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How Do Flexible Retirement Withdrawals Work in Practice?

Financial planner and retirement researcher Jonathan Guyton explains how to implement spending rules that fluctuate with the market--but not too much.

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The basic retirement spending strategies run to extremes.

Targeting a static real dollar amount year in and year out--such as the 4% guideline, which calls for taking out 4% in year one of retirement and inflation-adjusting that dollar amount thereafter--sounds appealing on its face. A major downside, however, is that ignoring portfolio performance isn’t ideal, especially if that overspending occurs during a weak market environment in the early years of retirement. And from a practical standpoint, retiree spending often varies quite a bit from year to year anyway.

At the opposite extreme, fixed-percentage withdrawals have the virtue of tethering spending to the portfolio’s value--a plus from a portfolio-sustainability standpoint. The major downside is that taking a fixed percentage withdrawal can lead to radical changes in retiree spending. A 4% withdrawal on a $1 million portfolio is $40,000, but it’s just $32,000 on an $800,000.

But what about a portfolio-withdrawal strategy that brings both concepts together? That’s the approach championed by Jonathan Guyton, a retirement researcher and financial planner in Edina, Minn., in his seminal research papers, “Decision Rules and Portfolio Management for Retirees: Is the ‘Safe’ Initial Withdrawal Rate Too Safe?” and “Decision Rules and Maximum Initial Withdrawal Rates.” (He co-authored the latter paper with William Klinger).

In this excerpt from a recent interview on “The Long View” podcast, Guyton discussed flexible withdrawal rates in detail. He also hit on other crucial retirement topics during the wide-ranging interview, including tax-planning considerations and why he’s favoring Treasury bonds for the fixed-income allocation of his clients’ portfolios.

Jeffrey Ptak: How do you inculcate your clients in a flexible withdrawal approach when perhaps many of them are accustomed to thinking of withdrawal is sort of a straight line type of rate?

Jonathan Guyton: Well, you know, it's funny, because I think one of the things that has helped me the most is that my full-time work is not as a researcher, or a writer, or anything like that. I'm a practitioner. And so, I get the chance to have retirees teach me and teach my colleagues what it's like to actually put this stuff into practice. And then we can adopt the way we implement things in a way that matches their behaviors, their lifestyles, and the emotions that affect their decision-making.

So, when you think about someone who is--we'll just make up a little scenario here. They're 65 years old, and now they're going to retire. And if they've made choices along the way, where they have put money away for retirement, we know that over the last 40 years they have had variations in their income. Somebody takes time off because they have a baby, somebody gets a bonus, somebody takes a leave of absence, somebody gets laid off, there's an illness. And so, people have 40 years of learning how to be flexible in their spending decision. And so, what we realized was that doesn't go away when you're 65. That's the only thing you know how to do. And so, the idea that retirees would have the ability to have some small amount of flexibility in their spending is actually something that lines up with people's real-life experiences.

And so, the work that I did basically said, since that is true, if we factor that into the idea of sustainable withdrawal approach over one's lifetime in retirement, does that make any difference to the amount of money that you can take out because of course the previous research had always said, every year you get a raise for inflation come hell or high water. And that is actually not the way retirees look at things. And the only reason we're talking here today is because that research revealed that if there can be a little bit of flexibility, then yes, you can turn the faucet on a little bit more and take more money out sustainably as long as you're willing and understand the adjustments that you need to make along the way when they're called for.

Christine Benz: You worked on some what I would consider seminal research, this idea of a system that would allow for fluctuating portfolio withdrawals. So, a question is how people can implement this? I think people stumble on this. I saw a query on an investment message board where someone said, “Can someone explain [Jonathan Guyton’s research] to me like I'm 5?” So, let's start there. Let's just talk about how in layperson's terms you would describe the strategy that you've researched.

Guyton: So, if you start with the idea that instead of taking out 4% safely, that that's what you do every single year forever and you just give yourself a raise for inflation. If you say, OK, I'm willing to have some flexibility and I'm going to start at a 5% withdrawal, which is 25% more money, that makes a real difference. It's important to know that your withdrawal percentage, which is what we call your withdrawal rate, is something that you can measure every single day. I don't do it every single day, but you can do it at any point in time. It's just how much money are you taking out regularly this year, divided by what is the portfolio worth whose job it is to generate that income. You get a percentage--$50,000 of withdrawals on $1 million portfolio is 5%.

And so, you track that. That withdrawal rate is like the temperature. It can get too hot or it can get to the point where it's too cold and it could be warmed up a little bit. But right now, we're talking about when it gets too hot. And that is when that $50,000 is suddenly only being supported by let's just say $800,000. That drives the percentage up. And we all know that if that portfolio value keeps falling, falls too fast, doesn't recover fast enough, we know that any withdrawal strategy can get in trouble.

So, we have what we call guardrails. And if you think about driving your car down a road, you hit a guardrail, it does two things. It puts a ding in your car, and it changes your momentum so that instead of the momentum is pushing you toward the edge of the road, it now starts to shift you back toward the middle where it's safe.

So, if that 5% withdrawal rate gets 20% higher, which would be 6%, if you hit that number, that's a warning, that's the guardrail and you say, I'm going to take that $50,000 down by 10%. So, I reduce it to $45,000. And that's all you need to do for a year. You can measure your withdrawal rate the next day if you want, but what really matters is a year from now. If it's still under 6%, you're fine. Keep going, give yourself a raise for inflation. But if it gets back up over 6%, it's like you hit the guardrail again. You need to adjust it down another 10%.

Now, in the pandemic, we have not actually seen that guardrail be hit. We got close toward the end of March. It was hit in the Great Recession, but that's really how it works and that's kind of what that medicine is. And I just want to add that a lot of times when retirees hear that notion reduce what you're taking up by 10%, what they think that means is reduce what I'm spending by 10%. And that's not true. Because your Social Security didn't go down, and your pension didn't go down. And furthermore, that $5,000 of reduced withdrawals, that's $5,000 that you can reduce from what you're withdrawing from your IRA or 401(k). In other words, that's $5,000 that isn't on your tax return. And so, guess what? Your income taxes are lower. Maybe your income taxes are $1,500 lower. So, that's not a $5,000 reduction in spending. It's $3,500, 300 bucks a month. Will that make a difference? Yes. Will it cause you to have to change your lifestyle? I doubt it.

Christine Benz does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.