Should Your Retirement Withdrawals Fluctuate With the Market?

On this episode of The Long View, Morningstar’s Amy Arnott and John Rekenthaler discuss some recently released Morningstar research, The State of Retirement Income, which they have co-authored along with Christine Benz.

Here are a few excerpts from Arnott and Rekenthaler’s conversation with Christine:

Christine Benz: Amy, you did the heavy lifting on the dynamic spending strategies this year. And I have to say, as we’ve done this paper a few years now, I’ve always been a little frustrated that the media don’t spend more time on the dynamic strategies because I think it’s so interesting. But can you describe some of the flexible strategies that you tested, and just the advantage of looking at some of these flexible strategies, which you’ve touched on a bit already?

Amy Arnott: We tested four different flexible methods. The first one would be a very simple approach of any time you have an annual portfolio loss, you skip the inflation adjustment when you make withdrawals the next year. So, very simple, but you are making some adjustments to your spending, which can really help support a higher withdrawal rate over time.

The second one is the required minimum distribution method. This is the same framework that anyone who is required to make minimum distributions from a 401(k) or an IRA is familiar with. It’s basically just taking the portfolio value divided by life expectancy. And we use the standard life expectancy table from the IRS and assume a 30-year retirement time horizon. This method, it’s inherently safe because you’re always taking a percentage of the remaining balance, which means you never run out of money. But because it’s based on two different variables, the life expectancy and the portfolio value, you can have a lot of variability in cash flows from year to year.

The third method is what we call the guardrails method, which was originally developed by Jonathan Guyton, who’s a financial planner, and William Klinger, who’s a computer scientist. And the idea behind this is to start with a standard withdrawal rate, but then adjust that if the market has particularly good returns or particularly bad returns. And the way this is tested is, you calculate the withdrawal percentage based on the portfolio’s current value. And if that withdrawal percentage falls below 20% of what it was initially, then you give yourself a raise by increasing the withdrawal by inflation plus another 10% and then doing the reverse in down markets. So, if you find that the portfolio value is down, your withdrawal rate becomes higher because of that, then you cut back your spending by 10%. So, this method is a little more complicated but actually comes out with some of the best results in terms of being able to improve both the starting withdrawal rate and the lifetime withdrawal rate.

And then, finally, we also tested a new method this year. In previous papers, we looked at an assumption of what happens if you don’t increase spending by the full amount for inflation. So, last year, we looked at what would happen if retirees adjusted their withdrawals by 1 percentage point less than the annual inflation rate. This year, we refined that a little bit more by looking at specific data on how much retirees actually spend at different stages of their life. We looked at a paper that was published by the Employee Benefits Research Institute, which looked at actual spending patterns. They surveyed a bunch of people in retirement at different stages of life over an eight-year period to get empirical data on how people actually spend. And they actually found that inflation-adjusted household spending has historically fallen by about 19% from ‘65 to ‘75, and then continues falling from ‘75 to ‘85 and ‘85 to ‘95. So, there’s actually a pretty significant decline throughout that 30-year period. To reflect this, we assumed that inflation-adjusted spending decreased each year by about 1.9 percentage points between ‘65 and ‘75, then by 1.5 percentage points between ‘75 and ‘85, and 1.8 percentage points between ‘85 and ‘95. We chose those numbers to match up with the actual spending rate patterns that were published in this paper.

Benz: So, a lot of flexible spending strategies there that you’ve just outlined. Do they generally enlarge starting withdrawals? So, if you say, I’m OK with this bargain that I may have to vary my spending as things play out and my portfolio value changes, but does the starting withdrawal generally go higher if someone is employing one of these variable strategies?

Arnott: It typically does. So, what happens when you’re changing your withdrawal rates from year to year is that it basically is keeping you from overspending when there’s a weaker market, but also letting you give yourself a raise in a stronger market environment. And making these types of adjustments based on how the portfolio performs also helps you draw down the portfolio more efficiently because you’re not just taking a set dollar amount and adjusting that for inflation, but you’re also taking into account how the value of the portfolio is changing.

Benz: Let’s discuss some of the less positive aspects of these dynamic strategies. One, obviously, is that they’re dynamic, that you’re going to have to put up with some changes in your cash flows. But Amy, maybe you can discuss other things that may be a little less obvious that come along with these dynamic strategies.

Arnott: We looked at four different metrics. We looked at the starting safe withdrawal rate, the lifetime withdrawal rate, which is like an average amount of how much you would be spending each year, the volatility of cash flows, and then the median ending value at year 30. And typically, if you choose a method that excels on one of those metrics, it won’t do as well on all of the others. So, for example, I talked about the RMD method and the guardrails method. Both of those would typically allow for a higher starting withdrawal rate, but also lead to much higher cash flow volatility from year to year.

Benz: Do you have a favorite when you look at these strategies? Or does it really depend on the level of cash flow volatility that the retiree’s willing to put up with along with their attitudes toward things like having money left over at the end?

Arnott: I think if I had to pick a favorite, it would probably be the guardrails method, which I think does probably the best job of maximizing the safe withdrawal rate. It actually has the highest starting safe withdrawal rate of any of these methods, but also leaving a decent median value at the end of the 30-year period. And there is a fair amount of volatility and spending rates from year to year, but it’s not quite as high as it would be if you were just following the RMD method. But as you said, it really depends on the individual and what your priorities are. If you wanted to maximize the portfolio value at the end of life to give a bequest, you probably would want to go with the base case instead. Or if you’re looking for very stable spending from year to year, you might also favor the base case.