A A I I J o u r n A l M A R C H 2 0 2 2 2 1

A A I I . C O M / J O U R N A L

P O R T F O L I O S T R AT E G I E S

The 4% rule is based on U.S. historical data, and we’ve

never had interest rates this low. Four percent is supposed

to be a safe withdrawal rate. I don’t think in this kind of

interest rate environment it can be considered a safe with-

drawal rate if you’re otherwise trying to maintain all of the

rule’s basic assumptions: a 30-year retirement, no invest-

ment fees, no taxes and a fairly aggressive asset alloca-

tion of 50% to 75% stocks. It’s just going to be under more

strain than the U.S. historical data would suggest.

[See Figure 1 for portfolio success rates using the 4%

rule.]

Is there a safe number now that you would give out?

There was a Morningstar study that was recently

updated. I was a co-author on the previous iteration, and

I think we had a number in the ballpark of 2.8%. The

updated study came out with a 3.3% withdrawal rate. Any-

thing in the area around 3% is more realistic in this inter-

est rate environment.

A New Perspective

on Withdrawal and

Allocation Strategies

for Retirees

Factoring in worst-case scenarios for your

early years of retirement helps ensure your

portfolio lasts.

AN INTERVIEW WITH WADE D. PFAU, PH.D.,

CFA, RICP

Wade Pfau is a widely followed retirement researcher and

a professor and program director at The American College of

Financial Services in King of Prussia, Pennsylvania. He is also

principal and director for McLean Asset Management and

RISA LLC. In this first of a two-part interview, we discuss both

retirement portfolio withdrawal rates and allocation strategies

for retirees.

—Charles Rotblut, CFA

There is much debate about whether the traditional rule

of taking 4% of a retirement portfolio’s starting value and

adjusting it annually for inflation still makes sense. What

are your thoughts?

There’s a lot of assumptions that go into calculations

for the 4% rule, and some of them are not very realistic.

One in particular is the notion that you never adjust your

spending in response to market performance, which actu-

ally creates more sequence risk. But if you’re trying to

stay as close as possible to the core assumptions, I think

a 4% withdrawal rate is too high at the present, primarily

because of the low-interest-rate environment.

Wade D. Pfau, Ph.D., CFA, RICP, is the

program director of the Retirement Income

Certied Professional designation and

a professor of retirement income at The

American College of Financial Services in

King of Prussia, Pennsylvania. He is author

of the book “Retirement Planning Guidebook” (Retirement

Researcher Media, 2021). Find out more at www.aaii.com/

authors/wade-pfau.

FIGURE 1

Portfolio Success Rates for the 4% Rule

This chart shows the likelihood of a retiree not outliving

their portfolio over a 30-year period when following the

William Bengen 4% withdrawal rule and using a portfolio

allocation of 50% stocks and 50% bonds. The historical

simulations use average returns for rolling periods. The

Monte Carlo simulations randomize the sequence of

returns. The adjusted returns scenario assumes a real

(inflation-adjusted) return of –1% for intermediate-term

bonds.

Source: “Retirement Planning Guidebook,” by Wade Pfau (Retirement

Researcher Media, 2021).

A A I I . C O M / J O U R N A L

2 2 A A I I J o u r n A l M A R C H 2 0 2 2

It was the best-case scenario in history, but it was too

late for those earlier retirees to benefit from what hap-

pened in the second half of their retirement. It was really

what happened in those early retirement years that led to

these worst-case scenario outcomes. The early retirement

years matter much more than the later retirement years in

determining retirement sustainability.

[See Figure 2 for an illustration of sequence of returns

risk.]

Is there a benchmark retirees can use to determine when

their portfolio is on safe ground if they reach it?

The thing about the 4% rule method is that the initial

withdrawal rate only applies in the first year of retirement.

Afterward, you’re always just adjusting your spending with

inflation, but you’re not worried about what the current

withdrawal rate is.

You could simply divide current spending by your

remaining portfolio balance to get a new withdrawal rate.

If things are going well in retirement and you’re spending

conservatively, your actual current withdrawal rate could

decline throughout retirement.

If your portfolio balance ever falls below where it

started just in nominal terms, without even making infla-

tion adjustments, that’s kind of a signal that you may be

getting into trouble. So, you might want to start cutting

back on spending and prepare for the possibility that you

are in one of those scenarios where you may deplete your

investment portfolio, or at least have an uncomfortable

time later in retirement.

Some investors prefer using time-oriented buckets. Could

you share some of the weaknesses and advantages of doing

a bucket strategy versus a traditional allocation?

With bucketing, the advantages are going to be behav-

ioral. And in some recent research I’ve done with Alex

Murguia, we talk about retirement income styles and iden-

tify bucketing or time segmentation as one of four viable

retirement income styles for people who do want some sort

of contractual protection, but also want a lot of optionality.

They use bonds to cover upcoming expenses, and then that

creates a window for not having to sell their stock market

investments during a market downturn.

Retirees can just continue to spend down their fixed-

income buckets. If that helps them to stay the course with

their strategy, then that’s a sort of behavioral advantage

toward having a better retirement outcome.

Now, in terms of disadvantages, this is a strategy where

it’s often discussed at a basic level but without details

about when you should refill your buckets. So, if you have,

just for example, five years’ worth of projected expenses in

bonds and everything else in stocks, you need some sort of

rule. As I spend my bonds, when am I going to sell stocks to

In my analysis of worst-case scenarios, it seemed that

a retiree was most likely to outlive their savings when a

sequence of bad returns occurred early in retirement. Have

you noticed something similar or different?

The worst-case scenario is some sort of prolonged

downturn in the early retirement years. If inflation is high,

that does seem to require lower withdrawal rates as well.

The worst case in the U.S. historical data was retiring

in the 1960s when there were big downturns in the stock

market, like in 1966. In 1973 and 1974 the S&P 500 index

fell by 47%. Combined with the inflation rate at that time,

it set up a scenario where these early market downturns

disrupted retirement.

In the data that William Bengen (the creator of the 4%

rule) used, 1966 was the retirement year that led to the

worst-case scenario. The year 1982 was a big turning point.

After 1982, the markets did great and accounted for almost

half of a 30-year retirement for the 1966 retiree. If you’d

retired in 1982, you could have used almost a 10% with-

drawal rate.

FIGURE 2

Lifetime Sequence of Return Risk

Returns in the early part of an investor’s career have very

little impact on the absolute level of wealth accumulated

at the end of the savings period. As retirement nears and

a large amount of wealth has been accumulated, a given

percentage return (be it positive or negative) has an in-

creasing impact. Investors are most at risk around the date

of retirement as they have a large amount of wealth saved,

leading to proportionately large changes in wealth for a

given return.

Source: “Retirement Planning Guidebook,” by Wade Pfau (Retirement

Researcher Media, 2021).

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A A I I . C O M / J O U R N A L

If you just hold the individual bonds to maturity, you’ve

got the right duration for your expenses, because as the

bond matures, it covers your spending. You could have

paper losses if interest rates go up, but if you hold your

bonds to maturity, you know what you’re getting.

If you’re trying to replicate this with bond funds, yes,

it’s mathematically possible but it’s just a lot more compli-

cated to do in practice.

You also found that the total-return strategies had a

better outcome than bond ladders, particularly if you’re

increasing your allocation to equities once you’re retired. Is

that correct?

When I looked at comparing the time-segmentation

strategies to total-return strategies, I usually just look

at a simple kind of 60% stock/40% bond allocation for

the total returns, where you have a fixed asset allocation

throughout retirement. But using time segmentation

actually leads to a rising equity glide path in many cases.

So, a kind of U-shaped lifetime stock allocation.

The reason time segmentation can work is because

it can give you a rising equity glide path during troubled

market environments. You’ve got to be comfortable with

that. If you’re not, then it’s not necessarily going to work

for you.

If you automatically refill your bond bucket every year,

you can have a declining equity glide path in retirement

because as the portfolio gets into trouble, your stock piece

is getting smaller, but you keep selling from it to replenish

your bonds until at some point you don’t have stocks any-

more. This could leave you in a scenario where you may

run out of money.

You get to the end where your stocks are gone, and now

all you have left is a five-year bond bucket. If you spend

that down over the following five years, you’ll be out of

money. That’s where it doesn’t work as well.

Where bucketing does work is if you use a rising equity

glide path. When Michael Kitces and I first wrote about the

rising equity glide path (“Reduce Stock Exposure in Retire-

ment, or Gradually Increase It?,” April 2014 AAII Journal),

we were thinking in terms of a total-return strategy, but it

shows up as well in a version of time segmentation that

works. It’s a rising equity glide path.

That leads to my next question about glide paths. Could

you explain to our members what a glide path is and why a

U-shaped path makes sense?

With a target-date fund, you have a higher stock allo-

cation when you are young. As you get to retirement, you

have a lower stock allocation. Target-date fund allocations

vary quite a bit, but they usually have between 20% and

40% in stocks at the retirement target date. That’s coun-

tered by all of the financial planning style research that

replenish my bonds so that I still have five years of bonds to

cover my upcoming expenses?

If you have a rule in place to automatically refill the

bucket every year, that can increase sequence of returns

risk, because you’re having to effectively take a full year

of spending out of a smaller stock portfolio to replenish

the bond portfolio. It can cause you to run out of money

sooner than if you just use a basic total-return strategy for

retirement. The only way bucketing can actually help get

a better outcome is the logic of not selling stocks during a

downturn.

The way bucketing is sold as an idea is to let my bond

ladder get smaller and smaller until at some point it could

even be gone. But if a stock market downturn occurs once

my bond ladder is depleted, I’ve already shifted toward

100% stocks.

A bucket strategy requires people to have a dynamic

asset allocation. It requires investors to effectively increase

their stock allocation during the market downturn. It’s not

that they’re buying more

stocks, it’s just that they’re

spending bonds and not

touching their stocks. This

pushes them more toward a

higher stock allocation. So,

if they’re comfortable doing that, then it’s good. If they’re

not comfortable doing that, if they use some other strategy

for refilling their short-term buckets, it could actually be

worse in absolute terms than just using a basic total-return

investing strategy.

Interesting. You wrote about bond ladders in your book,

“Retirement Planning Guidebook.” Can investors use bond

funds if they don’t want to ladder individual bonds? How

important is it to have bonds maturing on certain dates as

opposed to just having a source of cash flow available in the

shorter-term bucket?

There are debates about this. I think it’s much easier to

explain bucket strategies with a bond ladder tied to when

you’re planning to spend the money. You could do it as

bond funds, but I think it’s harder than is commonly appre-

ciated. The idea is if you have a constant duration—bond

funds with a duration that matches your expenses—then

it shouldn’t matter.

But when you’re spending from the portfolio, the math

to have the right duration on your remaining bonds is

incredibly complicated. There are a few commercial pro-

viders who’ve created solutions for that, where they use

bond funds in lieu of having a bond ladder. But for a house-

hold trying to do that on their own, good luck. You really

need to be an advanced engineer to handle getting the

right duration on your bonds so that you’re not exposed to

that interest rate risk.

A bucket strategy requires

people to have a dynamic

asset allocation.

A A I I . C O M / J O U R N A L

2 4 A A I I J o u r n A l M A R C H 2 0 2 2

Bengen did showing that retirees should hold 75% stocks

and in no circumstances hold less than 50% stocks.

A recurring theme calls for higher stock allocations,

but that’s different from what target-date funds call for.

So, we’ve got this disconnect. The 4% rule style research

says to hold a high stock allocation throughout retirement.

Target-date funds, in contrast, are saying no, have a lower

stock allocation at retirement. Then post-retirement, if it’s

a “to” target-date fund, it just keeps you at that same low

stock allocation afterward. If it’s a “through” target-date

fund, it might continue to decrease your stock allocation

as you go throughout retirement.

What we said was that you can go ahead and follow

the target-date fund approach, where you have a lower

stock allocation at retirement. But then what you do is you

increase your stock allocation again as you go throughout

retirement. It’s a risk-management technique because it

helps manage the worst-case scenario, which is having a

market downturn in the early retirement years.

So, a rising equity glide path—having a lower stock

allocation at retirement and then increasing that later—is

going to work best for you

when a bad market envi-

ronment occurs early in

retirement followed by a

better market environment

later on. Now, if you had a

bad market environment

for your entire retirement,

nothing’s going to work.

But a more probable worst-

case scenario is getting a

downturn early on, and

then markets recover. And

that’s where the strategy is designed to give you risk man-

agement to help you get through the sequence of returns

risk.

[See Figure 3 for an illustration of the U-shaped glide

path.]

How early before retirement should people start decreas-

ing their equities?

We never tried to optimize that side because we were

looking more at post-retirement, but I don’t necessarily

have any issues with how target-date funds approach that,

gradually over time. As you get to be maybe within 10 years

of retirement, that’s when you’re starting to get exposed

more to market returns. There is sequence of returns risk

prior to retirement as well for savers because those pre-

retirement returns are impacting their lifetime of savings.

So, that’s where you can start to take some of that risk off

the table.

I haven’t taken that analysis much further other than to

just start taking some of that risk off the table say five, 10

or 15 years before retirement.

Okay. What do we say to someone who reduced their

equity exposure heading into retirement and is nervous

about then raising their allocation? Perhaps a bear market

just ended. Any suggestions you’d give?

If you’re used to a lower stock allocation, and there was

some market volatility, it can be hard to increase your stock

allocation later. I suppose a time-segmentation strategy

like bucketing could be a behavioral way to implement

that, because you may not even realize you’re implement-

ing it. You may not realize bucketing gives you a rising

equity glide path.

If you’re coming at it from the total-return perspec-

tive, like the case study we looked at in the original article,

you’re at 30% stocks at the start of retirement and then you

work your way back up to 60% stocks.

Beyond that, just look at the historical data and see that

whenever these market volatility periods happen, things

do recover. So, just feel comfortable with that. It’s not

going to resonate with everyone. There are annuities. You

don’t have to have a total-return investment strategy for

retirement or a bucketing variation on it.

So, a rising equity glide

path—having a lower stock

allocation at retirement

and then increasing that

later—is going to work best

for you when a bad market

environment occurs early

in retirement followed by a

better market environment

later on.

FIGURE 3

U-Shaped Glide Path for Portfolio

Allocation

When an investor is young, most of their portfolio is allo-

cated to stocks. Then as the investor begins to near retire-

ment, exposure to stocks is reduced to protect the portfolio

against a bad sequence of returns. Once in retirement, the

investor then increases their allocation to stocks to support

spending.

Source: “Retirement Planning Guidebook,” by Wade Pfau (Retirement

Researcher Media, 2021).

A A I I J o u r n A l M A R C H 2 0 2 2 2 5

A A I I . C O M / J O U R N A L

One of our AAII asset allocation models uses a diversi-

fied version of the traditional 60% stock/40% bond alloca-

tion. For investors who are concerned about rising interest

rates, any suggestions on what to do on the bond side of the

allocation?

Everyone reading this understands the idea that if inter-

est rates go up, you can have losses on your bond funds.

And the longer the maturity or duration on your bonds,

the bigger the potential losses you experience.

If you are worried about a rising interest rate environ-

ment, that speaks more toward having lower-duration

bonds as part of your strategy. Such bonds are not going

to get as big of hit with the rising interest rates. The only

problem, of course, is that lower-duration bonds are not

yielding much at all. So, you’ve got that drag on potential

returns while you’re waiting for interest rates to rise.

Investors are in a tough spot going into retirement or

being retired in a low-interest-rate world. Even more so

in a low-interest-rate world where the expectation is that

interest rates will rise in the future. If these bonds are

meant to be the source of funds for funding their expenses

and they have to sell bonds after an interest rate increase,

then they will lock in capital losses. In this scenario, the

bonds aren’t really helping them. They’re doing the same

thing stocks do, which is creating the risk of having to sell

them at a loss.

That’s what creates the sequence of returns risk for

retirement. So, just keeping the same sort of high bond

allocation with a longer duration and so forth can create

risks if you’re worried about rising interest rates. ▪

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