Rethinking the 4% Withdrawal Rule

In a new study called “Breaking the 4% Rule,” researchers from J.P. Morgan argue that retirees—and the service providers supporting them—should take a more dynamic approach to managing retirement account withdrawals. The study finds that more rigid, percentage-based withdrawal rules can expose retirees to an increased chance of outliving their retirement assets or leaving too much wealth untapped, mainly because these strategies ignore the specifics of a retiree’s financial situation.

Greg Roth, a vice president for media relations with J.P. Morgan Asset Management, tells PLANADVISER his firm has crafted a new withdrawal strategy based on the outcome of the study. He says the strategy can be personalized for each retiree and is designed to incorporate shifts in people’s age, financial circumstances, personal preferences and market conditions as they move through retirement years. The goal, he explains, is to improve the likelihood that retirees will be able to maintain their standard of living in retirement while simultaneously reducing longevity risk.

As a first step, the study identifies potential shortcomings of conventional and more rigid withdrawal methods, especially the well-known “4% rule.” On J.P. Morgan’s analysis, more rigid strategies are inferior because they do not consider “lifetime utility” or retiree satisfaction in recommending spending levels—nor do such strategies respond to real-world events that can have a big impact on markets and investment performance.

Instead, J.P. Morgan says a portfolio-based solution using a more robust withdrawal framework should help investors better address their retirement funding needs by embedding market risk, longevity risk and evolving personal investment criteria in a way that a cash-flow-based approach simply cannot.

Key findings in the study show the following:

• Maximizing expected lifetime utility (i.e., potential derived satisfaction) serves as a more effective benchmark of retirement withdrawal success than typical measures, such as probability of failure. Focusing on utility offers a way to quantify how much satisfaction retirees receive from their portfolio withdrawals. This approach allows retirees to increase spending when they are most apt to enjoy their retirement dollars, while still avoiding the risk of premature portfolio depletion, as retirees would presumably slow their withdrawals if perceived longevity risk increased, pushing down satisfaction.

• Adapting to changes in economic and market environments (and to investors’ specific situations) over time can help maximize the expected lifetime income generated by retirement assets. This type of dynamic strategy may help provide greater payout consistency and reduce the likelihood of either running out of money or accumulating excess wealth that is unlikely to be used by the investor.

• Age, lifetime income and wealth all provide key insights into how to adjust investors’ withdrawal strategies throughout retirement. Holding all other factors constant, higher initial wealth levels suggest individuals can afford to lower their withdrawal rates, as income should still be sufficient to meet day-to-day expenses, while also increasing their fixed income allocations to protect larger account balances. Greater availability of lifetime income streams, whether through Social Security or a pension annuity, allows retired individuals to increase both their withdrawal rates and equity allocations. Increasing age allows individuals to increase their withdrawal rates, while also suggesting decreased equity exposure. All of this should be factored into withdrawal rate plans.

Based on those findings, the J.P. Morgan “Dynamic Withdrawal Strategy” incorporates five distinct factors: personal preferences for the amount and timing of withdrawals; wealth and “lifetime retirement income,” which the study defines as guaranteed income, such as Social Security, pensions and lifetime annuities; age and life expectancy; the randomness of markets and extreme events; and the dynamic nature of each retiree’s decisionmaking process.

“When all these factors are combined into a single, cohesive methodology, we can calculate an optimal withdrawal rate and asset allocation based on each retiree’s unique profile,” explains Abdullah Sheikh, a vice president and research analyst for J.P. Morgan Asset Management’s Asset Management Solutions-Global Multi-Asset Group.

Roth says the approach is patent-pending, and should help retirees smooth out the unpredictable nature of future expenses and personal circumstances. He also explains the dynamic withdrawal strategy requires consistent communication and planning between a retiree and an adviser.

To read the executive summary of the report, click here. The full research report can be accessed here.