A rule of thumb is fine, except whenpeople come to believe it should always be used, regardless of individual circumstances. They also see the results as set in stone, requiring no further thought regardless of what happens in the outside world. Unfortunately, that's what's happening to the "safe" 4% withdrawal rate.

The withdrawal rate attempts to answer the question, How much money can a client spend in retirement without fear of running out of money? Several planners have made their reputations trying to answer this question.

BENGEN SAYS . . .

William Bengen of El Cajon, Calif., published his research on this issue, "Determining Withdrawal Rates Using Historical Data," in the October 1994 issue of the Journal of Financial Planning. The influential paper was honored as one of the best in the publication's first 25 years, and its conclusion has become a widely cited rule of thumb.

Bengen concluded that "a first-year withdrawal of 4%, followed by inflation-adjusted withdrawals in subsequent years, should be safe." Since then, several additional papers have been written expanding on Bengen's work, with most placing a safe withdrawal rate between 4% and 4.5%. Bengen himself has written three follow-up pieces exploring different aspects of the problem. His book, Conserving Client Portfolios During Retirement, expands the basic premise of his work by explaining how other variables affect the equation through a "layer cake" approach. Depending on the layers employed, the safe rate can be close to 5%.

GUYTON SAYS . . .

In October 2004, Jonathan Guyton gave us his thoughts on withdrawal rates in his paper, "Decision Rules and Portfolio Management for Retirees: Is the 'Safe' Initial Withdrawal Rate Too Safe?" Previous studies projected retirees increasing their spending in lockstep with an assumed inflation rate. Guyton's experience with actual clients differed from that pattern. People simply did not robotically increase their spending each year. Guyton, a 2007 Financial Planning Mover & Shaker, came up with some decision rules and back-tested those rules assuming a client retired at the very beginning of the bear market of the early 1970s.

Guyton created specific rules for withdrawals. First, he examined the effects of a rule that barred increases in withdrawals in years in which the ending value of the portfolio was less than the beginning value. Unless the portfolio returned enough to cover the withdrawal, the client got no "raise." A second rule prevented increases in withdrawals if the portfolio return was negative.

Guyton also capped increases to withdrawals in any given year. Theoretically, clients would be willing to accept a cap in years that would otherwise require abnormally high inflation adjustments if it meant a higher initial withdrawal rate. In all cases, Guyton did not permit a makeup of capped increases in subsequent years. The results showed an initial withdrawal rate closer to 6% of the portfolio value.

KITCES SAYS . . .

More recently, Michael Kitces, another Mover & Shaker (2006), examined the issue from a different angle in his newsletter. In the May 2008 issue of The Kitces Report, he looked at the effect market valuations have on withdrawal rates.

Kitces presented empirical evidence that when market valuations are low, future returns tend to be higher and therefore can support a higher withdrawal rate. The converse of high valuations and lower withdrawal rates appears to hold as well. His follow-up article in April 2009 discussed the application of dynamic asset allocation to the valuation findings and the limitations of valuation as a strict timing tool.

PREPARING FOR CHANGE

As all three of these men would attest, not all variables can be modeled accurately. Life is full of surprises. Nonetheless, these studies and others give financial planners a more robust view of withdrawal planning. These and other views on withdrawal rates establish some framework for deciding whether a course of action has a reasonable chance of success. Lost in the math is the challenge of setting and managing expectations for withdrawal rates and counseling clients in real time.

There are two ways a withdrawal rate increases: either the withdrawal amount increases or the asset base upon which the rate is calculated decreases. The panic of 2008 offers great potential for better advice going forward. Consider the dilemma popularly known as Kitces Paradox. Kitces published an example, from the planner's perspective, of the silliness in blindly following an initial withdrawal rate rule of thumb. For any withdrawal rate that a planner views as a maximum, a decline in asset value can cause a different view for identical circumstances.

For example, say Mr. Smith has $1 million. The planner determined that 5% is the maximum safe initial withdrawal rate, so the client plans to pull out $50,000 that first year. A year later, the accounts are worth $900,000. Knowing the 5% accounts for market volatility, the new rate of roughly 5.6% isn't very alarming to the planner. Yet, if a new client with $900,000 wanted to spend $50,000 per year, the planner would likely say that that spending was over the maximum and at least a little risky.