The Difference Between ‘Safe’ and ‘Optimal’ Withdrawal Rates for Retirement Spending
Distinguishing between “safe” withdrawal rates and “optimal” withdrawal rates is an essential piece of the retirement spending conversation. I have discussed how the 4 percent rule may be too high for those focused on identifying a sustainable withdrawal rate that will not deplete the portfolio over a thirty-year period.
This does not necessarily forbid the use of a 4 percent or higher withdrawal rate. Retirees may still choose higher withdrawal rates as a part of downplaying the potential impact of investment portfolio depletion.
I was part of a research effort with Michael Finke and Duncan Williams to explore these issues in a March 2012 article in the Journal of Financial Planning called, “Spending Flexibility and Safe Withdrawal Rates.” We investigated withdrawal rates after adding other income sources from outside the retirement portfolio (such as Social Security and pensions).
Also, instead of focusing on the traditional objective of worrying only about using a low failure rate, we sought a better balance between two competing tradeoffs: (1) wanting to spend and enjoy more while you are still alive and healthy, and (2) not wanting to deplete the investment portfolio and rely only on non-portfolio income sources in later retirement.
What we call “spending flexibility” shares a lot with what Moshe Milevsky and Huaxiong Huang call “longevity risk aversion,” as both concepts are about identifying a willingness to reduce spending at advanced ages if necessary. We also brought asset allocation and randomized investment returns into the mix, seeking to determine both optimal withdrawal rates and optimal asset allocations for different retiree circumstances.
In practical terms, retirees who are more longevity-risk averse and less flexible with spending would like to smooth spending over retirement. These retirees aren’t overly interested in increasing spending if markets perform well, preferring instead to focus on keeping spending stable if they end up living longer than expected and see a poor sequence of market returns.
We found that someone with greater spending flexibility and more outside sources of income may be willing to accept rather high failure rates as a part of balancing these competing tradeoffs. Our study was based on historical U.S. data, which generally points to 4 percent as a “safe” withdrawal rate because it assumes higher bond yields than are currently available.
But we found that with those capital market expectations, the 4 percent retirement withdrawal rate strategy may only be appropriate for more risk-averse retirees with moderate guaranteed income sources.
The ability to accept greater failure probabilities means that risk-tolerant retirees will prefer a higher withdrawal rate and a riskier retirement portfolio. A risk-tolerant retiree may prefer a withdrawal rate between 5 and 7 percent with a guaranteed income of $20,000.
In addition, the optimal allocation to stocks increases by between ten and thirty percentage points, and the optimal withdrawal rate increases by between one and two percentage points for retirees with a guaranteed income of $60,000 instead of $20,000.
Again, there is an important point to re-emphasize here. In one case in the article we identify a 7 percent withdrawal rate as “optimal.” That is not a “safe” withdrawal rate. With the market assumptions in the article, the 7 percent withdrawal rate has a 57 percent chance of failure over a thirty-year retirement.
Though it is not safe, it does maximize the overall expected lifetime satisfaction for a fairly flexible retired couple who has a secured income base of $20,000 from Social Security.
In our analysis, 7 percent is how the couple could best balance the tradeoff between spending more in early retirement with the possibility of then having to spend less later in retirement.