Retirees, It’s Time to Give Yourself a Raise. How to Keep the Cash Flowing for Decades.

It’s time to throw out the 4% rule and give your retirement paycheck a raise. New research indicates that a 5% withdrawal rate is “safe”— although how you invest and tap your portfolio is critical to keep the cash flowing.

Investors have been conditioned for decades to believe they can withdraw only 4% a year through a theoretical 30-year retirement, adjusted for inflation. If you had a $1 million portfolio, for instance, you could take out $40,000 in the first year and $40,800 in the second year, assuming a 2% inflation rate. The idea is safety first, even if markets soar, to give your portfolio a high chance of lasting at least 30 years.

But several studies and retirement experts now view 4% as too conservative and inflexible. J.P. Morgan, in a recent report, recommended about 5%. David Blanchett, who has studied withdrawal rates for years, pegs 5% as a safe rate for “moderate spending” through a 30-year retirement. “It’s a much better starting place, given today’s economic reality and people’s flexibility,” says Blanchett, head of retirement research for PGIM DC Solutions.

The inventor of the 4% rule is hiking his “safe” rate too. Retired financial planner Bill Bengen tells Barron’s he is revising his benchmark in an upcoming book, and that a rate “very close to 5%” may be warranted.

How much you can take out depends on your circumstances, of course, including plans for leaving an inheritance. Assuming you have a cushion to withstand market downturns, there’s a strong case for taking out more in a bull market that has plumped up your portfolio.

Whether 5% is “safe” hinges partly on the outlook for stocks and bonds, the bedrocks of most portfolios. J.P. Morgan expects U.S. stocks to return 8% over the next 20 years and bonds to return 5%. Those figures are in line with historic averages and assume normal market conditions for the next two decades. PGIM Quantitative Solutions expects similar returns over a 10-year horizon. 

A dour forecast could mean taking out less each year. And today’s starting point isn’t promising by some measures. The cyclically adjusted price-to-earnings, or CAPE, ratio of the U.S. stock market is about 32% above Vanguard’s estimate of its fair value, the firm wrote in a note in late August.

When stocks are this expensive, prospects for returns diminish. For bonds, a good yardstick of expected returns is their current yield; the 30-year Treasury is now 4.1%, implying that it may be a stretch to hit 5%.

Yet exact numbers for withdrawal rates matter less than having a plan in the first place. More than half of retirees (53%) say they wing it, withdrawing money whenever they need it, according to a recent survey by investment firm Schroders.

Without a plan, it’s hard to determine if your spending is sustainable. “It’s extremely important to have a strategy,” says Eric Trousil, an advisor at Johnson Financial Group in Green Bay, Wis.

Your mix of stocks and bonds may vary. A typical “balanced” portfolio is 60% stocks and 40% bonds. Bengen used a 50/50 split for the 4% rule and found that closer to 5% could be achieved with a 55% stock allocation that is slightly overweight U.S. small- and microcap stocks. J.P. Morgan used a more conservative 30% stock and 70% bonds to  arrive at its “optimal” withdrawal rates of 5.6% for men and 5.3% for women (since women have longer life expectancies than men).

If you’re unsure about the right mix, consider hiring an advisor who can put your investments in the context of your broader financial life and manage your portfolio.

Building Your Bucket List

If you’re going it alone, consider putting your portfolio into buckets, a strategy popularized by Morningstar and credited to financial planner Harold Evensky. The approach can accommodate withdrawal rates like 4% or 5%, and it’s useful to tailor your portfolio to your specific spending and long-term growth needs.

The idea is to divide your portfolio into three buckets: one holding cash for near-term expenses, a second in fixed income and high yielding equities to handle intermediate expenses, and a third in growth stocks to help your portfolio beat inflation and possibly keep growing.

Your cash bucket is like your Fort Knox—it’s solid, no matter what the market does. Sitting on cash isn’t bad now, with yields of 4% to 5%, but this is an all-weather strategy to employ even after yields fall. You don’t want to be left vulnerable in a year like 2022, when both stocks and bonds fell by more than 10%. If that happens again and you don’t have a cash cushion, you’d be forced to withdraw money from a declining portfolio to pay the bills, locking in your losses and hastening the depletion of your savings.

Your cash bucket should hold enough money to help cover up to two years of expenses: budget items like housing, food, and transportation. It might hold vehicles like FDIC-insured certificates of deposit, high-yield savings accounts, and money market mutual funds from companies like Vanguard, Charles Schwab, and Fidelity.

As seen in Barron's.