Should Your Retirement-Portfolio Withdrawals Fluctuate With the Market?

"The 4% rule is the advice most often given to retirees for managing spending and investing. This rule and its variants finance a constant, nonvolatile spending plan using a risky, volatile investment strategy." -- From The 4% Rule--At What Price? by Jason Scott, William Sharpe, and John G. Watson. 

In a recent article, I noted that the so-called 4% rule for retirement portfolio withdrawals is a reasonable starting point for calibrating an in-retirement spending rate. It's easy to understand and implement, and it allows for a fairly stable stream of income during retirement--a predictability that's desirable for most retirees.

For example, say a retiree with a $1.5 million portfolio has decided to use the 4% rule for her in-retirement withdrawals, combined with an annual adjustment to help her withdrawals keep up with inflation. That rule doesn't mean that she withdraws 4% of her portfolio in each year of retirement, which could result in wildly differing annual withdrawals, depending on her asset allocation and market performance. Rather, the 4% rule stipulates that she takes 4% of her portfolio in year one of her retirement, then inflation-adjusts that initial dollar amount each year thereafter. Assuming a 4% distribution rate and a $1.5 million portfolio, she would withdraw $60,000 in year one, and that amount would jump up to $61,800 in year two ($60,000, adjusted for a 3% inflation rate).

But sticking with a fixed withdrawal amount, as the 4% rule dictates, can also have some perverse effects in both very good and very bad market environments. The originator of the 4% rule, Bill Bengen, discussed the downside of underwithdrawing in buoyant market environments in this paper. Such a scenario is clearly better than running out of money during retirement. However, the net effect of ignoring the strong market performance and sticking with the original 4% withdrawal amount, adjusted for inflation, could be that the retiree lives more frugally than she actually needed to, passing money to heirs that she might've preferred to spend during her own lifetime.

On the flip side, employing the 4% rule during a very weak market environment can also lead to unintended consequences, particularly if the bear market hits early on in one's retirement years. To use a simplified example, say the aforementioned retiree encounters a bear market in year three of her retirement, nudging her original $1.5 million portfolio down to $1 million. Her withdrawal would be $63,654 in year three (arrived at by inflation-adjusting her year-two withdrawal amount of $61,800), pushing her total portfolio value down to $936,346 and below $900,000 in year four. What started as a 4% withdrawal rate in year one would grow to more than 7% by year four. Sticking with fixed dollar withdrawals during a sustained bear market also limits the pool of assets that can appreciate when the market improves.

Is there a better way to do it? That question has been the subject of much research during the past few decades, with many studies converging around the idea that withdrawal rates should fluctuate during a retiree's lifetime. Some of these studies, such as this one from financial planner Jonathan Guyton, are complicated and probably best employed by financial advisors. But there is a unifying message that retirees who are managing their own distribution streams should take to heart: As comforting as it might seem to rely on a straight inflation-adjusted withdrawal amount, for best results retirees should adjust withdrawals up or down as circumstances dictate. That means staying attuned to what's going on with the market and attempting to reduce withdrawals during periods of extreme market duress. It also means being realistic about the fact that your own income needs during retirement are apt to fluctuate, as I explored in this article.

Here's a roundup of some of the methods that lead to variable-dollar-amount withdrawals per year as well as some of their pros and cons.

Fixed-Percentage Withdrawals
At first blush, withdrawing a fixed percentage amount from a portfolio per year would seem to elegantly address some of the shortcomings of the 4% rule, which calls for withdrawing inflation-adjusted dollar amounts. Because the retiree's withdrawals are limited to a percentage of the portfolio, there's no risk of running out of money. Moreover, sticking with a fixed-percentage-withdrawal amount prompts the retiree to withdraw more in good markets and less in lean ones.

The big downside to taking a fixed percentage from a portfolio, however, is that volatile markets can mean big swings in the retiree's payout, which in turn can have a big impact on quality of life. A fixed percentage drawn on too small a portfolio might not result in a livable income stream.

The Income-Only Approach
Using this approach, retirees would simply live on whatever bond or dividend income their portfolios kick off. This is the most intuitively appealing strategy, in that a retiree wouldn't need to invade principal to fund living expenses, so there's no chance of outliving his or her portfolio.

Investors have experienced the downside of this strategy during the past several years, however, as bond yields have sunk ever lower and dividend payouts remain quite low by historical standards. For individuals without very large portfolios or income from other sources, such as pensions, this strategy doesn't deliver a livable income stream unless they heavily emphasize risky asset classes such as high-yield bonds or companies with very high dividend yields, which are often distressed. Moreover, income-focused portfolios can skew heavily to certain dividend-rich equity sectors such as financials, thereby jacking up their risk levels. 

Reduced Post-Bear-Market Withdrawals
Because market weakness can greatly increase the probability that a retiree will outlive his or her money, T. Rowe Price analyzed whether reducing withdrawal rates after bear-market bottoms enhanced success rates. The answer was yes. Retirees with 55% equity/45% bond portfolios who were able to reduce their spending rates by 25% after the bottom of a bear market had a much better shot of not outliving their assets than those who stuck with the 4% rule and ignored market conditions.

Yet T. Rowe's study acknowledged that such a large reduction in withdrawals is pretty radical, so the firm investigated another idea--whether sticking with the 4% rule but foregoing inflation adjustments for the three years following a bear market helped improve the portfolio's ability to last. That tweak didn't improve the portfolio's success rate quite as much as the 25% reduction in withdrawals, obviously, but it did move the needle. This research makes real-world sense, too, in that inflation is often tame following periods of economic and market weakness like the financial crisis of 2007-09.

Percentage of Portfolio With Ceiling and Floor
There are a few different variations of this strategy floating around--one from Bill Bengen and another that Vanguard presented last year. The strategy uses the fixed-percentage-withdrawal method, as outlined above, as a starting point. However, the ceiling/floor strategy seeks to address the problem that withdrawing a fixed percentage per year can leave the retiree buffeted around by market winds: In good markets the retiree is living high off the hog, and in bad ones, taking fixed-percentage withdrawals might not deliver a livable income stream. Floor/ceiling strategies vary, but the central premise is the same.

By specifying a ceiling and floor on withdrawals--percentage amounts that withdrawals might not rise above or below--the method gives the retiree leeway to adjust portfolio withdrawals upward, on a percentage basis, from the initial amount when the market is weak and downward, on a percentage basis, in better markets.

Using Vanguard's model, let's say our our retiree with a $1.5 million portfolio started with a 4.0% withdrawal rate--$60,000 in year one--but specified a 5.0% ceiling and a 2.5% floor. That means that in year two, her withdrawal would not be allowed to increase by more than $3,000 ($60,000 x 0.05) or decrease by more than $1,500 ($60,000 x 0.025). After year one, she'd have $1.44 millon (her initial $1.5 million minus her $60,000 withdrawal).

Let's say her portfolio appreciates by 20% in year two, to $1,728,000 ($1,440,000 x 1.20). At her 4% withdrawal rate, year two's withdrawal would come out to $69,120 ($1,728,000 x 0.04). However, she's capped her maximum withdrawal rate at $63,000 (her initial $60,000 plus her $3,000 ceiling amount), so that extra $6,120 ($69,120-$63,000) stays in the portfolio. For year three, she will apply her ceiling and floor percentages to $63,000.

Alternatively, let's say our retiree's portfolio goes down 20% in year two, to $1,152,000 ($1,440,000 x 0.80). At her 4% initial withdrawal rate, year two's withdrawal would come out to $46,080 ($1,152,000 x 0.04). However, she's established a minimum withdrawal rate of $58,500 (her $60,000 year one withdrawal minus her $1,500 floor amount), so she would take that amount and pray for better years ahead. For year three, she would apply her ceiling and floor percentages to $58,500.

Like the aforementioned T. Rowe research, the floor/ceiling approach helps address the fact that retirees reduce the risk of outliving their assets by reducing their withdrawals during weak markets. Vanguard's research found that portfolios using a 5.0% ceiling and a 2.5% floor had a high probability of long-term success.

Market Valuation
Whereas the preceding two approaches suggest that investors react to market performance by reducing withdrawals in periods of market stress, the valuation-sensitive approach advanced by researcher Michael Kitces aims to be preemptive. Specifically, Kitces argues that those who retire into high-valuation environments, as measured by market P/E ratios, should employ lower withdrawal rates than those who retire during periods of low market valuation. (Kitces uses Robert Shiller's P/E 10, which uses earnings during the past 10 years in an effort to drown out short-term noise, to measure market valuation.) That might seem counterintuitive, but it's based on the logical notion that low market valuations foretell better subsequent returns than high valuations.

Retirees who are lucky enough to retire into periods of low market valuation may take comfort in Kitces' assertion that they can sustain withdrawal rates of as high as 5.5%. On the flip side, he argues that those who retire into higher-valuation environments should keep withdrawals to 4.5% to avoid running out of money during their lifetimes.

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