Retirees, here’s how to tweak the 4% rule to protect your nest egg

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New retirees might enter a different environment than their predecessors_the economy or market might have changed slightly or dramatically.

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Morningstar researchers have investigated and identified their latest starting safe withdrawal rate. Hint: it’s slightly lower than last year.

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Here to discuss this research is Amy Arnott, a portfolio strategist with Morningstar. The interview has been edited for length and clarity.

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Q: You and your co-authors recently published your annual report on the state of retirement income. Can you talk about the main goal of this research and how it’s different from other research that looks at retirement income strategies?

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A: The goal was to estimate how much you can safely withdraw from your portfolio during retirement.

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This is one of the most difficult questions that people will face during their financial lives. When you’re saving for retirement, it’s pretty straightforward as long as you start early and you’re consistent. But when it comes to your retirement portfolio and figuring out how to turn it into a paycheck for yourself, that gets more complicated.

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There’s the danger of running out of money during retirement, but on the other hand, a lot of people actually end up underspending. So, there’s a balance between spending enough that you can enjoy your retirement, but not spending so aggressively that you might have to cut back later in life.

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Most retirement withdrawal research is based on looking at historical market data. This started with William Bengen’s landmark paper in 1994, which looked at market data going back to 1926 and figured out the highest withdrawal rate you could have made that would’ve survived. That’s the origin of the 4% rule.

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But we decided that instead of looking at past data, we would do something more forward-looking, using market estimates for possible future returns.

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Q: The latest starting safe withdrawal rate for the base case is 3.7%. How did you calculate that number and why is it a conservative estimate?

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A: The base case is the foundation of where all our research starts, and it assumes that you want to create a steady paycheck equivalent throughout retirement.

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It assumes that you take a certain withdrawal rate, say 4%, and apply that to your starting portfolio balance. That becomes your first-year portfolio withdrawal, and then each year after that, you adjust that dollar amount for inflation. So you’re basically keeping a steady spending amount and never changing it.

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The reason it’s conservative is that we’re looking for a very high probability of success. We’re also looking for a very long time horizon, assuming a 30-year retirement period.

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And finally, we’re using conservative estimates for market returns. So we build in a buffer so that we’re not assuming the best-case scenario, but also there’s a bit of a cushion built into the numbers in case things don’t go as well as expected.

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Q: The starting safe withdrawal rate has fluctuated over the years. In the previous report, it was 4%. Why did it tick down?