Alternative to the 4% Rule Using Variable Withdrawals for American Electric Power Employees

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How much can you spend during your American Electric Power retirement without running out of money.

This is an essential consideration for your retirement assets. By striking a balance between current spending and prospective asset value, you will be able to sustain your current level of spending in the future.

American Electric Power employees are given the option of taking income now and running out of money if they withdraw too much or withdrawing too little and leaving more than expected to their successors.

Variable retirement withdrawals or 'guardrails' can help you accomplish this balance in a systematic manner that eliminates the element of chance.

How to Determine Withdrawal Amounts

A method for calculating the income or withdrawals that American Electric Power employees can take from their investment portfolio involves withdrawing a fixed percentage of the portfolio and adjusting the withdrawal each year for inflation using the 4% rule. If you elect to do so, this method will provide you with a consistent income throughout your American Electric Power retirement. With this method, both the quantity of your withdrawals and your ability to maintain that income throughout your lifetime are quite secure.

When evaluating the validity of the 4% rule, it is important to consider how analyses of the 4% rule fared during the 1929 stock market collapse, the Great Depression, World War II, and stagflation in the 1970s. History indicates that the 4% rule is a reliable method for determining how much American Electric Power employees can spend in retirement, despite the unpredictability of the future. Nonetheless, there are dangers that must be addressed.

When you consistently withdraw funds from your portfolio, you are exposed to sequence of return risk. The sequence of return risk is the downside risk incurred when normal downside volatility strikes your account early in your American Electric Power retirement, which can have a negative effect on your account value in the future.

Despite taking this risk by selecting this strategy, there are methods to safeguard yourself. In this article, we will discuss a strategy for taking variable withdrawals from your portfolio, thereby protecting it from sequence risk and inflation.

Why Variable Withdrawals?

Throughout your American Electric Power retirement, variables such as inflation, interest rates, investment returns, and taxes will impact your portfolio. Adjusting withdrawals to reflect these changes will ensure that your expenditure remains in line with what your portfolio can support.

Adjusting withdrawals based on the value of the account affords the opportunity for improved investment performance. It is advantageous to withdraw more when markets are rising, while it is unwise to withdraw more when markets are falling because you would be selling at a time of low market value.

How do I adjust my withdrawals?

This section will discuss how American Electric Power employees can modify their withdrawals in response to changes in their retirement accounts. The demonstrated adjustments are formally known as the Guardrail or Guyton-Klinger method.

This strategy is guided by four (4) principles:

1. Rule Regarding Withdrawal

2. Portfolio Management Rule

3. The Capital Maintenance Rule

4. The Success Principle

American Electric Power employees must remember that the last two principles are interdependent. Together, these two principles serve as 'guardrails' for your withdrawal, preventing it from becoming excessively high or low.

This section will entail how American Electric Power employees can adjust withdrawals based on changes in their retirement accounts. The adjustments demonstrated are formally known as the Guardrail or Guyton-Klinger methodology.

There are four (4) guiding rules to this strategy:

1. Withdrawal Rule

2. Portfolio Management Rule

3. The Capital Preservation Rule

4. The Prosperity Rule

It is important for American Electric Power employees to remember that the last two rules work as one. Taken together, these two rules establish “guardrails” around your withdrawal that keep it from drifting too high or too low.

The Withdrawal Rule

This regulation resembles the 4% rule, with a few minor modifications. Choose a fixed percentage to withdraw from your portfolio in the first year. For each succeeding year, alter your withdrawals to account for inflation.

This methodology differs from others in that the inflation adjustment is not made if portfolio returns are negative, resulting in a higher withdrawal rate than the initial withdrawal rate.

An Example:

Assume you begin with a portfolio worth $400,000 and withdraw 4% in the first year. That's $16,000.

Then, let's presume that the annual inflation rate is 4.3%. You would increase your withdrawal for the following year by 4.3%. You would withdraw $16,640 over the next year.

The rule would be triggered if your investment returns were negative, for example -1%, AND the $16,640 represented more than 4% of the portfolio.

In this example, a 1% loss plus a $16,000 withdrawal results in a second-year portfolio value of $380,000.

$17,100 is 4.5% of $380,000. Since 4.5% is greater than 4%, you would forsake the inflation increase and withdraw $16,000 instead.

Portfolio Management Rule

The portfolio management rule addresses how your portfolio is rebalanced in response to the fluctuating values of the various asset classifications.

Retirement Income Guardrails

Together, the capital preservation rule and the prosperity rule can be considered. Consider these two principles as establishing withdrawal limits for your retirement income.

By utilizing the safeguards, you are effectively establishing a buffer around your savings. The portfolio income is recalculated based on the account's value. If the account grows, so does the income. If the value of the account decreases, income is reduced.

How it operates

To comprehend how the rule operates, consider first your initial portfolio withdrawal rate. Suppose you commence the first year of your retirement by withdrawing 4% of your portfolio. Considering a portfolio worth $400,000, this equates to $16,000. Next, you apply the standard rule of increasing withdrawals annually to account for inflation.

The guardrails function as follows:

1. When the present withdrawal rate exceeds the initial withdrawal rate by more than 20%, the withdrawal is reduced by 10%.

2. When your present withdrawal rate is more than 20% below your initial withdrawal rate, you increase your withdrawal by 10%.

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The Prosperity Rule

Let's presume that the markets and your investments have performed well for a number of years. The value of your account has increased to $800,000 despite the fact that you have made withdrawals for several years. Your withdrawal quantity has increased to $20,800 as a result of inflation adjustments.

Ok. Here come the figures...

$20,800 represents just 2.6% of $800,000. When your present withdrawal rate is 20% less than your initial withdrawal rate, the rule states that you should increase your withdrawals. 20% of 4% is 0,8%. 4%-0,8%= 3.2%. Given that 2.6% is lower than 3.2%, you would increase your withdrawal by 10%.

10% of $20,800 is $2,080. You would take out $22,880 in cash.

In this instance, the unanticipatedly high investment gain enables you to withdraw a larger income from your portfolio.

The Capital Preservation Rule

This represents the opposite of the prosperity norm. If your account balance falls too low, you reduce your withdrawals to avoid running out of money too quickly.

Considering the same scenario as previously, your annual withdrawal is $20,800. However, as a result of a prolonged bear market, you now have only $350,000 in your portfolio as opposed to a truly excellent investment performance.

$21,700 is 6.2% of $350,000.

The capital preservation rule dictates that you must reduce your expenditures by 10% because your current withdrawal rate of 6.2% is more than 20% higher than your original withdrawal rate of 4%.

10% of $20,800 is $2,080. Since the value of your account has decreased significantly relative to your withdrawal amount, you would reduce your withdrawal by that amount. The amount of your new withdrawal is $18,720.

Conclusion

Using a 'Guardrail' or variable withdrawal strategy more closely aligns your retirement expenditures with the value of your investments. It allows you to spend more when your portfolio can support it and prevents American Electric Power employees from depleting their portfolios too rapidly when returns are low.

Added Fact:

According to a study published in the Journal of Financial Planning in October 2019, using a variable withdrawal strategy rather than the traditional 4% rule can significantly improve the sustainability of retirement income for American Electric Power employees. The research suggests that by adjusting annual withdrawals based on portfolio performance and market conditions, retirees can potentially withdraw higher amounts during favorable market periods and reduce withdrawals during market downturns, effectively safeguarding their retirement assets. This approach provides more flexibility and adaptability to changing economic conditions, ensuring a more secure and stable income throughout retirement. Source: 'Does the 4% Rule Still Work?' Journal of Financial Planning, October 2019.

Added Analogy:

Imagine you're embarking on a road trip to a dream destination. You have a fixed budget for the journey, but instead of sticking to a rigid plan where you spend the same amount every day, you decide to adapt your spending based on the conditions you encounter along the way. Some days you may splurge on a luxurious hotel or a fancy meal, while other days you opt for more economical choices. By adjusting your expenses to match the ups and downs of the trip, you ensure that your budget lasts longer and that you can enjoy the journey without worrying about running out of funds. Similarly, American Electric Power employees can consider a variable withdrawal strategy for their retirement savings, allowing them to adjust their income based on market conditions and ensuring a more sustainable and enjoyable retirement experience.