In-Retirement Distributions: There's More Than One Way to Get It Done
Each method has its own pros and cons, but understanding your options is the key to implementing a successful strategy.
I recently asked Morningstar.com readers whether their retirement-plan withdrawals were fixed or variable. A lively thread on our Discuss forum boards ensued, with retirees and pre-retirees sharing lots of sensible advice.
As I read through the comments, however, I realized that there's still a lot of confusion about this topic, and I inadvertently stoked it with the terms I referenced in my question. For starters, whether a payout is fixed and variable is really in the eye of the beholder: Taking out a fixed percentage of a portfolio per year results in varying amounts of dollars coming in the door, while taking out fixed dollar amounts will mean that a retiree's withdrawals will vary on a percentage-of-portfolio basis.
Moreover, even though "safe withdrawal rate" has become a nearly ubiquitous term in retirement-planning circles, the "withdrawal" part of the phrase is something of a misnomer. As such, it tends to stir up unnecessary acrimony or, at the very least, confusion. Some income-oriented investors assume, not unreasonably, that "withdrawal" means that retirees steadily invade their capital until it's all gone, ignoring income-producing securities altogether. But the "withdrawal" in "safe withdrawal rate" generally assumes that retirees can be free-ranging in terms of where they go for cash, such as drawing income for living expenses from bonds or dividends, rebalancing proceeds, required minimum distributions, tax-loss sales, and yes, the outright selling of securities. In a similar vein, the term "income" also fans the flames of confusion (and stirs investing passions). Are we talking about actual interest and dividend income, or income for living expenses from wherever we can scare it up? The term "distribution" is more encompassing than "withdrawal" or "income," but you don't see it used as much.
Given all of the question marks flying around about the topic of--ahem--retirement distributions, as well as the importance of arriving at a sensible and sustainable strategy, I thought it would be useful to provide an overview on some of the key approaches: how they work as well as their pros and cons.
The granddaddy of all retirement strategies, the income-only approach means that the retiree subsists on whatever dividend and interest income distributions his or her holdings kick off. Someone earning 5% in dividend and interest income on a $1 million portfolio can spend $50,000 that year.
Pros: It's no wonder so many retirees anchor on this strategy. In addition to being easy-to-understand, there are few more comforting notions than knowing that your portfolio can create all the income you need. Because you're not touching your principal, you can pass it to your heirs or use it for periodic splurges.
Cons: The obvious drawback with income-centric approaches, as yields have slunk lower during the past few decades, is that it has gotten tough to generate a livable income stream from an income-only portfolio without an awful lot of wealth or without taking substantial risk. Because yields on safe securities like cash and high-quality bonds have dropped so low, many income-hungry retirees have found themselves venturing into increasingly arcane and volatile asset types in order to generate the income they need. Moreover, those using the income-only approach may give short shrift to their own quality of life in retirement while passing on outsized sums to their heirs; that may or may not have been their plan.
Percentage of Starting Balance With Annual Inflation Adjustment
This is the strategy that underpins the so-called 4% rule for retirement distributions. The 4% rule doesn't mean the retiree withdraws 4% of her portfolio's value throughout her retirement years. Rather, under this method, retirees calculate 4% of their starting balance when embarking upon retirement, and use that as their distribution amount in year 1. (Again, that distribution can come from any combination of dividend and interest income, rebalancing and tax-loss sale proceeds, and portfolio withdrawals.) The retiree then inflation-adjusts that dollar amount annually throughout her retirement, as discussed in this article.
Pros: The big benefit of this approach is that the retiree's real payout remains fixed throughout his or her life, allowing for an even-keeled and predictable standard of living--something most retirees want. And assuming the starting withdrawal amount is reasonable given the retiree's time horizon and the investment portfolio's asset allocation, the retiree will have a good chance of not outliving his or her nest egg, according to a fairly broad body of investment research.
Cons: The big disadvantage of distribution approaches that use a fixed real dollar payout is that they're not sensitive to market performance. In very strong and sustained up markets, for example, sticking with the predetermined withdrawal amount might lead the retiree to live more modestly than necessary. Perhaps more worrisome is what can happen if a retiree doesn't adjust his or her withdrawal rate in a prolonged down market: What started out as a 4% rate of withdrawal can readily morph into a much higher percentage in an unforgiving market. Although a fixed real dollar payout is appealing on many levels, real-life income needs might be lumpy: higher in some years, lower in others.
Percentage of Starting Balance With Bear-Market Reduction
This approach is similar to the previous one, with a tweak. Rather than blindly using a predetermined withdrawal amount and adjusting it for inflation each year, as the 4% rule dictates, this method calls for the retiree to pull in his or her belt during bear markets. Research conducted by T. Rowe Price showed that retirees who reduced their portfolio spending rates by 25% in the wake of bear markets substantially improved their odds of not outliving their nest eggs. Even retirees who took more modest steps to rein in spending in the bear market's wake--forgoing their annual inflation adjustment, for example--also improved the odds of not outliving their money.
Pros: This approach attempts to achieve two important goals for most retirees: ensuring at least a baseline amount of living expenses while also providing safeguards against outliving their assets. Moreover, the "lite" version of this approach--forgoing inflation adjustments in the wake of bear markets--is likely to be fairly easy to employ, given that the economy, and in turn inflation, is often muted in the wake of big market downturns.
Cons: Reducing post-bear-market withdrawals by 25% greatly improved the longevity of model portfolios with 55% in stocks and 45% in bonds, but that kind of belt-tightening might be more radical than many retirees would care to handle.
Percentage of Ongoing Portfolio Balance
This approach had many proponents in our recent Discuss Forum thread. Under this method, the retiree pays himself a fixed percentage each year--say, 3%, 4%, or 5%. In contrast with the income-only approach, however, the payout can come from a multitude of sources: interest and dividend income, capital gains distributions, RMDs, tax-loss sales, rebalancing proceeds, and so forth.
Pros: In contrast with strategies that deliver a fixed real dollar payout, this strategy is extremely plugged into market fluctuations and, in turn, the retiree's portfolio balance. Thus, in good years the retiree is able to take home a bigger paycheck while automatically reining in spending during weak ones, giving the approach points for low maintenance. Moreover, assuming the withdrawal percentage is loosely aligned with the total-return expectations for a portfolio, retirees employing this approach will tend to place fewer demands on their principal than those withdrawing a fixed dollar amount of their portfolios per year. And unlike the income-only approach, this strategy gives the retiree leeway in terms of where he or she goes for cash.
Cons: The big drawback of this strategy is that it can lead the retiree's standard of living to be whipped around by market winds. In good years, the retiree might be taking cruises and writing big checks to the grandkids, but forgoing those costly but pleasurable activities in weak years. There's also the risk that a bad year for the market, and in turn withdrawals, could coincide with high unplanned expenses such as medical bills or home repairs.
Percentage of Ongoing Portfolio Balance, With Ceiling and Floor
This strategy seeks to rectify the key shortcoming of the previous one: The retiree employs a baseline percentage distribution rate but ratchets that amount up or down based on portfolio performance. The "ceiling" sets the maximum upward adjustment the retiree could take in good years, while the "floor" means that the distribution couldn't drop below a certain level, even in very bad years for the market. This article provides a detailed example of how this method works.
Pros: The strategy provides for fairly consistent distributions while also maintaining a sensitivity to market and portfolio performance. In contrast to strategies that rein in withdrawals during weak markets, this approach also allows the retiree to enjoy a higher payout during periods of strong market performance. A Vanguard study showed that portfolios using this strategy, along with a 5% ceiling and 2.5% floor, had a high probability of long-term success.
Cons: The key drawback to this strategy is that it's the most complicated, necessitating that the withdrawal amount be recalculated each year.
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