Not all retirement spending guardrails are created equal. And, as retirement researcher Derek Tharp emphasized in a recent post on LinkedIn, not all financial advisors who are using guardrails seem to understand the risks involved.
“I do agree that there’s a lot of nonsense in financial planning software, but it’s alarming how many advisors are running around using Guyton-Klinger's guardrails (or similar variants) and either don’t know or don't care how disastrously such frameworks would have performed historically,” Tharp said.
An increasingly rich body of academic and industry research details the pros and cons of dynamic income strategies. The clients best suited by a guardrails-based approach, planning experts agree, are willing to accept an added level of risk to vary their spending and avoid the standard 4% withdrawal rule.
How to get clients to that point is less settled. Tharp’s post originated as a reply to a separate discussion sparked by Matthew Jarvis, an advisor and popular retirement podcaster who says that financial planning software is advisors’ “single biggest productivity killer … sucking up hours of time to generate dozens or even hundreds of pages of noise, none of which tells the client anything useful, or more importantly, what step to take next.”
“But seriously, what action has a client ever taken based on a 100-page report that couldn’t be done in just minutes with a calculator?” Jarvis asked. “How much to save for retirement? How much to safely spend? When to start Social Security? This is all basic math, not elaborate rocket science.”
More than 150 commenters weighed in on Jarvis’ simplified approach. Tharp has some sympathy for the argument, he said, but he’s also convinced that building a safe guardrails-based spending strategy is all but impossible without planning software. The process, more time-consuming than setting clients up with a fixed withdrawal rate between 4% and 6%, is worth the effort, he believes.
“I’m not sure how anyone can possibly do guardrails right without some sort of software,” Tharp said. “And no, Guyton-Klinger is not the right way to do guardrails, unless your clients are cool with cutting their spending 50% or more.”
Big Risk of Simple Guardrails
The Guyton-Klinger guardrail approach, detailed by Jonathan Guyton and William Klinger in 2006, is a retirement income strategy based on higher initial withdrawal rates that requires adjusting spending around market performance.
This system sets boundaries, or “guardrails,” for annual withdrawals, with adjustments made if the withdrawal rate deviates significantly due to portfolio performance.
The Guyton-Klinger approach represented an important theoretical development, according to Tharp, but he is concerned that the strategy can leave investors exposed to more downside risk than they generally appreciate. This is made apparent through historical review, Tharp noted.
“Justin Fitzpatrick and myself used historical simulation and found that Guyton-Klinger would have called for as much as 54% spending cuts relative to initial spending [during the stagflation period],” Tharp wrote. “Wade Pfau (2015) used Monte Carlo simulation to evaluate Guyton-Klinger and found a 10% chance of an 84% cut in spending.”
Tharp also cites 2017 research from Karsten Jeske, a former Federal Reserve economist, that found that even when starting with distribution rates as low as 4%, retirees using Guyton-Klinger would have historically faced at least one year-over-year spending cut greater than 50%.
“Properly setting risk-based guardrails doesn't have to be rocket science, but advisors shouldn't be ignoring the huge spending cut risks that come with frameworks like Guyton-Klinger's guardrails just because markets have been favorable during the times that advisors have actually been using such frameworks with clients,” Tharp said.
There are additional practical ways in which Guyton-Klinger guardrails aren’t ideal for real-world retirees, he observed. For instance, Tharp has written, this strategy assumes that retirees will target steady withdrawals during retirement — whereas portfolio income needs often vary, for example to cover expenses before claiming Social Security benefits.
Additionally, these income reductions tend to overcorrect for market losses, meaning that more capital is often preserved than necessary at the cost of severe reductions in a retiree's standard of living.
Getting Guardrails Right
Tharp favors a risk-based guardrails approach that resets spending based on a series of frequent projections.
With ongoing planning and regular adjustments based on recalculated probabilities of success, a very different spending approach emerges — one that gives clients more exact expectations in real dollar terms about how their spending might need to be adjusted to keep their retirement prospects on track.
As Tharp has previously written, an examination of how a retirement portfolio would have performed using this method reveals that much smaller income reductions would have been required, relative to the classic guardrails system, to prevent exhausting the client's portfolio.
For instance, those retiring just before the financial crisis would have seen only a 3% income reduction from the initial withdrawal rate using risk-based guardrails, compared with 28% for the Guyton-Klinger guardrails approach. Those retiring before the stagflation era of the 1970s would have experienced a “still painful” 32% reduction, compared with 54% for the original approach.
Moving beyond the simple framework of Guyton-Klinger guardrails and implementing a risk-based guardrails system, Tharp advocates, can help mitigate downward spending adjustments while ensuring that a portfolio supports a retiree's lifetime spending needs.
© Arc, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to TMSalesOperations@arc-network.com. For more information visit Asset & Logo Licensing.