4 Retirement-Withdrawal Strategies

Christine Benz: Hi,I'm Christine Benz for Morningstar.com. A sustainable withdrawal rate is one of the linchpins of a successful retirement strategy. Joining me to discuss various withdrawal-rate strategies as well as their pros and cons is David Blanchett--he's head of retirement research for Morningstar Investment Management.

David, thank you so much for being here.

David Blanchett: Thanks for having me.

Benz: Retirement withdrawal rates are a really hot topic among Morningstar.com users. I'd like to cycle through some of the strategies that people use to get cash out of their portfolios in retirement and talk about their pros and cons. You say there's really no one-size-fits-all answer; it really depends on the variables that appeal to you and that make sense for you. Let's start with the most intuitive way to think about extracting money from your portfolio, and that is to focus on income-producing securities and spending whatever those kick off. Let's talk about the positives and the potential drawbacks associated with that kind of strategy.

Blanchett: I think that a lot of retirees view income that way. For those who have saved enough for retirement and have a portfolio, the goal is to live off of the income. I think that that's definitely a very valid strategy. One potential con there is that, if your portfolio isn't growing, you are going to have less and less income throughout retirement based upon inflation. That's kind of a concern if you are thinking about maintaining a constant standard of living; you might not do that through that kind of portfolio unless it's growing over time.

Benz: Let's talk about the current yield environment and how that has made income-focused strategies somewhat challenging for retirees unless they've been willing to edge out on the risk spectrum little bit.

Blanchett: One issue we see today is that, historically, the average yield from large-cap stocks has been about 5%. The problem today, though, is that about half of that yield is going to repurchases. More companies are rebuying shares versus giving dividend yields. So, today is a very trying time for investors focused on income because, as we all know, bond yields are low and so is the average dividend from stocks. So, it really is tough today to create a higher income than, say, maybe 4% or even 5% from a portfolio focused on more income-paying securities.

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Benz: The next strategy is one that I know a lot of our Morningstar.com users are familiar with. This is the 4% rule, which involves a static dollar-withdrawal amount that then gets inflation adjustment in subsequent years. Let's talk about that one.

Blanchett: That came about more than 20 years ago from research by Bill Bengen, and there has been a lot of research since then. I think that one issue with the 4% rule, as it's called, is that it's often misunderstood. As you said, the 4% rule applies to the initial withdrawal rate, where that amount is increased by inflation. I actually call it 25 times what you need--25 times your initial income goal. One divided by 4% is 25, and that's just the starting point for retirement. I think that that's an excellent place to start for most retirees. I've done some new research with Wade Pfau and Michael Finke talking about how maybe lower withdrawal rates are a better starting point today. I think that a key issue for a lot of retirees, though, is how does your income profile change over your lifetime and what is your required level of certainty. Do you really need to have the same amount of income in today's dollars every year for 30 years? If not, other strategies might work better.

Benz: And you have done research about how retirees' spending needs tend to fluctuate over their life cycles. Let's talk about that.

Blanchett: I think that one assumption that almost everyone makes when it comes to retirement is that your income need increases every year by inflation in retirement. So, if you spent $10,000 last year and inflation 3%, you are going to spend $10,300 the following year. If you look at the actual spending of retirees, that isn't actually the case. People actually tend to reduce their consumption in today's dollars as they move through retirement.

Benz: You referenced a paper that you had worked on with some co-authors where you poked at that initial 4% withdrawal rate and suggested that potentially that's too high for some retirees. Is that the case for everyone or should some retirees feel OK about taking that 4% initial withdrawal?

Blanchett: I think that, if you are a retiree who has to have a guaranteed amount of income that increases every year by inflation for 30 years, then 3% is the new 4%--or you have to have, effectively, about 33 times your income when you first retire. However, for most people, they have Social Security or they have defined-benefit plans; they have other sources of income. So, if their portfolio were to fail, so to speak, it wouldn't be disastrous. So, I think that 4% is a great starting point for a lot of people--5% or even 6% can work based upon your overall level of risk tolerance.

Benz: It also depends on your age, correct?

Blanchett: Of course.

Benz: As you get older, you could arguably take more from the portfolio.

Blanchett: If you're single versus married, too. All of these factors look at how long retirement is going to last. If you are 65 years old, married, joint couple--maybe 30 years. If you're retiring at 60, it could be 35 years. So, all of these things help plan what is the right withdrawal rate based upon the remaining duration of retirement.

Benz: The next strategy that we want to discuss is what you call the endowment approach. This is where you take a fixed percentage of your portfolio, and you take that year-in, year-out, regardless of what your balance is. Let's talk about the positives and the potential drawbacks associated with that strategy. One obvious drawback is that you have that fluctuating income stream, which may not be agreeable.

Blanchett: So, I call it the endowment approach because endowments--like a college endowment--take out a fixed percentage every year. I think it can make a lot of sense. One benefit with the endowment approach is if 4%, say, is the right number for a constant withdrawal amount, 6% is actually the right number for the endowment approach. One benefit of that is that you know your ongoing withdrawal rate from the portfolio. A pitfall is that it possibly will decrease over time. If you take out 6% per year, without healthy market growth, it's not going to maintain that 6% level of income every year. I think that you can do things that will kind of smooth that out over time. One example is an endowment where you take the average of the last three years' values. So, what is your account value now versus a year ago and then two years ago? Then, average those three values to figure out what the actual withdrawal should be.

Benz: The last strategy I want to discuss is the endowment approach, but with a twist. You say I should focus on some percentage per year, but I won't take any more in dollars than X amount and I won't take any less than Y amount. Let's talk about the pros and cons of that strategy.

Blanchett: I think the key for a lot of people is to figure out what they need--not just today, but also throughout retirement. Obviously, things change; the markets haven't behaved very well over the last decade. So, I think that if you don't go back and revisit what your withdrawal amount or rate is, things get out of whack. So, going back and saying, "This year I can take out, say, 5%--but I need 6%." Well, you can do that; but that means, at some point in the future, you may have to take out less. The key is figuring out what those boundaries are for retirement and readjusting your withdrawal amount based upon portfolio performance.

Benz: Flexibility, it sounds like, is key.

Blanchett: If you don't have flexibility, it means you have to take out less. That's why I think 4% is a good starting point, but if you absolutely need the income, you have to be more conservative--say, 2.5% or even 3%.

Benz: David, this is such an important topic. Thank you so much for being here to share your insights.

Blanchett: Thanks for having me.

Benz: Thanks for watching, I'm Christine Benz for Morningstar.com.

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