I’m sure you’ve all heard about the 4% rule for retirement planning. This rule is great for speculating your likelihood of success, but it isn’t always the best rule to follow in practice.
Druce Vertes at AdvisorPerspecives.com offers a different approach to implementing the original 4% Rule. On this episode of Retirement Starts Today, we’ll dive into his technical article which explores the idea of making the normally rigid 4% rule more flexible to maximize spending for different levels of risk aversion.
I’m always looking for innovative ways to help you turn your retirement portfolio into income and that’s exactly what we’re exploring this week. Tune in to hear how to tweak the 4% rule and maximize your spending in retirement.The 4% rule is great for speculating your likelihood of success, but it isn’t always the best rule to follow in practice. Click To Tweet
Outline of This Episode
- [2:52] Infinite risk aversion
- [9:04] Constant relative risk aversion
- [14:06] Thoughts on 401K rollovers
What exactly is the 4% rule?
The original 4% rule was theorized by Bill Bengen in the 1990s. This rule is handy for napkin math but doesn’t allow much flexibility and it may be overly cautious.
The 4% rule states that you can invest an equal amount in stocks and bonds and withdraw 4% of your starting portfolio during each year of retirement. As long as you adjust for inflation each year, you would never exhaust your money over the course of a 30-year retirement. Have you used the 4% rule to help you calculate the likelihood of financial success of your retirement?Are you looking for innovative ways to help you turn your retirement portfolio into income? Click To Tweet
How can one make the 4% rule more flexible?
Our retirement headline this week is titled Beyond the 4% Rule: Flexible Withdrawal Strategies Using Certainty-Equivalent Spending. It examines what would happen if we explored options beyond Bengen’s 4% rule. It asks, what flexible rules would maximize spending for different levels of risk aversion? The author used the programming language Python to maximize certainty-equivalent spending. This led him to three generalized rules based on one’s risk tolerance.
3 rules for 3 separate risk tolerance categories
For those that are completely risk-averse, Bengen’s 4% rule is the safest bet. The fixed constant withdrawal level never experiences a shortfall or reduction in withdrawals.
The next category is for those who don’t mind plenty of risk in their portfolio. This is why this rule is not recommended for most people. It finds the withdrawal amount that historically maximized spending irrespective of market volatility. This risk-neutral category is for those that can tolerate reductions in spending or shortfalls in some years as long as they are offset by gains in other years.
For those that fall somewhere in between the two ends of the risk tolerance spectrum, different rules apply which trade off higher mean withdrawals against the risk of lower worst-case withdrawals.
Using some of these rules, a retiree could achieve more than the 4% expected withdrawal rate. All of these models are simplifications, but they are useful and allow you to visualize the choices between different rules that have varying levels of risk tolerance.What flexible rules would maximize spending for different levels of risk aversion? Click To Tweet
Visualize your retirement spending
The author strived to create a simple model to help people understand strategies that may improve on a fixed withdrawal at varying levels of risk aversion. You can test out the different rules by using this online tool which allows you to try out and visualize each one.
It’s always refreshing to learn about new ways to live off your retirement savings. Vertes’ idea splits the difference between the 4% rule and a dynamic distribution plan. This hybrid plan would allow for higher spending in good markets and a scientific way to gradually reduce portfolio withdrawals when the market dips.
Listen in to hear how each of these rules could play out with concrete examples using actual numbers. You’ll also hear Joe’s question regarding multiple 401Ks.
Resources & People Mentioned
- Advisor Perspectives article
- Python programming language
- Online tool to help visualize the different rules
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