There are many methods for establishing and monitoring safe portfolio withdrawal (spending) rates. Finding the method that assures your retired clients’ money lasts as long as they do is particularly important in the current environment where inflation (and hence, expenses) are high and portfolio values are reduced — a “double whammy” for your clients.
We’ve found that taking a flexible approach is best.
A number of withdrawal methods, varying in complexity and goals, have evolved over the years. Here is a look at five of those methods: Bucketing, Percent of Portfolio, Constant Dollar Plus Inflation, Required Minimum Distribution and Dynamic Withdrawals.
Bucketing
Assets here are divided into different “buckets,” each assigned a defined time period in retirement. A typical bucket model looks like this:
- Bucket 1. Contains cash and cash equivalents, to be used over the first five years of retirement.
- Bucket 2. Contains fixed-income; covers Years 6-15 of retirement.
- Bucket 3. Contains equities and covers; for beyond Year 15 of retirement.
As retirement spending progresses, funds are moved from bucket three to two to one.
The main benefit of this strategy is 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. It 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 investment plan with appropriate risk by using a single-portfolio approach.
Constant dollar plus inflation
This method begins retirement with an established withdrawal rate (specified dollar amount) and increases that amount each year with inflation. 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. 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.
Your clients may be aware of the 4% rule because media stories about retirement planning often mention it. It’s simple for media sources to explain and for clients to understand. However, like many simple solutions to complex problems, the 4% rule may not provide an optimal solution to managing client withdrawal needs. The Schwab Center for Financial Research cautions that:
- It is a rigid rule. It does not consider changes in a client’s portfolio or spending.
- It applies to a specific portfolio composition. The 50%/50% stock/bond split may not match your client’s portfolio.
- It uses historical market returns. Many firms forecast future market returns to be lower than historical returns.
- It assumes a 30-year time horizon. This may be too short or too long for your client’s needs.
- It does not include taxes or investment fees.
Meanwhile, 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 method 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 method are good places to begin to think more concretely about safe spending rates at the beginning of retirement. But as your client’s financial advisor, you can add value by taking a closer look at their specific needs.
Percent of portfolio
This method withdraws a constant, fixed percentage of the portfolio each year. There doesn’t seem to be a consensus on how to choose an optimal percentage. In practice, a “rule of thumb” approach is used. For example, retirees in their 60s can withdraw 4%. Accordingly, those in their 50s could withdraw a lower percentage, to increase the odds their portfolio will last longer, and those in their 70s, with fewer years of retirement to provide for, could withdraw a higher percentage.
Although this strategy increases the likelihood that the portfolio will never be depleted, it is. highly responsive to market changes. This may create a high level of income volatility as the portfolio rises and falls due to changing market conditions. In other words, your client’s spending in any given year would be dependent on underlying market performance. This means that they have less “control” over their 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.
Required minimum distribution (RMD)
The approach is similar to the IRS’s 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 on market performance.
This strategy is a reasonable alternative to the more common constant dollar and constant percentage of assets methods. A financial advisor could use it when they feel that using their clients’ 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.
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 is to establish a percentage withdrawal rate and to establish upper and lower bounds (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 falls when the market declines. Three scenarios illustrating this guardrail method would be:
- The portfolio increases 10% to $2.2 million: A withdrawal at the 7% cap would equal $107,000 ($100,000 plus 7% of this base withdrawal). Rather than withdrawing $110,000 (5% of $2.2 million), the client only withdraws $107,000 ($7,000 more than the base spending level), and the additional $3,000 is saved for future use.
- The portfolio decreases 10% to $1.8 million. A withdrawal at the -7% floor would be $93,000 (7% less than the $100,000 base withdrawal). In this instance, the client still withdraws $93,000 (rather than $90,000, or 5% of $1.8 million). The portfolio withdrawal is decreased by $7,000, rather than $10,000, due to the guardrails, and thus an additional $3,000 is withdrawn from the portfolio to fund spending.
- Market changes resulting in a withdrawal amount between these two guardrails would simply follow the 5% percentage distribution rule.
The ‘inflation adjustment’ approach
The retiree skips an inflation adjustment in the year following any year in which the portfolio has dropped.
Bear in mind
These two dynamic withdrawal methods offer a more flexible method than the others and 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.
This method 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.
Additional Reading: The Great Resignation of Great Retirement?
Key questions
Each portfolio withdrawal method brings something of value to the retiree. How do you choose the approach that is right for your client? Here are some questions to consider:
- Do they want to spend more now and adjust later or be more conservative now with a larger cushion later?
- How flexible can they be if spending reductions are needed to maintain their portfolio?
- Do they feel that some spending reductions will happen naturally as they age—less travel, entertainment, downsizing their home, etc.?
- What financial factors are they 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 their 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. As their financial advisor, you can help your client sort through the best options for their retirement planning.
Richard B. Freeman, CFP is a senior director, wealth advisor with Round Table Wealth Management and is based in New York City. He can be reached at Rich@Roundtablewealth.com.
