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By Christine Benz | 08-23-2012 10:00 AM

What's the Most Efficient Withdrawal Strategy?

Morningstar research found that the 4% withdrawal rate is not as practical for retirees as many think, while an optimal approach combines mortality rates with portfolio performance.

Christine Benz: Hi, I am Christine Benz for Morningstar. One of the linchpins of a successful a retirement plan is settling on a sustainable withdrawal rate. Joining me to share some recent research into this area is David Blanchett. He is head of retirement research for Morningstar Investment Management.

David, thank you so much for being here.

David Blanchett: Thank you for having me.

Benz: David, you looked at various strategies for setting withdrawal rates, and you've calculated what you call the efficiency rate of each of these strategies. Let's look at what specifically you looked at when gauging the efficiency of withdrawal-rate strategies.

Blanchett: The idea behind this paper is if you have a pool of assets, you can withdraw money for income during retirement. How much can you take from the portfolio for your lifetime? And there are two key unknowns you have when you first retire. The first is how long you're going to live--so you do have to plan for a 10-year retirement period or a 30-year retirement period--and the [second is] market returns. The better the market returns, the more you can from a portfolio.

And so the idea for the research was to figure out how efficient a strategy is. If you had known how long you are going to live and the returns you are going to receive, you can know exactly how much you could take out every year during retirement. What we did is we compared the income you would use from different strategies against this efficient amount. That creates the efficiency ratio, which is, how much you actually received or what you could have received if you had perfect information.

Benz: So you tested various scenarios using different time periods, as well as different portfolio performance, to see which of the strategies was in fact the most efficient.

Blanchett: Yes. The time period is based upon life expectancy. We kind of randomized life expectancy. For someone who is 65 years old, they are going to live, say 20 years. Well, sometimes they will live two years; sometimes they live 40 years. The idea is to kind of make that random based upon mortality tables and then also randomize the returns based upon our forward-looking estimates, and say, "Given all these different simulations, what could we expect the portfolio to do if you'd known that information beforehand?"

Benz: Let's look at one of the most commonly used methods, sort of the baseline strategy that you often hear about in the context of withdrawal rates, that's the 4% rule. So there, you take 4% of your initial balance upon retirement, and then you just inflation-adjust that dollar amount. How did that do from an efficiency standpoint?

Blanchett: Not very well. I think the 4% rule is the research notion of retirement. It doesn't mesh well with actual retirement because the 4% rule is a rule that you make at one point in time. So you would decide at age 65, I'm going to take out 4% of my portfolio. If I have $1 million, [I'd take out] $40,000 a year and increase that every year by inflation. You totally ignore other things that happen, your portfolio performance, your ongoing life expectancy. What you see with that is it's very inefficient because it doesn't reflect what happened in your life. It doesn't reflect that if your portfolio goes way up in value, you can take more money out. It's a very static decision that's kind of a one-off versus a more dynamic approach.

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