“How much income can I safely take from my investment portfolio?” This is one of two questions that financial planners face on a daily basis.
The 4% rule, introduced by Bill Bengen in 1994, is commonplace in the financial advising industry to address such concerns; however, 4% may not meet the needs of every individual.
Jonathan Guyton and William Klinger set out to use decision rules to help advisors withdraw a greater amount. Their work is featured in the March 2006 article, “Decision Rules and Maximum Initial Withdrawal Rates,” published in the Journal of Financial Planning.
Guyton and Klinger used a Monte Carlo simulation to organize decision rules in order to increase maximum initial withdrawal rates. The authors utilized four decision rules: portfolio management, inflation, capital preservation and prosperity. Portfolio management determines where funds are withdrawn. The inflation rule determines the size of the annual withdrawal. Capital preservation lowers the withdrawal amount in a stock market decline and the prosperity rule increases withdrawals when the market is doing well.
Following these decision rules, investors can increase the initial withdrawal from 4% to 5.2% -5.6% for portfolios containing at least 65% equities to sustain a 40-year period at the 99 percent confidence standard. Withdrawal rates can rise to 5.7% – 6.2 % at the 95 percent confidence standard. The confidence standard indicates the percentage of time withdrawals succeed. In other words, if you were flipping a coin 100 times, 95% to 99% the coin would flip a specific way.
The type of decision rule an individual chooses depends on the benefits a retiree most values and the trade-off that he or she is willing to make, although Guyton and Klinger indicate that in all cases, the portfolio management rule should always be applied.
The portfolio management rule determines where withdrawals are taken from. When an asset increases above its allotted allocation, the difference is withdrawn and deposited to cash for future withdrawals. Withdrawals are funded in the following order: When equities are overweight, when fixed income is overweight, cash, withdrawals from remaining fixed income assets and withdrawals from remaining stocks. The portfolio is allocated in percentages between cash, fixed income, U.S. large cap growth, value, small cap growth, international equities and real estate (REITS).
The prosperity rule is applied when withdrawal rates are 20% below the initial withdrawal rate and can be used to increase withdrawals by 10%. Such increases set the new base or high water mark. The prosperity rule offsets the drawback of market decline and prohibits investors from increasing withdrawals with inflation.
The capital preservation rule is applied if a series of declines in the market ensue. When the withdrawal rate is 20% or more than the initial withdrawal rate, withdrawals decline by 10% in the current year and this rate becomes the new base rate for the following year.
The authors found that an individual’s retirement failed most often during adverse market events. To overcome, an individual must be willing to reduce spending if such an event occurs. Combining the prosperity rule and capital preservation can help decrease the chance of running out of money and increase purchasing power.
Overall, Guyton and Klinger found that applying the decision rule in their report eliminated the risk of depleting one’s retirement accounts.