In Part 1 we explained what the 4% rule is, how to apply it and where it came from.
In Part 2 we went through the sequence of returns risk.
Today, in part 3, we’ll discuss dynamic withdrawal rates.`

What are dynamic withdrawal rates?

As you remember from part 1, the 4% rule means we will withdraw a certain amount regardless of the market performance. If the market goes up by 50% or down by 60%, we withdraw the same amount of money. This is the kind of behaviour that was tested in the researches that resulted in the 4% rule. However, we can add safety by withdrawing a little less money in years following a bear market (when the market goes down). On the flip side, we might even be able to withdraw more money from our investments following a bull market (when the market goes up). The added safety would (hopefully) result in a higher initial withdrawal rate. For example, we may be able to start withdrawing 5% (instead of 4%) and adjust it to the market performance each year. This approach is one example of “dynamic withdrawal rates”.

Advantages of dynamic withdrawal rates

The main 2 advantages of dynamic withdrawal rates:

• They reduce the risk of withdrawing too much money during a bear market. We discussed this in part 2 where we went through sequence of returns risk. In simple words, it reduces the risk of you running out of money.
• Becuase it reduces the risk of you running out of money, you can “use” this extra safety towards a higher (initial) withdrawal rate. As it will change to adapt to market performance, rather than being set in stone, a flexible higher-than-4% dynamic withdrawal rate can be safer than a fixed 4% withdrawal rate.

Disadvantages of dynamic withdrawal rates

The fact that my spending (and lifestyle) will depend on market performance once I retire is something I’m not too comfortable with. There is something very reassuring and straightforward about the original 4% rule. The fixed 4% withdrawal rate (which we adjust only for inflation) means we get to keep the same lifestyle (level of spending in real terms) regardless of market performance.

So how does it actually work?

Of course, you can’t decrease your spending by 30% just because the market went down 30%. In the same way, there is no reason to increase your spending rate by 20% just because the market went up by 20%. These extreme changes to your spending are not something most people would like.

Usually, when dynamic withdrawal rates are discussed, it means much more subtle adjustments.

My lazy friends, I did the work for you, I read the research papers. let me summarise them for you.

Side note: Reading the papers summarised below to write this post was extremely fun. I find the concept of dynamic withdrawal rates fascinating, I hope you will find them interesting too. If you do, consider reading the full papers.

Guyton- Klinger (2006)

One of the biggest researches about dynamic withdrawal rates is one done by Jonathan Guyton and William Klinger.

I really like the fact they looked at 40-year periods. It is higher than the original research papers (Bengen and the Trinity study), who came up with the 4% rule after only looking at a maximum period of 30 years. While they did it to be prudent, it makes it a lot more relevant for young retirees (the members of the FIRE community/movement).

They found that if you adopt some “rules” you can start with an initial withdrawal rate higher than 4%.

Guyton-Klinger set 4 rules:

The portfolio management rule

This rule sets out the sources of each year’s withdrawal. It essentially tells you which assets to sell first to fund your withdrawal. I don’t really want to go into it, partly because I find it over-complicated (and I prefer simple solutions). I also plan on retiring on a very high-on-equity portfolio so find it less relevant for me. If you’re interested, I found this video (go to 06:00 for the portfolio management rule) that explains the rules in a very good way.

The Inflation rule

Just like in the 4% rule, we adjust our withdrawals for inflation. However, Guyton and Klinger set a cap for that, 6%. This means that if inflation is higher than 6% in a certain year (10% for example), we will only increase our withdrawals by 6%. My issue with this approach is the scenario in which you have a few years of high inflation. This can reduce the value of your money and may make it harder to maintain your lifestyle. However, these rules do come with a huge advantage in the form of a higher initial withdrawal rate. Another inflation-related rule is the withdrawal rule.

The withdrawal rule

Based on this rule, we do NOT adjust for inflation in a year following a year in which the market had a negative return.
If 2022 had negative returns, we would not adjust for inflation in the 2023 withdrawal.
This actually works perfectly with the research done by Tharp (see “Kitces 2017” below), which explains why this is so effective.

We also don’t “catch up” for years where we didn’t adjust for inflation. If year 1 was bad and year 2 was amazing, we don’t adjust inflation for both years 1 and 2 after year 2’s amazing returns. We would only adjust for the inflation of year 2. The “skip” of year 1 inflation adjustment is permanent.

The capital preservation rule

Based on this rule, if your current withdrawal rate (current withdrawal divided by current portfolio value) is 20% higher than your initial one, you need to decrease your withdrawal by 10%. For example, if you start with a 5% withdrawal, your upper limit is 6% (5% * 120%).

Example:
If you start with a £1,000,000 portfolio value, your initial annual withdrawal would be £50,000. If I ignore inflation for a second, this rule comes into action if your portfolio goes down in value to a point that those £50,000 represent more than 6% of it. This means that if your portfolio value goes below £833,333, you need to reduce your withdrawal by 10% to £45,000 (50,000* 90%).

This rule prevents you from spending too much money and helps you avoid running out of money.

The prosperity rule

The prosperity rule is the exact opposite of the capital preservation rule. It says that if your current withdrawal rate (current withdrawal divided by current portfolio value) is 20% lower than your initial one, you need to increase your withdrawal by 10%. For example, if you start with a 5% withdrawal, your lower limit is 4% (5% * 80%).

Example:
If you start with a £1,000,000 portfolio value, your initial annual withdrawal would be £50,000. If I ignore inflation again, this rule comes into action if your portfolio goes up in value to a point that those £50,000 represent more than 4% of it. This means that if your portfolio value goes over £1,250,000, you need to increase your withdrawal by 10% to £55,000 (50,000* 110%).

This rule prevents you from spending too little money and “taking the money with you to the grave”. However, as this is a blog aimed mainly (but not just) at parents, we have someone leave the money to.

An important note for both the preservation and prosperity rules is that once you adjust your withdrawals, they become the new “base”. In the example above, the £55,000 (or £45,000 in the previous example) withdrawal is what you will adjust for inflation next year.

Diversification

While this is not an additional rule, a really interesting finding from this research is the benefit of diversification. For example, they took 2 different portfolios and implemented the 4 rules above. In both portfolios, there were 65% equities. However, one of them had only S&P500 and the other had the 65% broken into 6 categories:

US large cap value (13%)
US large cap growth (13%)
International (15%)
US small cap value (9%)
US small cap growth (9%)
Real estate (6%), they used a REIT here.

The interesting thing is that when they looked at these 2 portfolios they saw the diversified one had a much higher safe withdrawal rate. For example, the 99% success rate for the one made of 65% S&P500 portfolio had a safe withdrawal rate of 5.1% while the diversified one had 7.1%!

That is actually amazing. Most of our investments are in the S&P500, could that mean we’re losing out on a 2% extra withdrawal rate?! that’s an additional £20,000 a year for a £1,000,000 portfolio! That’s just crazy. I’ll have to let Lazy FI Mum read this section and see what she thinks.

Before I do that, I must admit that 65% equity is way too low for our risk tolerance and the 80% equity is much more relevant to us personally. However, the conclusions are the same. Looking at the 99% success rate with 80% equities, using the S&P500 as the only equity class results in a 4.7% initial safe withdrawal rate. Once you diversify, it goes up to 5.6%, which is still almost a full per cent and represents an extra £9,000 a year based on a £1,000,000 portfolio.

While the point of reading this research was to learn about the rules and dynamic withdrawal rates, I think this is the part that shocked me the most. I was not ready for that. As you can probably feel by reading this, I really enjoyed this research (nerd alert).

Did you notice that all the SWR I mentioned in this research are higher than the original 4%? That’s because these rules prevent you from blindly following the 4% off a cliff if a horror scenario happens. This means extra safety which can be translated to a higher initial withdrawal rate.

Pfau (2015)

Another important research was conducted by Wade D. Pfau. While he did not make any rules himself, he tested different sets of rules and compared them with a new approach.

The XYZ formula

Before he even goes into the rules, Pfau sets out his approach. He does not like “failure rate”, which is basically saying that in a certain percentage of cases, you run out of money.

He prefers what he calls the “XYZ” formula, which says “you have an x% chance of your annual spending (withdrawals) dropping below $Y by year Z of retirement”. I actually like this approach as it’s not binary like the failure rate.

Fees and taxes

In his research, Pfau assumed a 0.5% annual fee, which is also an interesting point as the original researches that resulted in the 4% rule ignored fees. including fees reduced (of course) the safe withdrawal rate.

As tax differs from person to person, he ignored tax, which makes sense. I wrote a post on why I assume I will pay 0% tax (or a very low rate) in retirement.

The approach

Pfau took 10 strategies (including Guyton-Klinger and constant inflation-adjusted spending). However, instead of checking how often these scenarios end up running out of money, he looked at them from an XYZ formula approach. He tested what chances retirees have of their annual spending going below 1.5% of the initial retirement portfolio value by year 30. In his research, he assumed an initial portfolio of $100,000 and tested the probability of withdrawals going below $1,500 a year. This is equivalent to a £15,000 annual withdrawal and an initial portfolio value of £1,000,000.

Results

For example, using the constant inflation-adjusted spending (the 4% rule), if a retiree starts with a 2.86% withdrawal rate, they have a 10% chance of having their withdrawal rate drop to 1.5% by year 30.

This is lower than the original 4% for two reasons. First, Pfau added 0.5% fees so I would expect that to bring the withdrawal rate down by roughly 0.5% to around 3.5%. In addition, the fact that he looked at 1.5% as the “fail” here, means more scenarios end up with $1,500 withdrawals than scenarios ending up with no money. That reduces the initial withdrawal rate too.

Using the Guyton-Klinger approach actually resulted in an initial withdrawal rate of 4.82%, which is the highest out of the 10 strategies tested, wow. It is important to note this assumes 50% equity (stocks/shares) and 50% bonds. With the low-interest rates around today (and when the paper was published), all of these withdrawal rates seem a bit low. I can only guess that increasing the share of equity in your portfolio (to 75% for example) will increase the initial withdrawal rates. However, as opposed to Pfau, this is just me guessing, I don’t have data to back me up.

Pfau also tested the same approaches again with a lower limit. This time with a lower limit of $250 (instead of $1,500 in the previous section). I won’t go into detail because this is too much like a failure (running out of money) in my opinion. If you can only spend 0.25% of your initial portfolio, you clearly can’t sustain your desired lifestyle.

Additional thoughts

The first section is a review of other researches done on this topic. Wow, this section is written so well, what a great summary.

My biggest issue with this research is that it only used a 50% equity-50% bond portfolio. I would have loved to see these results with a higher equity allocation. For example, 75%-25% or 80%-20% portfolios.

Kitces 2017

Derek Tharp, from the Kitces.com team, wrote a really interesting piece in 2017. In his research, he actually found out that one-off big changes are much less effective than small but permanent changes.

Let me explain.

In table 1 (above) you can see that even if we reduce our spending by 20% (that’s huge!) for 3 years after every year with a negative (or 0%) market return, it “only” increases our safe withdrawal rate (SWR) by 0.6% (from 4.08% to 4.68%).

However, in Table 2 (above), you can see that we can, instead, just reduce our spending permanently by 3% and get an additional 0.48% to our SWR. I don’t know about you but I prefer a permanent 3% decrease in spending, that’s roughly like skipping one year of the inflation adjustment. The effect on my lifestyle will be minimal. However, if you prefer to take a bigger decrease for a shorter period, be my guest. I’m just here to present you with the options.

This actually shows how effective Guyton-Klinger’s withdrawal rule is.

Please notice that based on this piece by Tharp, you do not adjust the SWR upwards during good years. However, you can start with an initial higher SWR than 4%, which basically “assumes” that a year is good by default. If it is not, then we adjust downwards.

Kitces 2019

When looking at SWR, Kitces.com is a good place to start reading. In an article from 2019, Michael Kitces looked at the SWR from a FIRE perspective, for people who plan to retire early.

Before I even go into the dynamic withdrawal rate he discusses, he raises a super important note. Most people who achieve FI and decide to retire end up having another income. This could be from a new business, freelancing or working part-time. As you know, I plan to tutor. However, most people in the FIRE community ignore that income. This is funny because if the additional income can cover part of your expenses, your investments only need to cover the remainder of your expenses and not all of them. If people considered that, they would probably realise they could retire sooner than they thought.

Let’s assume you generate £500 a month in retirement, that’s £6,000 a year, which means you need £150,000 less to retire! that could shave a few good years off your FI date. Do you think you’ll earn £1,000 a month? you can reduce your FI amount by £300,000!

Back to dynamic withdrawal rates. In his article, Kitces presents a few approaches.

Kitces’ 3 approaches

1. Ratcheting

This approach is for people who can’t even stand the thought of reducing their expenses. Therefore, we start with a low withdrawal rate (he uses 3.5%) but increase it if the portfolio value goes up.

His suggestion is to increase spending by 10% if the portfolio value reaches 150% (50% increase) of the initial value at retirement. For example, let’s assume you retire with £1,000,000. Using 3.5% means you can withdraw £35,000 a year. Once your portfolio value reaches £1,500,000 you can increase your spending by 10%. In our example, that would be from £35,000 to £38,500 (plus inflation of course).

2. Guardrails

This approach is for people who are OK with changing their expenses from time to time if the market goes up a lot or down a lot.

In this approach, you start very similarly to the 4% rule. You withdraw 4% of the initial portfolio value and adjust for inflation each year. However, you also need to set a “floor” (for example, 3%) and a “ceiling” (for example, 5%). For example, let’s assume you retire with £1,000,000. Using 4% means you can withdraw £40,000 a year.
Every year you will adjust this figure for inflation BUT with limits.

If the inflation-adjusted amount is less than 3% of your CURRENT portfolio value- happy days, increase your spending by 10%.

However, if the inflation-adjusted amount is more than 5% of your CURRENT portfolio value- Sorry, you reached the danger zone, you need to reduce your spending by 10%.

I actually really like this approach, it makes sense and is simple enough to easily apply.

These “guardrails” are basically Guyton-Klinger’s prosperity and preservation rules.

3. Segmented spending

In this approach, you split your spending into 2 categories.

The first category is the essential (core) expenses which you won’t give up. Please notice that we’re not talking about just food and shelter, this is personal to you. If you can’t give up your annual holiday abroad, that’s fine! just put it in the essential expenses. We all have our own lifestyles and things that are important to us. However, maybe going out to restaurants is something you’re willing to give up if your portfolio value becomes dangerously low.

The second category is adaptive, which is basically the difference between your essential budget and your desired lifestyle budget. In this approach, you only adapt the second category for market performance.

Bonus material

I think Kitces is amazing at simplifying complex concepts. If you find the topic of dynamic withdrawal rates interesting, you might enjoy his interview on ChooseFI, I know I did. You can watch it here.

What we plan on doing

It is important to note that in his research, Kitces found that for longer (than 30 years) retirement periods, the 4% rule actually becomes 3.5%. However, we must remember that this (and the 4% rule) is based on the assumption that once we retire, we will not earn another single £ in our lifetime, which is quite a big assumption.

I plan on still tutoring after I reach FI. In addition, Lazy FI Mum plans on continuing to work full time. The additional income should provide an additional safety buffer to the already-super-safe 4%.

Before I started writing this post, I was sure I was going to stick to the original 4%, even though I do see the advantages of a dynamic withdrawal rate and implementing some rules. However, the results from the Guyton- Klinger research made me doubt my current approach. I think we will still try and save 25 years worth of expenses (4% rule). However, we may look into implementing the Guyton- Klinger rules once we reach FI. We also may look into adding some international equities.

A part of me still prefers not to let the market determine our lifestyle. Saying that, if we do experience a 50% drop in the market, I might think otherwise.

Maybe we will apply the Guyton- Klinger rules, but with an initial withdrawal rate of 4%. That seems to me like a nice compromise. That way, our goal (in £) doesn’t change and we still get the safety of the 4% rule plus the added safety of the Guyton- Klinger rules.

“You muppet, didn’t you say you can withdraw almost 5% using these rules with a 99% success rate following these rules? You literally just spoke about people not realising they could reach FI (and maybe choose FIRE) earlier than they thought”

Don’t worry, I am currently planning on changing careers to tutoring “full time” in 5-6 years, while I only expect us to achieve our FI goal in around 9-10 years. I am sure that my tutoring income plus Lazy FI Mum’s salary will easily get us to our FI goal.

Let me know what you plan to do in the comments section.

Have a great weekend everyone!