Two Retirement Withdrawal Strategies

Once in retirement, how much you withdraw is as important as how you invest. Withdraw too much and you will greatly increase the risk of outliving your money. Even a period of above-average returns will not protect you if your withdrawal rate is too high.

There are two primary withdrawal strategies individual investors can use. The first is the 4% rule. This strategy calls for withdrawing 4% of savings during the first year of retirement. Each year thereafter, the initial withdrawal amount is adjusted upward for inflation. The second is the Level3 withdrawal approach. It enables retirees to withdraw as much as 5% of their portfolio each year. It calls for allocating up to four years’ worth of living expenses into safe assets [money market funds, short-term high-quality bonds, certificates of deposit (CDs), etc.]. The remainder of the portfolio is allocated for growth, primarily in stocks. Investors then alternate taking withdrawals from the growth assets and from the safe assets depending on market conditions.

The first strategy was developed by former financial planner William Bengen. It is commonly referred to as the Bengen 4% rule or simply the 4% rule. The second was developed by AAII founder James Cloonan. It is known as the Level3 withdrawal strategy. Both have been shown to work over a long period of time.

To make the comparison between the two approaches easier, we will apply some simple numbers to a hypothetical retired couple, Laura and Allison. They have $1 million in savings as of their retirement date. They estimate that their annual living expenses will require a withdrawal of $40,000 during the first year of retirement after accounting for their guaranteed sources of income (Social Security, pensions, etc.).

I’ll start with the 4% rule. It suggests Laura and Allison withdraw $40,000 during their first year of retirement. The math is $1 million × 4%. (Bengen later revised the initial withdrawal rate to 4.5% for those with a diversified stock portfolio. For the sake of simplicity, we’ll use the lower 4% figure.)

Laura and Allison’s withdrawal amount for their second year of retirement would be influenced by the rate of inflation. If the inflation rate was 2% during their first year of retirement, the couple would increase their withdrawal amount by 2%. So, the second-year withdrawal would be $40,800. The math is $40,000 × 1.02. The withdrawal amount in the third year would be the second-year withdrawal rate ($40,800) increased by the current rate of inflation, and so on.

Notice how the withdrawal rate is independent from the portfolio each year. If Laura and Allison experience a good sequence of returns in retirement—especially early in retirement—their withdrawals may prove to be conservative. The 4% rule is designed to limit the odds of a retiree running out of money over periods of 30 years when holding a portfolio of stocks and bonds.

Bengen used a portfolio of 35% large-cap stocks, 20% small-cap stocks and 45% intermediate-term bonds in his later research. He suggests that retirees consider allocations of between 45% and 55% in stocks, 35% to 45% in bonds and approximately 10% in cash. He told us in a 2018 interview (linked below) that a 10% to 15% allocation to cash gives retirees comfort because “they’re not going to have to sell their stock investments in a really bad market environment.”

Cloonan’s Level3 approach is more aggressive. As noted above, it calls for most of the portfolio to be allocated to stocks. Only four years of living expenses are to be allocated to safe assets.

Should Laura and Allison choose to follow the Level3 approach instead, they would estimate their living expenses for the next three years. This estimate is combined with their first-year spending forecast to develop an estimate of total planned withdrawals for the first four years of their retirement. The total dollar amount calculated through this process would be allocated to safe assets.

The forecast is going to require assumptions about expenses and inflation. Since the forecast will never be correct, the couple will need to update their four-year spending forecast every year based on real-life expenditures and changes in the rate of inflation.

As noted above, Laura and Allison estimate the amount needed to cover living expenses beyond sources of guaranteed income for the first year of retirement to be $40,000. This is the amount they will withdraw under the Level3 approach. In his book, “Investing at Level3” (AAII, 2016), Cloonan cautioned retirees to withdraw “only what you need to fund your living expenses” after accounting for guaranteed sources of income.

Under the Level3 approach, the couple could potentially take a larger withdrawal if they needed to. Cloonan suggested that a ceiling of 5% of portfolio value each year was possible given his testing of the strategy over a 45-year period. By not taking the maximum withdrawal, a cushion is created for years when Laura and Allison may need to go a bit above the maximum limit. There will be years in the future when they may incur expensive housing repairs and/or higher-than-anticipated medical bills.

The Level3 withdrawal approach varies the sources of withdrawals based on market conditions. If the stock market is within 5% of its highs, Laura and Allison will take withdrawals from the equity portion of their portfolio. If the market is below its highs by a margin of greater than 5%, they will take withdrawals from the safe assets portion of their portfolio (“defensive mode”). Once the market returns to being within 5% of its record highs, the couple will replenish the safe assets portion back to an amount equal to four years of living expenses by taking money out of the equity allocation over a period of two years. As Cloonan explains, “the key to the strategy is to use the funds put aside for rainy days when it rains.”

Though different, there are two big commonalities between the two approaches. The first is an upper limit on the size of annual withdrawals. Withdrawing too high a percentage, especially early in retirement, can lead to a funding gap later in life that cannot be overcome. Secondly, maintaining an allocation to cash prevents Laura and Allison—or any other retiree—from having to sell stocks during down markets. This safety valve provides time for the stocks held to rebound in price.

Both approaches have their merits. The choice depends on which one you are willing to stick to. The Level3 approach is designed for those who are willing to accept greater volatility in returns in exchange for greater wealth. The 4% rule is a more traditional approach of taking withdrawals.

To help those of you who are about to retire or are currently retired calculate how much you should withdraw, we’ve published a new worksheet as part of the project we’ve code-named The AAII Way. (An official name will be announced next week during our webinar on Wednesday, September 30.) Try it out and let us know if it is helpful.