people can use to minimize the tax impact of portfolio withdrawals. A third area would be looking at additional flexible-spending strategies, like maybe a fixed percentage approach, where you’re taking a certain percentage, like 5%, and then applying that to the portfolio balance each year to figure out your portfolio withdrawal amount. And finally, we’re interested in looking at guaranteed income strategies in more detail and giving people more guidance on how they can combine different sources of guaranteed income with the various withdrawal strategies that we look into in the paper.

Hampton: I’m looking forward to reading about all of it when it comes out. Thank you, Amy, for coming to the table and discussing this important retirement research.

Arnott: Thanks. It’s always great to talk to you.

Hampton: That wraps up this week’s episode. Thanks for watching and making this show part of your day. Subscribe to Morningstar’s YouTube channel to see new videos about investment ideas, market trends, and analyst insights. Thanks to Senior Video Producer Jake VanKersen, Associate Multimedia Editor Jessica Bebel, and Digital Communications Specialist Kumudini Devalla. I’m Ivanna Hampton, lead multimedia editor at Morningstar. Take care.