Financial Planning

Use the Guardrails Approach to Avoid Running Out of Money in Retirement

By  Opher Ganel

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The guardrails approach lets you spend more money in retirement while lowering your risk of running out and falling into poverty.

In a recent article, I detailed the three main reasons we all need to be concerned about our retirement plans:

  1. Retirement has been getting longer and longer because we’re living longer.
  2. Projected market returns are significantly lower in the coming decades.
  3. Inflation is running at historically high levels.

Then, I provided a list of things you can do to reduce your risk of falling into abject poverty in retirement. Some of these things are obvious (e.g., start saving as soon as possible, save as much as possible, etc.), and some are a bit less obvious (e.g., avoid lifestyle inflation, invest your retirement money in a prudently aggressive manner, maintain adequate insurance, etc.).

I also briefly mentioned the best way to avoid running out of money in retirement. An approach called “guardrails.”

You can read the full article on Medium here: “How to Have Your Best Retirement, Feel Confident, and Never Run out of Money.”

In this article for Wealthtender, I offer a deeper dive below into the guardrails approach, a less well-known, advanced strategy to provide you with the best retirement possible at the lowest risk possible.

The 4-Percent Rule and How People Try to Update It

If you’ve been reading about retirement planning, I’m confident you’ve heard of the so-called 4-percent rule.

Published by financial advisor William Bengen in 1994, this “rule” states that if you invest your retirement nest egg in a 50/50 mix of large-cap stocks and intermediate-term Treasury bonds, withdraw 4 percent of the total in your first year of retirement, and then each year thereafter increase the number of dollars you draw by the prior year’s inflation rate, your nest egg will last for at least 30 years.

This was based on Bengen’s analysis of historical investment returns all the way back to the Great Depression.

More recently, Bengen said that by adding small-cap stocks, you could increase your initial draw to 4.5 percent.

On the flip side, research from, e.g., Morningstar suggests that with lower projected returns in the future, you need to reduce your initial draw to 3.3 percent to maintain the safety level of the original 4-percent study. Their main concern is that with lower equity returns, the volatility of stocks poses a greater risk to your portfolio than it did when returns averaged 10+ percent.

Once you start drawing money from your portfolio, if stocks crater and you still need to sell shares to cover your expenses, you’re pulling more shares out of your portfolio for the same number of dollars (i.e., selling low), which hamstrings your portfolio’s ability to recover with the market.

Monte Carlo Simulations – Better than the 4-Percent Rule?

Many financial advisors use sophisticated software that runs thousands or tens of thousands of what-if scenarios based on the past behavior of different asset classes.

They plug in assumptions for your specific case, such as:

  • Your portfolio size at retirement
  • Your asset allocation
  • Your age at retirement
  • Your age at death
  • Your proposed draw as a fraction of your portfolio

They then say something like, “Your plan has an 85-percent likelihood of success.”

What does that mean?

It means that in 85 out of every 100 scenarios, you would have died before running out of money.

How about the other 15 percent? In those scenarios, you run out of money and suffer poverty.

So, do you feel lucky?

The problem is, of course, that we don’t know what future investment returns will be, in what order, with what inflation, or even what life will throw at you (e.g., expensive health problems). And unless you want to gamble with your future financial well-being, even a 90-percent likelihood of success (which many professionals see as the “gold standard” of planning) may leave you anxious (it sure does me!).

Of course, if you’re not looking to leave a big bequest to your heirs, the other direction is also not wonderful.

Say you retire with a $1.5 million portfolio and pass away 30 years later with a $10 million portfolio. It would be fair to say in retrospect that you underspent what you could have and had a less enjoyable retirement than you could have had.

As Zack Swad, President & Wealth Manager, Swad Wealth Management, says, “A static spending rate is a huge risk to your retirement because… you could end up broke or not living retirement to the fullest.

Interestingly, a recent Monte Carlo analysis of Bengen’s 4-percent rule shows that it has an 87-percent likelihood of success – not great!

The “Guardrails Approach” – Adjustable Draws Allow Higher Spending with Lower Risk

Developed by financial planner Jonathan Guyton and business professor William Klinger, the guardrails approach offers a far better, dynamic method for deciding how much you can spend each year in retirement.

In this approach, when your investments do very well, you increase your draw, but when your portfolio value drops a lot, you cut your spending.

Swad explains, “To implement guardrails, you first select an initial withdrawal rate. The higher this rate, the more likely you are to have to adjust your spending later. Let’s say you select 5 percent.

Next, you determine when to adjust your withdrawal rate (a.k.a. your guardrails). Let’s say you set your guardrails to 20 percent above and below your withdrawal rate. If your target rate is 5 percent, your lower guardrail would be 4 percent, and your upper one would be 6 percent.

If your withdrawal rate falls outside your guardrails (after adjusting for inflation), you’d increase or decrease your withdrawal amount by 10 percent, which should get you back into your target withdrawal range of 4-6 percent.”

Swad then gives an example of how things could play out in a bear market.

  • “Year 1: You have a $2 million portfolio, and you draw 5 percent, or $100,000.
  • “Year 2: Inflation in Year 1 was 3 percent, and your portfolio dropped 20 percent to $1.6 million. Your inflation-adjusted withdrawal amount is $103,000 ($100,000 x 1.03). Dividing that by $1,600,000 = 6.4 percent. Since that’s higher than your 6-percent upper guardrail, you need to cut your draw, so you reduce it by 10 percent to $92,700 ($103,000 x 0.9), which is 5.8 percent of your $1.6 million current portfolio value, safely back inside your upper guardrail.
  • Repeat this check at least annually.

If the market has an incredibly good year instead, it might play out like this:

  • Year 1: You start out with the same $2 million portfolio and draw the same 5 percent, or $100,000.
  • Year 2: Inflation in Year 1 was 3 percent, and your portfolio soared 35 percent to $2.7 million. Your inflation-adjusted withdrawal amount is $103,000 ($100,000 x 1.03). Dividing that by $2,700,000 = 3.8 percent. Since that’s lower than your 4-percent lower guardrail, you increase your draw by 10 percent to $113,300 ($103,000 x 1.1), which is 4.2 percent of your $2.7 million current portfolio value, back over your lower guardrail.

In a 2020 Morningstar interview, Guyton said, “…if you think about driving your car down a road, you hit a guardrail, it does two things. It puts a ding in your car, and it changes your momentum so that instead of the momentum pushing you toward the edge of the road, it now starts to shift you back toward the middle where it’s safe…”.

He then goes on to explain that if the guardrails system tells you to cut your draw by 10 percent, that doesn’t translate to cutting your spending by 10 percent! That’s because (a) your Social Security benefits aren’t affected, and (b) drawing less out of your IRA or 401(k) (unless they’re Roth plans) means that your taxable income is lower, so your taxes are lower too.

For example, say your draw is $50,000, your Social Security benefits are $30,000, and your taxes total $10,000. When the market tanks, you hit your upper guardrail and need to cut your draw by 10 percent, to $45,000.

Drawing $5000 less from your portfolio, your taxes could be $1500 lower or $8500. This means that instead of having $70,000 to spend ($50,000 + $30,000 – $10,000), you have $66,500 ($45,000 + $30,000 – $8500).

Just a 5-percent budget cut.

Is it fun to trim nearly $300 from your $5830 monthly budget? No. But it’s no disaster either.

Interesting, I’m thinking. But how much safer are you, and can you draw more on average than you would with the 4-percent rule?

Swad pointed me to two research papers:

  • Guardrails to Prevent Potential Retirement Portfolio Failure (by William Klinger): Here, Swad quotes, “Simulations using the 4 percent rule with the above assumptions failed 13.7 percent of the time… If you used the withdrawal rate ratio applied to the 4 percent rule in the first 15 years (see page 51), the failure rate was only 0.07% for a withdrawal rate ratio increase of 20%.
  • Lifetime Adjustable Income vs. the 4% Rule: Can You Spend More in Retirement with Less Risk? (by Rob Williams, CFP®, CPWA®, Managing Director Eric Tarkin, and Senior Researcher Chris Kawashima, CFP®, Senior Research Analyst): This report uses a slightly different methodology than  Klinger’s but reaches similar conclusions. For example, the initial draw could be 4.3 percent instead of 4 percent, the average annual (inflation-adjusted) draw increases from $39,000 to $49,000, and the probability of running out of money in 30 years drops from 13.2 percent to just 3.8 percent! Note that this study shows the average remaining portfolio at death (in future dollars) drops from $1.3 million to just $618,000.

Depending on the details of how you implement your guardrails, your risk of poverty drops from over 13 percent to somewhere between 0.07 percent and 3.8 percent!

The Guardrails Approach Implemented in Real Life

I asked Swad and other financial professionals questions on how they implement the guardrails approach with their clients.

Q: Do you implement the guardrails approach with all clients, or are there certain types of clients for whom you feel another approach is better?

Swad says, “I implement guardrails for all clients who are in the retirement/distribution phase of life. I believe it’s a fit for all clients as it’s a better approach to helping ensure they don’t run out of money in retirement, which is almost always a top concern for retirees.

With that said, there are different degrees of guardrails that can be used. For example, if a client is relatively conservative and doesn’t want to have to adjust their income as much throughout retirement, we’ll use a relatively conservative income approach, which means starting with a lower withdrawal rate. Also, for clients who want to leave a legacy, we adjust the spending parameters down so they don’t spend as much throughout retirement, allowing them a better chance of leaving the legacy they desire.

Brandon Renfro, a financial advisor with Belonging Wealth in Longview, TX, says, “This is my single favorite approach to taking distributions from a retirement account, but I don’t implement it with every client. For some clients, the potential variability is too stressful, so we stick to a more standard withdrawal rate approach like the 4-percent rule.

Doug Oosterhart, founder & financial planner at Lifepoint Planning, says, “I implement guardrails with as many retirees as possible, as long as they understand that there’s a chance their income could be cut in the future. If clients are adamant that they aren’t willing to take a potential pay cut in the future, I discuss the pros and cons of a fixed withdrawal rate that is often lower than 4 percent.

The guardrail strategy allows for some optionality in the sense that we might be able to start with a withdrawal rate higher than 4 percent, knowing that income could change (up or down) moving forward.

Q: When implementing the guardrails approach, how do you work with clients to determine what their initial withdrawal rate should be?

Swad says, “I discuss how willing and able they are to adjust spending throughout retirement and base the parameters on their answer.

Renfro answers a bit differently, “This is a key piece. To determine the initial withdrawal rate, we start by figuring out what they need to take to make their plan work. To gauge whether it’s an acceptable rate or not, I consider the results of their plan’s Monte Carlo analysis against the backdrop of historical research.

Oosterhart details, “I use a variety of software programs (primarily Income Lab). Rather than a specific starting percentage, Income Lab looks at dynamic guardrails from an actual-dollars standpoint. This makes it easier to convey to the client that if their portfolio hits a certain dollar amount (up or down relative to where we started), that’s when the guardrail change in income would happen.

Locking the client into a starting percentage withdrawal is often too rigid – for example, we might delay claiming social security to age 70, so their withdrawal rate might be high for a few years and then taper off once Social Security benefits start.

Q: Do you work with clients ahead of time to identify where in their budget they could (or should) trim if and when they need to cut 10% off their spending?

Swad sees this as critical, “I believe understanding where a client can adjust is critically important to their plan. There are two ways to address the need to cut: 1) Determine beforehand during a budgeting conversation and exercise exactly what they are willing and able to cut, and/or 2) Consider part-time work during a tough market period. For #2, even a small part-time income will often allow someone to avoid having to cut their spending.

Oosterhart agrees, “Yes. We factor in baseline spending needs and then variable spending needs on top of that. We talk to clients about how it’s possible that they will spend more in the first ‘phase’ of retirement as they check off bucket list items. After that, the next phase might be a time when they spend less as they get into more of a routine. Like everything else in financial planning, there is an art and a science.

Renfro takes the opposite approach, “My clients typically don’t want or need this level of input from me. My role is to help you live your life the way you want to, help you withdraw in the most tax-efficient way possible, and let you know if you’re taking on too much risk. Clients decide where to cut back. However, most of my clients aren’t in a position where a 10-percent cut would be that stressful.

I also like to couple this strategy with a ‘floor’ approach where there’s enough Social Security or pension income to cover necessities, or that their withdrawal is simply way more than enough to cover their lifestyle, and the cuts are made to luxury or leisure spending.

Q: For clients using the guardrails approach, additional discipline is required, especially when the withdrawal rate has to be reduced. How do you help your clients adjust?

Swad: “First, it’s important to understand a client’s willingness to adjust throughout retirement. If a client tells me they don’t want to have to adjust their spending, we’re going to use a much more conservative income approach with a lower withdrawal rate. I use Income Lab, a software package that uses guardrails. As part of my process, I regularly review plans with my clients and monitor them to see if they need to make adjustments.

We know WHEN we need to cut and WHAT we will cut from their budget (or alternative ideas to create more income that we’ve discussed, e.g., part-time work). When an adjustment is needed, I will notify them, and we’ll discuss this in our next meeting to help ensure they stay on track.

Oosterhart says, “It’s important to identify the client’s specific retirement spending style (i.e., are they more safety-first and prefer guarantees OR are they more probability-based and trust the market as a medium to fund their retirement).

Communication is key – some clients are on board with the guardrail approach, but others would rather use guaranteed income sources to fund their retirement. It’s important for financial planners to stay strategy-agnostic to find the best-fit strategy for each client’s ‘style’ in retirement.

In terms of helping clients adjust, the classic question this year has been, “Do we need to change anything?” I like my clients to keep a war chest of cash and short-term investments to make sure we don’t have to sell investments when they’re down, like in 2022.

The Bottom Line

There are many well-known strategies to save more for retirement, invest more, build a bigger nest egg, etc. The less well-known strategies have to do with converting your portfolio into a source for a never-ending stream of income to fund your best retirement without ever running out.

The “guardrails” approach does exactly that, and as described above, lets you spend more in retirement with a far lower risk of running out and dropping into poverty when you’re old and can’t recover.

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Disclaimer: This article is intended for informational purposes only, and should not be considered financial advice. You should consult a financial professional before making any major financial decisions.

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About the Author

Opher Ganel

My career has had many unpredictable twists and turns. A MSc in theoretical physics, PhD in experimental high-energy physics, postdoc in particle detector R&D, research position in experimental cosmic-ray physics (including a couple of visits to Antarctica), a brief stint at a small engineering services company supporting NASA, followed by starting my own small consulting practice supporting NASA projects and programs. Along the way, I started other micro businesses and helped my wife start and grow her own Marriage and Family Therapy practice. Now, I use all these experiences to also offer financial strategy services to help independent professionals achieve their personal and business finance goals.

Connect with me on my own site: OpherGanel.com and/or follow my Medium publication: medium.com/financial-strategy/.

Disclaimer: To make Wealthtender free for our readers, we earn money from advertisers, including financial professionals and firms that pay to be featured. This creates a natural conflict of interest when we favor their promotion over others. Wealthtender is not a client of these financial services providers. Learn how we operate with integrity to earn your trust.