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portfolio withdrawal is decreased by $7,000 rather than $10,000 due to the guardrails, and thus $3,000 additional is withdrawn from the portfolio to fund spending.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.