Looking Beyond the 4 Percent Rule: Modern Retirement-Drawdown Strategies

If you’re nearing retirement, you’ve probably heard of the 4 percent rule. It’s a popular retirement savings withdrawal strategy.

It states you should withdraw 4 percent of your savings in the first year of retirement. Then, you adjust that dollar amount for inflation each following year. And the theory is that this should help your savings last about 30 years.

It was developed by financial advisor William Bengen in 1994. But a lot has changed since then. A lot is changing now—and a lot will change in the future.

That’s important to think about, considering people are living longer these days and you may outlive your savings.

And factors such as sharp market volatility, fears of rising inflation, and higher health care costs could also put a strain on the longevity of your retirement savings.

Then you set your guardrails. For instance, they can be set to 20 percent above and 20 percent below that initial withdrawal rate. In this case, the upper guardrail would be 6 percent and the lower guardrail would be 4 percent.

So if your inflation-adjusted withdrawal amount lands outside your guardrails, you’d increase or decrease your withdrawal amount by 10 percent. This would get you back in the middle.

Assuming inflation for year one sat at 3 percent, your target withdrawal rate for year two becomes $103,000.

But by year two, a market crash diminished your portfolio by 20 percent to $1,600,000.

Now, let’s figure out what percent of your new portfolio size would be made up by your withdrawal target.

So you divide your inflation-adjusted withdrawal amount of $103,000 by your portfolio size of $1,600,000 to get 6.4 percent. You’ve crossed your upper guardrail. So you decrease the current year’s withdrawal by 10 percent. This would result in a year two withdrawal of $92,700. That equates to 5.8 percent of your $1,600,000 current portfolio size. So you’re safely back within your guardrails.

But let’s flip the tables. What happens during a market rally?

So say your portfolio is still $2 million and your initial withdrawal is still $100,000 (5 percent drawdown rate).

Inflation remained at 3 percent. So your year two withdrawal target also remains at $103,000.

But a market rally caused your portfolio to rise 35 percent to $2,700,000.

So you divide your inflation-adjusted withdrawal rate of $103,000 by your larger portfolio size of $2,700,000 to get 3.8 percent. Since that’s below your 4 percent lower guardrail, you increase your withdrawal by 10 percent to $113,300. That’s 4.2 percent of your new portfolio size of $2,700,000. So you’re back in the middle zone.

The guardrail strategy was developed by financial planner Jonathan Guyton and business professor William Klinger.

Like the 4 percent rule, the guardrail strategy focuses on a single retirement savings portfolio.

Instead, it’s a holistic approach that’s designed to create a steady and predictable stream of income to cover your needs, while also providing growth potential.

It dictates that you should build a “floor” on which you cover your basic needs like food, housing, and health care using guaranteed income from sources like Social Security benefits, pensions, and annuities. This could ensure that the floor never falls out from under you regardless of market conditions.

But it also has an upside. So you fund discretionary expenses such as travel and leisure with growth-oriented assets like stocks.

For example, bucket one would hold funds you’ll need to cover immediate expenses for the next one to three years. So you can fill these buckets with safer and more liquid investments such as cash, high-yield savings accounts, certificates of deposit (CDs), and short-term bonds. This bucket would help you meet your necessities without the need to sell investments during a market downturn.

The next bucket can cover expenses from year three to 10. It can be filled with assets like intermediate-term bonds to grow and outpace inflation. And it can replenish the bucket one over time.

Bucket three can cover years 11 and after. It can be filled with growth-oriented investments like stocks, exchange-traded funds (ETFs), and mutual funds. This can compound and outpace inflation as it replenishes buckets one and two over time.

So if the market falls in the early years of retirement, you can keep drawing from bucket one without resorting to growth-oriented assets like stocks and ETFs in bucket three. This would allow those funds to compound and grow as much as they can over time.