This paper is the third of a series addressing retirement planning issues. In the first part, we discussed how to prepare a retirement cash flow forecast. In the second part, we discussed how to prepare a portfolio for the transition years from working through retirement. In this paper, we will consider the different methods for establishing and monitoring safe portfolio withdrawal (spending) rates. The objective is to find a method that improves the probability that a retiree’s money lasts as long as they do.
Saving for retirement is a common goal, but once retirement is achieved, withdrawing those funds in an optimal way is equally important. A number of spending methods—each varying in complexity and goals—have evolved over the years. This paper will review five withdrawal methods: Bucketing, Percent of Portfolio, Constant Dollar Plus Inflation, Required Minimum Distribution and Dynamic Withdrawals.
Under this method, assets are divided into different “buckets,” with each assigned a defined time period in retirement. A typical bucket model looks like this:
- Bucket 1: contains cash and cash equivalents and is to be used over the first five years of retirement.
- Bucket 2: contains fixed-income and covers years six through fifteen of retirement.
- Bucket 3: contains equities and covers beyond year fifteen of retirement.
As retirement spending progresses, funds are moved from bucket three to two to one.
The benefit of this strategy is primarily psychological. The large, stress-inducing problem of navigating financial markets with one portfolio is broken down into more manageable pieces, with each bucket directly linked to a specific goal. Some retirees may find this very comforting. The biggest drawback is figuring out how to rebalance the investment portfolio and refill the near-term buckets over time. Funds move from risky buckets to more conservative buckets based upon spending levels. Timing is a key factor as this may cause retirement funds to become conservative early, thus making it difficult to sustain income through retirement.
This mental accounting method can be useful when a retiree cannot get comfortable establishing an appropriate investment plan with appropriate risk through a single portfolio approach.
II. Constant Dollar Plus Inflation
Start retirement with an established withdrawal rate of a specified dollar amount, and then increase that amount with inflation each year. In practice, there are two common methods for establishing this initial dollar amount:
- The “4% Rule”: The retiree calculates 4% of the portfolio at retirement and the resulting dollar amount plus an inflation adjustment each year is what can “safely” be spent.
- The Probability of Success/Failure method—Monte Carlo Analysis: A retiree’s spending levels—typically a fixed amount that rises with inflation—are tested against a range of portfolio outcomes based on a portfolio’s asset allocation. The analysis determines the probability of success that portfolio assets will last for a predetermined number of years given that spend rate.
The 4% Rule is a good place to start for thinking in very broad terms about retirement spending. However, it is overly rigid and ignores the impact of varying portfolio returns. A retiree could run out of money or dramatically reduce spending with sustained bear markets, or conversely live well below their means in a sustained bull market. Therefore the 4% rule should be considered a rough guide and not a firm rule to follow.
The Probability of Success/Failure method is useful in that it brings portfolio risk and return into the retirement analysis. Additionally, a stress test can be performed to determine a maximum annual withdrawal rate. However, the strategy does not easily incorporate dynamic withdrawal strategies and therefore must be continuously monitored to make sure the portfolio withdrawal amount is adjusted to reflect market conditions through retirement. The Monte Carlo analysis can illustrate adjustments that can be made to meet spending goals. This could include increased savings, decreased spending, a more aggressive investment strategy, etc. Differing assumptions will dramatically impact the results.
Both the 4% rule and the Probability of Success/Failure methods are good places to begin to think more concretely about safe spending rates at the beginning of retirement.
III. Percent of Portfolio
This method withdraws a constant, fixed percentage of the portfolio each year. Based upon historical market data, in practice, a “rule of thumb” approach is used. If the retiree is in his/her 60s then use 4%, if in his/her 50s use a lower percentage to increase the odds the portfolio will last longer. If in his/her 70s then a higher percentage may be used as there are fewer years of retirement to provide for.
This strategy increases the likelihood that the portfolio will never be depleted. It is highly responsive to market changes. However, this may create a high level of income volatility as the portfolio rises and falls due to changes in market conditions. In other words, your spending in any given year would be dependent on underlying market performance. This means that you have less “control” over your annual spend.
This strategy is good for retirees who are very concerned about the markets and are able to change their spending requirements within a wide range.
IV. Required Minimum Distribution
The approach is similar to the IRS RMD rule, which requires an individual to start drawing a certain percentage of the money in retirement plans after age 72. The percentage withdrawn rises slowly each year as the individual ages and life expectancy is reduced.
This strategy takes mortality into account. The longer a retiree lives, the longer he/she is expected to live. The mortality adjustments allow the retiree to increase income—subject to market performance—as they live longer. The increasing percentage withdrawal creates more stable income in declining markets. However, the increasing percentage withdrawal may create too much income in a rising market. Therefore, it is advisable to reset the withdrawal rate periodically based upon market performance.
This strategy is a reasonable alternative to the more common constant dollar and constant percentage of assets methods. A retiree would use it when they feel that using their age (longevity) and portfolio size to arrive at a “safe” spending level is the best way to meet their spending needs while assuring their portfolio lasts as long as they do.
V. Dynamic Withdrawals
There are several ways to structure dynamic withdrawals, but the common denominator is that the withdrawal amount is changed when portfolio returns vary greatly from expected returns. When markets decline the retiree reduces spending. When markets rise the retiree increases spending. This assumes that spending can be divided into discretionary and non-discretionary portions. Typically, it is the discretionary portion that changes. Different methods include:
- The “guardrail approach”: this let’s retirees choose how much spending can fluctuate from year to year. One approach would be to establish a percentage withdrawal rate—5% for example—and when the resulting dollar amount to withdraw fluctuates with the portfolio, establish an upper and lower bound (guardrails) for the following year’s distribution.
For example, assume the 5% withdrawal rate is applied to a $2 million portfolio for an initial withdrawal amount of $100,000. The retiree then establishes a “ceiling” in which a spending increase is capped at 7% above the initial withdrawal amount, or $107,000, no matter how large the portfolio grows due to market increases. A “floor” of -7%, or $93,000, is set no matter how much the portfolio has fallen when the market declines. Three scenarios illustrating this guardrail method would be:
a. Your portfolio increases 10% to $2.2M: A withdrawal at the 7% cap would equal $107,000 ($100K plus 7% of this base withdrawal). Rather than withdrawing $110,000 (5% of $2.2M), you only withdraw $107,000 ($7,000 more than your base spending level), and the additional $3,000 is saved for future use.
b. Your portfolio decreases -10% to $1.8M: A withdrawal at the -7% floor would be $93,000 (7% less than your $100k base withdrawal). In this instance, you still withdraw $93,000 (rather than $90,000, or 5% of $1.8M). Your portfolio withdrawal is decreased by $7,000 rather than $10,000 due to the guardrails, and thus $3,000 additional is withdrawn from the portfolio to fund spending.
c. Market changes resulting in a withdrawal amount between these two guardrails would simply follow the 5% percentage distribution rule.
2. Skipping inflation adjustments in the year following any year in which the portfolio has dropped.
These two dynamic withdrawal methods offer a more flexible method than the others that considers both market volatility and more stable income. However, keep in mind that dynamic withdrawal strategies can be complex. Current financial planning tools do not easily lend themselves to managing this approach, and therefore a custom approach is necessary. This strategy requires regular updating and assumes there is some level of discretionary spending that can be adjusted as appropriate.
When a retiree (with the help of their advisor) is capable of managing this method, it works well for retirees who have reservations about how market performance will impact their cash flows but who do not want to dramatically change spending in any given year.
Each method brings something of value to the retiree. How do you choose the approach that is right for you? Do you want to spend more now and adjust later or be more conservative now with a larger cushion later? How flexible can you be if spending reductions are needed to maintain your portfolio? Do you feel that some spending reductions will happen naturally as you age—less travel, entertainment, downsizing your home, etc.? What financial factors are you most concerned about in retirement?
There is no one “right” answer. The optimal solution is unique to each retiree, and it hinges on their specific financial situation as well as the method(s) that they are most comfortable implementing. A combination approach will likely produce the best results. One approach may make sense at the beginning of retirement when your spending needs are uncertain with a change to another approach once retirement needs are more firmly established. Navigating these different distribution methods can be complex. A Round Table Wealth Advisor can help you sort through the best options for your retirement planning.