The ‘guardrails approach’ to retirement income

Retirement spending strategies typically balance two competing priorities: maximizing the retiree’s spending or leaving a legacy. But research from Morningstar looks at a new metric – the spending/ending ratio – to help retirees assess how various retirement spending strategies balance those competing priorities. Flexible portfolio-spending strategies, delaying Social Security and purchasing annuities can help increase lifetime income while making less money available as a bequest.

Morningstar researchers broke down several spending strategies during a recent webinar. But a flexible strategy called the guardrails approach, when combined with delayed Social Security claiming, was found to yield the highest level of lifetime income. Researchers said that cash flows from the guardrail strategy appeared volatile by themselves, but adding the increased Social Security monthly benefit added valuable stability to the plan.

Morningstar’s 2024 research suggests that 3.7% is the highest safe starting withdrawal rate for retirees spending from an investment portfolio, assuming a 90% probability of having funds remaining at the end of an assumed 30-year retirement period. Morningstar also assumed a starting portfolio balance of $1 million and a $36,000 annual Social Security benefit at age 67. The base case scenario assumes a 3.7% fixed real withdrawal with a 2.3% annual inflation adjustment thereafter combined with Social Security filing at age 67, also adjusted by 2.3% annually.

The guardrails approach

The guardrails method sets an initial withdrawal percentage, then adjusts subsequent withdrawals annually based on portfolio performance and the previous withdrawal percentage. The guardrails attempt to deliver sufficient — but not overly high — raises in upward-trending markets while adjusting downward after market losses.

In upward-trending markets, in which the portfolio performs well and the new withdrawal percentage (adjusted for inflation) falls below 20% of its initial level, the withdrawal increases by the inflation adjustment plus another 10%

The guardrails apply during down markets, too. The retiree would cut spending by 10% if the new withdrawal rate (adjusted for inflation) is 20% above its initial level.

Researchers gave an example with a Year 1 withdrawal percentage of 4% – or $40,000 – from a $1 million portfolio. If the portfolio increases to $1.4 million at the beginning of Year 2, the retiree could automatically take $40,000 plus an inflation adjustment — for a total of $40,928, based on a 2.32% inflation rate. The $40,928 withdrawal is 2.9% of the $1.4 million portfolio value. Since that 2.9% figure is 28% less than the 4% withdrawal taken in Year 1, the retiree qualifies for an upward adjustment of 10%. The new withdrawal amount then becomes $45,021.

The guardrails apply during down markets, too. The retiree cuts spending by 10% if the new withdrawal rate (adjusted for inflation) is 20% above its initial level. For example, if the retiree withdrawing 4% - or $40,000 – from the $1 million portfolio in Year 1 immediately strikes an investment iceberg, losing 30% of the portfolio value in Year 1, the portfolio drops to only $672,000 at the beginning of Year 2. The Year 2 withdrawal would be $40,928 on a pretest basis. But because $40,928 from $672,000 is a 6.1% withdrawal rate — far above the initial 4% — the retiree would need to reduce the scheduled $40,928 amount by 10%, to $36,835.

Advantages of the guardrails approach, Morningstar said, include:

• It supports the highest starting safe withdrawal rates across most allocations.
• Its lifetime withdrawal rates are substantially higher than other approaches.

But the approach has some disadvantages, which include:

• It is more complicated than other methods.
• It results in much higher cash flow volatility than other methods.
• It typically leads to lower ending portfolio value than most other methods.

The guardrails approach is best suited to retirees who prioritize maximum spending over leaving a bequest to family or charity.

“The guardrails system — flexible withdrawals with parameters, or guardrails, that prevent withdrawals from being either too high or too low — does the best job of enlarging payouts in a safe and livable way,” Morningstar’s research said.

For those who want a simpler approach that provides more predictable retirement withdrawal amounts, a fixed real withdrawal system that forgoes inflation adjustments after a losing year moderately increases lifetime withdrawals without greatly increasing cash flow volatility. It is also straightforward to implement.

Retirees who believe that their spending needs will not keep up with inflation over their drawdown period might consider the simple system of making slight reductions to their annual spending over time, the researchers said.

 

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