As prospective retirees near retirement, one of the most important things they’ll need to do is come up with a sustainable withdrawal strategy for the retirement assets they’ve accumulated. Importantly, this decision could determine whether or not one’s portfolio will run out of money. Here’s a brief summary of many of the methods available to retirees:
FIXED AMOUNT METHODS
1.) Constant Dollar Amount (adjusted for inflation each year)
- One method to accomplish this has historically been the “Income Portfolio” wherein a portfolio is invested in dividend stocks and interest bearing bonds.
2.) Fixed Percentage Amount (adjusted for inflation each year) – For example, William Bengen’s well-known 4% rule. Designed to address sequence of returns risk, the idea is that withdrawing 4% of a portfolio’s total value each year resulted in the portfolio safely lasting for 30 years (3.8% is the safe withdrawal rate if one does not want to spend down principal). The downside is that simply because a portfolio will last 30 years doesn’t mean that it will meet one’s income needs (i.e. 4% might be too low of an income). Additionally, research has shown that this strategy usually results in significant under spending. Nevertheless, this approach is widely known and still represents a helpful point-of departure for many practitioners when beginning to frame the retirement income discussion.
3.) Bucket Strategy / Evensky & Katz Cash Flow Reserve Strategy – This is a needs-based strategy that is a fixed dollar amount, but is also in conversation with the fixed percentage amount strategy. A financial planner works with a client to determine a realistic dollar amount that can be withdrawn from the portfolio (but this dollar amount can also be viewed as a percentage for discussion purposes). Then, 1-2 years of income needs and/or any additional short-term liquidity needs (e.g. a new home, car, wedding) are set aside in a cash reserve “bucket”. This cash bucket can either sit statically as a retirement reserve so that positions that have declined in value don’t necessarily have to be liquidated in a down market, or it can be set up to pay out the client’s actual income needs (most often the case).
The rest of a client’s retirement assets are invested in an investment portfolio “bucket” that is segmented to be able to provide for an additional three years of income in fixed income holdings and the rest of the portfolio in an equities portfolio designed to provide long-term growth. This approach is implemented with a total return investment approach (contra an “income” approach) that takes into account taxes (both in the types of accounts and vis-a-vis liquidations), costs, goals, and other financial planning priorities.
4.) Annuity Methods – These methods range from putting small to significant amounts into single premium immediate annuities or deferred income annuities (SPIAs and DIAs). The idea is to protect against longevity risk and to ensure that a certain level of one’s income needs are met in the form of an annuity income stream.
DYNAMIC AMOUNT METHODS
5.) Bengen’s Floor and Ceiling – This is a variable percentage method. It starts with a fixed withdrawal percentage, but the percentage can then decrease to a fixed-dollar “floor” that is 15% below the initial amount or increase to a fixed-dollar “ceiling” amount that is 20% above the initial amount depending on market factors.
6.) Guyton and Klinger’s Decision Rules – This is a variable percentage method. Withdrawals are based on a percentage, but they can vary according to 4 rules:
- The withdrawal rule: Withdrawals are adjusted for inflation each year unless the portfolio loses money, in which case no inflation adjustment is allowed.
- The portfolio management rule: Extract the gains from an asset class that has performed best in the previous year to provide the income, and move excess portfolio gains (beyond what is needed for the withdrawal) into a cash account to fund future withdrawals.
- The capital preservation rule: If the current withdrawal rate rises above 20% of the initial rate, then current spending is reduced by 10%.
- The prosperity rule: Spending in the current year is raised by 10% if the current withdrawal rate has fallen by more than 20% below the initial withdrawal rate. Doing this means the client does not miss out on higher sustainable spending when markets are doing well.
7.) RMD Method – Follows a formula similar to the IRS’ RMD formula so that each year’s changing portfolio balance and remaining life-expectancy are taken into account when calculating how much can be safely withdrawn.
8.) Kitces’ Ratcheted 4% Rule – Another dynamic approach that allows spending to be increased (“ratched up”) if the portfolio grows to a certain level but, unlike the Guyton approach, manages the increases in such a way that it does not necessitate spending cuts.