Get a Lifetime Investment Income From Your Retirement Portfolio

I’ve written quite a bit about the infamous 4% withdrawal rate rule. I say “infamous” because I don’t like it. It may have worked in the past. Now this rule of thumb is more like a rule of “dumb.” We are more prone to black swan market crashes and burdened by less predictable market returns. This requires alternative strategies for procuring a lifetime of investment income from our retirement portfolio. It starts with liability-focused investing rather than pure wealth building.

My favored approach is to use sources of guaranteed retirement income to meet basic living needs, then increase risk from there. Others have proposed a modified version of the 4% rule. To explain one such version, let’s first review the basics of the 4% rule. It postulates that in your first year of withdrawals, you take 4% of the total value of your retirement portfolio. For each year during the remainder of  your retired life, you  withdraw that same dollar amount, adjusted by the prior year’s rate of inflation.

The 4% rule has been popular for several reasons. First, it helps manage the longevity and inflation risks in retirement. Second, it is simple to use.  Third, it provides retirees a steady amount of spending money each year.

But the 4% rule has serious problems. For one, the rule attempts to combine a rigid spending plan with an investment portfolio that can (and probably will) experience substantial changes in value every year. If the markets are strong, a retiree may end with a large stash of money to leave to his or her children. If the markets are weak, that same retiree could easily run out of money halfway through retirement. In the words of Laurence Kotlikoff, economics professor at Boston University: “This is a prescription for getting people into serious trouble.”

Now here is an explanation of an alternative to the 4% rule – an alternative that is more likely to succeed in providing a lifetime of investment income: Each year the retiree withdraws a fixed percentage of the current value of the retirement portfolio.

Unlike the 4% rule which permanently establishes a fixed dollar amount plus inflation, the fixed percentage approach causes the retiree to adjust spending in response to market performance. Thus, if the size of the investment portfolio grows from the prior year, the withdrawal amount also grows.  If the portfolio declines, so does the amount of the withdrawal.  Using this technique, the retiree will never run completelyout of money.

The obvious downside to the fixed percentage withdrawal strategy is that there can be significant fluctuations in spending power from year to year. Your standard of living may not be “fixed” the way you would like.

To minimize the risk of extreme fluctuations in spending, you can adopt a more flexible version of this strategy. You do this by placing upper and lower limits on the changes in the dollar amount of your annual withdrawals, based on your prior year spending.

As one example, a retiree may determine to withdraw a fixed 4% of his retirement portfolio each year. That same retiree doesn’t want his spending power to change more than 5% from one year to the next. Assume that a retiree withdraws $40,000 (4%) from a $1 million portfolio balance in year one, and in year two a strong market boosted the portfolio to $1.1 million. A strict 4% withdrawal rule would allow that retiree to withdraw $44,000 in year two. However, by creating a 5% “spending band”, that retiree will limit the withdrawal to $42,000. This is a more balanced approach because spending can remain relatively steady from year to year while also responding to changes in investment performance in a way that will help the retirement investment portfolio to last throughout retirement.

In a further improvement to this fixed percentage withdrawal strategy, you can create spending bands or caps that are not symmetrical. In other words, you allow for more variability on the spending downside compared to the upside. For example, a retiree might might adopt a 3% cap on a yearly increase in the withdrawal amount but allow a larger 5-10% drop if the portfolio experiences a major down year.

I think the fixed percentage yearly withdrawals with spending bands has merit as a strategy for providing a lifetime of retirement income. What do you think?


  1. says

    You write, “I think the fixed percentage yearly withdrawals with spending bands has merit as a strategy for providing a lifetime of retirement income. What do you think?”

    I think you’re exactly right! I wonder, though, how many people will have such flexibility in their retirement spending choices. The numbers I see published so often don’t seem to offer much hope of that.

  2. says

    Very similar idea to John Guyton’s work, actually. He proposes the same bands around the retirement rate. Slightly more complex, but similarly effective and much steadier than a fixed percentage every year.

    – Start with X% withdrawal in year 1
    – In subsequent years, increase by inflation (max of 6%); this is a candidate for the next year’s withdrawal
    – Apply adjustments:
    + If candidate is more than (1.2X)% of portfolio, reduce by 10%
    + Else, if candidate is more than X% of portfolio and last year’s return was negative, no change from last year
    + Else, if candidate is less than (0.8X)% of portfolio, increase by 10%

    With the constraints (i.e. the willingness to go down), he makes a convincing case that X can be greater than 4 and still work. I’m leary of high values of X for other reasons, but it seems like you’re taking a similar approach with the banding.

  3. Bill Marshall says

    I think there is a fundamental problem with backtesting strategies such as this against past market performance. As they often say, “past performance is no guarantee of future results.” With 50% fluctuations in the market becoming expected during a 30-year retirement window (the previously so-called “black swan” events), what will a new “black swan” look like? I shudder to guess, but one example: in the 1930s, the market did not recover to its previous level within a small number of years, as it has been doing recently. When the Monte Carlo simulations of retirement portfolios report 90% success, I suspect most the failing 10% are those that retired in the 1910s or 1920s, who would have been hit by that black swan.

    This means the “percent of portfolio” strategy, with or without spending bands, may essentially wipe out all but the basic living needs. It reminds me of the writings of Laurence Kotlikoff, comparing a fluctuating investment portfolio to casino chips still on the table.

    I think the bottom line is — you need to be brutally honest with yourself about what really are the “basic living needs”, and make sure that you’ll be happy in a long retirement with just those.

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