Many retirement income solutions have been invented over the years. They’re all trying to solve the same basic problem: generate enough income for the rest of your life from a limited pot of money without running out.
Some of them are real income strategies. Some are just management techniques with catchy names like the Bucket Strategy that help people keep track of where their money is coming from, but don’t tell them how much they can safely withdraw.
We’re going to stick with the real solutions in this article. Management techniques can be used on top of any of these if you find them valuable.
Let’s look at some of the most popular retirement income solutions. We’ll discuss why you might use one over the other. Then see which one might be best for you.
Fixed Retirement Income Solutions
I put each of the strategies into one of two groups: Fixed or Dynamic.
The fixed rate strategies set either your inflation-adjusted income, the percentage of your portfolio that you will draw, or the base income that you’ll live on each year. Depending on which of these factors you hold constant, your income profile over the years can look very different.
We’ll start with the most famous of all.
1 The 4% Rule
What it is
The 4% Rule is a was discovered by Bill Bengen and published in his 1994 paper Determining Withdrawal Rates Using Historical Data. It isn’t a rule of finance in the way that gravity is a rule of physics, though. The 4% Rule of Thumb is a more appropriate name.
Bengen looked at 67 years of stock and bond returns from 1926-1992. Then he studied the outcomes of retirements that began in 1926-1976. For 1976 retirees, he only had 17 years of real data and had to make some assumptions beyond that. But the early years in retirement are what matters most. So he could tell within those 17 years which portfolios were going to last or not.
He found that a 50% stock / 50% bond portfolio always lasted more than 30 years when the retirees began by drawing 4% of their starting portfolio value, then adjusted their income by inflation the following years.
A 75% stock / 25% bond portfolio lasted almost as long. So Bengen concluded that a 50-75% stock allocation was best.
Bengen’s research was backed up by another study, called the “Trinity Study”, 4 years later. The Trinity Study looked at data from 1926-1995 and again showed that a 4% withdrawal rate worked nearly 100% of the time in 30-year retirements for a 50-75% stock portfolio. The major difference between these studies was their choice of bonds. Bengen used intermediate-term treasuries and the Trinity study used more volatile long-term treasuries.
How it works
Let’s say you have a $1 million portfolio at retirement.
To follow this strategy, you would invest half in the S&P 500 and half in intermediate-term treasuries on the day you retire. You could go up to 75% in stocks if you wanted to be more aggressive. Then you would hold that allocation constant for the rest of your life.
The first year, you’d withdraw $40,000 (4% of $1 million). The second year, you would adjust your withdrawal up or down by the Consumer Price Index (CPI) for the previous year. So if inflation was 3%, you would withdraw $40,120 in year 2. And so on.
The following table shows 2 scenarios for year 3, which will become important for other retirement income solutions. But notice that the 4% Rule doesn’t care whether your portfolio balance goes up or down. Withdrawals only look at inflation, not at how much money is left.
Also notice that the withdrawal rate as a percentage of the remaining portfolio changes from year to year. The inflation-adjusted income stays constant. But the amount of the portfolio that’s withdrawn each year changes.
Advantages
The biggest advantage of the 4% Rule is that you get to keep constant spending power over your lifetime. You don’t have to worry about how much you can spend next year based on how your investments perform this year.
Another advantage is that it’s simple to follow. You don’t need to do fancy calculations or pay an advisor to figure out how much money you can spend each year. All you have to do is check last year’s inflation, draw your income, and rebalance your portfolio once a year.
Disadvantages
The 4% Rule doesn’t allow you to adjust for life changes or major expenses.
What if you want to spend $20,000 on travel in your first year of retirement—to see the world while you’re young—then cut your travel budget the next 4 years to make up for it? The 4% Rule won’t let you withdraw $50,000 the first year and $35,000 the next 4 years. Even if it balances out.
There are retirement planning solutions for this. But that’s outside the scope of this article.
The biggest disadvantage of the 4% Rule is that there is risk of running out of money. Particularly if you have a longer retirement planned than 30 years, which is the case for many of us in the Pathway to FI community!
The first 5-10 years of returns will determine the chances of your portfolio lasting, however. So there will be time to adjust if needed.
Another disadvantage is that the 4% Rule limits your portfolio choices.
Many people in the FIRE (Financial Independence Retire Early) community try to apply the 4% Rule to their 100% stock portfolios. But if they read Bengen’s paper, it clearly states that 100% stock portfolios are too risky for a long retirement!
Better portfolios have been designed today, including the Pathway to FI Model Portfolios. That’s because we have much more data almost 30 years after Bengen’s original research, including many more asset classes to work with. Bengen himself has been updating his research and believes that a more diversified portfolio can achieve higher 30-year Safe Withdrawal Rates (SWR).
My research has found portfolios with a 30-year SWR of over 6% and a 40+-year SWR of over 5%! So how about the 6% Rule?
My personal choice would be to use a more dynamic approach with these portfolios. Knowing they can handle bad times in the economy. But allowing for a more natural spending pattern rather than a constant budget each year.
Why you might choose it
You might like the 4% Rule if:
- your fixed expenses make up most of your annual expenses,
- you expect your retirement to last 30 years or less,
- having a constant “paycheck” helps you sleep well at night, and
- you don’t expect to have big changes in your spending needs from one year to the next.
2 Constant Percentage Withdrawal Strategy
What it is
The constant percentage withdrawal strategy is almost the opposite of the 4% Rule. It also starts by taking a percentage of the first year’s portfolio balance. But instead of adjusting with inflation every year, it recalculates each year’s income based on the portfolio’s starting balance that year.
It doesn’t have as much research history as the 4% Rule. But it also doesn’t have the same issue of running out of money if the chosen percentage is too high. In fact, it can’t run out of money. That’s because the lower your portfolio goes, the lower your income gets.
So instead of worrying about running out of money, with the constant percentage strategy you’ll worry about having years of very low income.
How it works
Let’s say you want to withdraw 5% of your portfolio each year.
Using the $1 million starting portfolio example, you’ll take $50,000 in the first year. If your portfolio declines by 10% the next year, your income becomes $42,750 (5% of $855,000). If it falls by 20% the next year (scenario 3a), your income that year is just $32,490. But if it recovered by 30% instead (scenario 3b), you get to withdraw $52,796.
As you can see, income is much more variable. In good years, you’ll get a big raise. But if you catch a bad sequence of returns the first few years with inflation like we saw in 2022, your buying power can decline quickly.
Advantages
The biggest advantage with this method, if you strictly follow it, is that you can’t run out of money. If the market is down, you simply spend less.
Because it adjusts when your portfolio is down, you can start with a higher income in the first year. This helps if you’re planning for large initial expenses that won’t repeat in following years. If you have a good sequence of returns, it also keeps you from spending too slowly.
It’s also simple to calculate your income each year. No advanced math required.
Disadvantages
One disadvantage is the big swings in income that can come with market volatility. Those swings could be upward, in which case you’ll be happy. But they can also go the other direction. Most people would rather match their income to their desired lifestyle. Not to the markets.
Another disadvantage of constant percentage withdrawals is that income can get very small some years. If your fixed expenses are large, this could drive you into debt or cause you to change withdrawal strategies and draw your portfolio uncomfortably low.
Why you might choose it
The Constant Percentage Withdrawal method could be right for you if you:
- have low fixed expenses,
- are a conservative investor with a large allocation to bonds and cash, and
- are happy spending a lot of money one year and much less money the next.
3 Safety-First Strategy
What it is
The Safety-First strategy is a fixed retirement income solution that avoids the need for large annual withdrawals. It’s been around since the 1920s. But has been popularized recently by Dr. Wade Pfau, author of Safety-First Retirement Planning and Retirement Planning Guidebook.
The idea is to allocate your resources to achieve maximum life satisfaction rather than maximum risk-adjusted returns. Funding is prioritized in this order:
- Needs – essential expenses for shelter, food, healthcare and transportation
- Contingency Fund – unexpected expenses for home and auto repairs or emergencies
- Wants – discretionary expenses for travel, luxuries, and entertainment
- Legacy – leaving money to heirs and charities
Because Needs and a Contingency Fund are top priorities, Safety-First tries to remove the risk that your assets won’t cover them over your lifetime. It does this by using guaranteed sources of income—pensions, Social Security, annuities, and treasury bond ladders—to cover your expected income needs. Then a contingency fund is set aside in a safe, liquid asset such as a bond ladder or high yield savings account.
Wants and Legacy are covered with the rest of your portfolio, which can then be invested more aggressively. If all goes well, you will have plenty of money for Wants and leave a Legacy in the end. But if the sequence of returns is bad or you spend too quickly, you will still sleep well, knowing that Needs and Contingencies are covered.
How it works
To implement the Safety-First strategy, you begin by estimating your base income needs over your lifetime. Let’s say you decide that $40,000 per year covers those needs. And you’re starting with a $1,000,000 portfolio.
Next, you look at any defined-benefit pensions and Social Security payments that you’ll receive. Few people are lucky enough to have a pension these days. So let’s say you and your spouse expect $23,000 per year in Social Security and no pension. Subtracting this from your $40,000 base, you still need to cover $17,000 per year for the rest of your life.
You look at annuities and decide to purchase an immediate annuity that pays $12,000 per year at a price of $250,000. That leaves you with $5,000 per year to cover your base income. So you allocate another $150,000 to a bond ladder that should cover at least 30 years of income at $5,000 and pay interest that will help keep up with inflation.
Your total base income cost you $400,000. You allocate another $50,000 to a contingency fund.
So you still have $550,000 in a portfolio that looks something like the Descent Model Portfolio. This portfolio has an impressive historical 30-year SWR of 6.3%. But you conservatively plan to follow the 4% Rule and draw $22,000 the first year for Wants, and then see how your sequence of returns plays out.
In this example, your $1 million is providing $17,000 in base income and $22,000 in discretionary income. Social Security is covering another $23,000 in base income. So your total expected income is $62,000, subject to the performance of your discretionary portfolio and before taxes.
The following table shows how this might play out. Social Security isn’t included for fair comparison to the other strategies.
As the table shows, income steadily increases as bonds mature and inflation adjustments are taken from the Descent portfolio. The annuity does not adjust for inflation. Of course, you could choose another withdrawal strategy for the Descent portfolio portion instead of the 4% Rule.
Advantages
A big advantage of the Safety-First approach is longevity protection. Adding an annuity to your retirement income plan gives you a guaranteed source of income for as long as you live.
Annuities also have the potential for higher income in the early years than you would otherwise be comfortable spending.
Insurance companies have thousands of payers in a “pool” with your annuity. This allows them to calculate the average expected life span of people in that pool with high accuracy. Those in your annuity pool who die earlier are paying for those who live longer. This allows the annuity provider to pay you a higher rate than you might be comfortable taking from your own portfolio. Depending on your age and whether you add a spouse’s life to your annuity, you might see rates of 5-8%.
Another advantage is peace of mind. Since your base income needs are met, and you are taking your bonds to maturity, you don’t have to worry as much about financial markets.
Along with that, you may feel more comfortable investing aggressively with your discretionary portfolio. This could end up being a good thing if your investments do well.
This is also a good approach if you like having a steady paycheck since an annuity can pay you at the frequency you desire.
Disadvantages
The big disadvantage of Safety-First is inflation risk.
Social Security adjusts with inflation. And if you buy TIPS (treasury inflation protected securities) for your bond ladder, it will have inflation protection too. But most pensions and annuities don’t. If you buy inflation protection for an annuity, your payment will go down substantially. So it would cost you much more for the same amount of base income, which probably isn’t desirable.
The longer you expect to live, the greater inflation risk becomes. So you might have to build in an additional level of conservatism to maintain buying power for your base income.
The good news is that spending generally declines with age, particularly in the middle years of retirement. This phenomenon is called the retirement spending smile since the plot of changing retirement spending over time looks like a smile. So you may be okay having a little less buying power when you’re 85 than you do at 65.
Another disadvantage is flexibility. If you decide to move to a more expensive cost of living area mid-retirement, your base income needs will go up. You won’t be able to cover that with your fixed annuity or bond ladder. So it will have to eat into your discretionary portfolio, leaving you with less money for Wants and Legacy.
Why you might choose it
The Safety-First retirement income strategy may be right for you if:
- you like having a steady paycheck,
- leaving a legacy is not as important to you,
- you expect to live much longer than average, based on health and genetics,
- you really worry about the future of the stock market and economy and
- you retire at 65+ and will therefore receive a high annuity payout.
Dynamic Retirement Income Solutions
The dynamic strategies try to solve the problem of flexibility that the 4% Rule and Safety-First strategies have. And the problem of a low potential income floor that the Constant Percentage Withdrawal strategy has.
They do this by adjusting withdrawals based on market conditions or portfolio size. Less money is drawn during market declines, and more money is drawn when the market is high.
4 Guardrails (Guyton-Klinger) Strategy
What it is
The Guardrails strategy, aka Guyton-Klinger after its inventors, starts with a constant withdrawal from the initial portfolio value. Withdrawals increase with inflation each year, similar to the 4% Rule. Then, if the portfolio grows much larger or smaller compared to the withdrawal amount, withdrawals are adjusted upward or downward, respectively.
Guardrails are set around the starting withdrawal percentage. If the inflation-adjusted withdrawal is above the upper guardrail, you get a pay cut. If it’s under the lower guardrail, you get a raise.
To use this method, you need to select the guardrail parameters to some percentage above and below the starting withdrawal rate. You also select the maximum raise and pay cut you will take in a specific year.
A final rule is that your income doesn’t get an inflation adjustment if the portfolio had a negative return for the year. Even if it would stay within the guardrails. This adds further complexity to an already complicated strategy, so some people avoid this extra rule.
How it works
Using the same example as we had for the Constant Percentage strategy, let’s say you want to start with a 5% withdrawal. You set your guardrails to ±15% (4.25% to 5.75% withdrawal rate) and your maximum annual pay raise/cut to 5% of the previous year.
With a $1 million starting portfolio example, you’ll take $50,000 in the first year. If inflation increases 3%, your income would increase to $51,500. Your portfolio declined by 10% to $855,000, so $51,500 is 6.02% of your current balance. Above the top guardrail of 5.75%. So instead of an inflation adjustment, you take a 5% pay cut to $47,500.
The next year, inflation is another 3%. This brings your potential inflation-adjusted income to $48,925. But your portfolio fell another 20% to $646,000. That would make income 7.58% of your portfolio, so you get a 5% pay cut to $45,125 instead. This is still 6.99% of your portfolio, but will not drain it as much as an inflation adjustment would have.
If the portfolio gained 30% instead of losing 20% in year 3, the portfolio would recover to $1,049,750. The lowest your income could be is 4.25% or $44,614. But inflation would have naturally brought it to $48,925. That’s $4,311 above the lower guardrail, so no additional boost is needed.
As you can see, income is much smoother for the Guardrails strategy than it was for the Constant Percentage strategy. But unlike the 4% Rule, it can decline from one year to the next and keep going down if there’s a poor sequence of returns.
As this article explains, the Guardrails strategy is somewhat of a happy medium between the Constant Percentage strategy and 4% Rule. Yet it isn’t perfect. And your income needs might not match what it produces as closely as the Safety-First approach does.
Advantages
The Guardrails strategy is flexible. It allows you to take more income if your portfolio is doing great, but makes you spend less when it’s down enough to hit the guardrails.
It’s hard to run out of money, if done correctly.
You can safely start with a higher withdrawal than a fixed income strategy like the 4% Rule. This is because your withdrawal will fall if the market declines. But with the 4% Rule, your withdrawal will just keep increasing with inflation.
Disadvantages
The Guardrails strategy is more complicated to follow than the Fixed retirement income solutions above.
It’s also complicated to figure out which guardrail and pay raise/cut parameters are “safe” for your retirement. To do that requires simulation and many assumptions about future returns.
The inflation-adjusted income (buying power) can get uncomfortably low in worst case retirement years, as explained in this article. And there is a significant chance that you will end up spending less in inflation-adjusted terms over a portion of your retirement than in year 1, as explained here.
Why you might choose it
Consider the Guardrails retirement income withdrawal strategy if you:
- enjoy doing calculations and simulations to dial in the right income for you each year,
- expect good returns in the first 5-10 years of retirement and want to spend more if that happens and
- can live on 20-50% lower income than your starting point if a bad sequence of returns happens.
As with any strategy, it’s best to be flexible and have a backup plan if your portfolio and income are not supporting the lifestyle that you want. You may fill in the gap on lower income years by working part-time, for instance. A little extra income or reduced spending are sometimes the only things that will save you.
5 CAPE-Based Withdrawal Strategy
What it is
The Shiller Cyclically-Adjusted Price-to-Earnings (CAPE) ratio is a measure of stock prices compared to their average inflation-adjusted earnings over the past 10 years. A CAPE greater than 20 is considered high. In fact, according to this article, the 4% Rule has only failed when CAPE is above 20!
The CAPE-based withdrawal strategy adjusts your withdrawal rate every year by the portfolio balance and the CAPE ratio. If your portfolio is up, CAPE is likely down. And vice versa. This keeps withdrawals from changing too much from one year to the next.
The withdrawal rate involves a little math. If that makes your eyes glaze over, you can skip this part:
Withdrawal rate each year is set by the formula:
WR=a+bCAPE
where WR = withdrawal rate, and a and b are constants chosen to fit a SWR model. Work by Early Retirement Now seems to settle on a = 0.015 or 0.0175 and b = 0.5 as a good fit for a 40+ year retirement. A higher number for the constant a gives you a higher initial withdrawal rate with the possibility of a larger reduction if you get a bad sequence of returns.
How it works
Let’s stick with our $1 million portfolio example and use a starting CAPE of 22. For a = 0.0175 and b = 0.5, your initial WR = 0.0175 + 0.5/22 = 4.02%. So your income is $40,227 in year 1.
In year 2, your portfolio drops by 10% to $863,795 and CAPE is now 19. Your new WR = 0.0175 + 0.5/19 = 4.38%. But 4.38% of $863,795 is $37,848. So your income is cut by $2,379.
In year 3, your portfolio drops 20% to $660,758 and CAPE drops to 13. Now your WR = 0.0175 + 0.5/13 = 5.60%. But 5.60% of $660,758 is $36,977—another $871 cut.
If instead the portfolio gains 30% to $1,073,732 and the CAPE rises to 27, your WR = 0.0175 + 0.5/27 = 3.60%, so you take $38,674 of income. That’s an $826 raise.
Advantages
The CAPE-based retirement income withdrawal strategy has similar advantages to Guardrails:
It’s more flexible when markets are doing good or bad.
You can safely start with a higher withdrawal than the 4% Rule if the CAPE isn’t too high.
And it’s highly unlikely that you will run out of money.
If there’s a bad sequence of returns, you’ll draw less and give your portfolio a chance to recover. CAPE does this right away, whereas the Guardrails strategy might wait until withdrawals hit the guardrail before income is reduced.
It doesn’t cut income as fast as the Constant Percentage withdrawal strategy, though. It falls somewhere in the middle of those two.
Unlike the other strategies, the CAPE-based strategy gives guidance on what your initial withdrawal rate should be. It adjusts to market conditions when calculating each withdrawal. It doesn’t just rely on surviving the worst markets in history.
Disadvantages
Buying power goes down when markets decline. But compared to the Constant Percentage and Guardrails strategies, CAPE smooths the ride a little. This might not be obvious from the examples above. But a detailed analysis was performed here, showing that CAPE-based rules have less income volatility.
It’s important to note that the CAPE ratio is not a crystal ball that can predict when stocks will go up or down. And it isn’t perfect. It’s been in the 20s and 30s for almost all of the past 30 years as tech stocks have taken over the S&P 500. So be careful how you use it.
This article from Early Retirement Now makes some useful adjustments to CAPE according to the facts that corporate tax rates are lower and companies are reinvesting their earnings more often now instead of paying them to shareholders as dividends. That explains why today’s CAPE may not be quite as high as it looks. But it’s still over 20 and higher than its long-term average.
Using the adjusted CAPE would let you spend a little more today. But it adds to the effort of calculating your withdrawal each year. The CAPE-based rules are otherwise simple to follow since you can find CAPE with a quick Google search and plug it into a simple formula. Overall, it’s easier to implement the CAPE-based rules than the Guardrail rules.
Why you might choose it
A CAPE-based retirement income solution may be right for you if you:
- want your income to adjust with market conditions,
- aren’t comfortable raising your income in a year where the market declined,
- want to spend more if you get a good sequence of returns and
- can live on 20-30% lower income than your starting point if a bad sequence of returns happens.
The CAPE-based strategy is more balanced overall than the Constant Percentage and Guardrails. And even if you don’t believe fully in the CAPE ratio as a tool to put valuation on markets, it’s directionally accurate.
My personal strategy
My personal plan is a hybrid of several strategies. First, we have some big near-term expenses that are outside our normal annual spending. So I set aside funds for those expenses as I describe in How to Plan for Irregular Spending in Retirement.
With the remaining portfolio, I’m starting with a CAPE-based mindset.
When I left my job, market values were high, though the S&P 500 was down 15% from its peak. And I’m planning for a long retirement. So my initial withdrawal rate is 3.25%.
If markets do well, I’ll begin raising my income according to CAPE-based rules, then spending and giving more.
If markets do poorly, I may switch to a fixed 3.25% version of the 4% Rule. A fixed 3.25% strategy is super safe based on the historical returns of my portfolio.
At age 65, I’ll take a closer look at Social Security and annuity options to see if the Safety-First approach works best for the remainder of my retirement plan.
Summary
This article presented 5 popular retirement income solutions and discussed why you might choose one over the other. The following table summarizes the discussion.
Bottom line: there’s no perfect set-it-and-forget-it strategy. Flexibility is key. Any retirement plan should involve yearly evaluations to make sure your portfolio is still on track and your goals and life situation haven’t changed.
Another way to improve the odds that your money will last—and increase the lifetime income that you can safely withdraw from your portfolio—is to build a portfolio with the highest Safe Withdrawal Rate that you can. Read How to Make More Money from Your Retirement Savings for more on SWR.
And don’t forget to sign up for FREE to get much more value from PathwayToFI.
Join me on the path to FI!
