Three Strategies for Retirement Withdrawals

Christine Benz: Hi, I am Christine Benz for Morningstar.com.

I recently sat down with Colleen Jaconetti, part of Vanguard's Investment Strategy Group. We discussed a number of topics related to retirement planning, including how much in withdrawals retires can safely take out.

Colleen, thank you so much for being here

Colleen Jaconetti: Thank you.

Benz: So I know that one of the key things that pre-retirees and retirees wrestle with is figuring out their withdrawal rate for their portfolio, and you and your colleagues recently studied this issue; you tried to arrive at what is an optimal strategy for calculating withdrawal rate.

Let's talk about what the research is. You looked at three separate strategies. Two that are commonly employed and one that you think is kind of a good hybrid. Let's talk about one strategy many people employ where they decide how much they are going to withdraw on a dollar amount and then plan to make percentage inflation adjustments on an annual basis. What are the key pros and cons associated with that strategy?

Jaconetti: We usually call that strategy the "dollar amount grown by inflation strategy" and what that provides is stable spending from year-to-year. So retirees will know how much they could spend each year. It's indifferent to what happens with the capital market. So if the market is going up or the market is going down, the retiree is still taking out the same amount each year.

Benz: So if you decided you're going to take $36,000 in year one, in year two, you take out that $36,000 plus maybe enough for CPI.

Jaconetti: Exactly.

Benz: Okay.

Jaconetti: So you could end up having significant surpluses or shortfalls based on ... how you set your initial withdrawal rates. So if the market is not doing very well and your portfolio is dropping, but you're still seeking out a steady amount grown by inflation, you could actually run out of money early.

Or you could actually spend too little--so someone could set their spending level so low as to hoping that they wouldn't run out of money, that they could actually end with a lot of money left over at the end.

Benz: So, what kind of parameters did you put in place in terms of: what portfolio asset allocation did you assume and what kind of time horizon?

Jaconetti: We looked at time horizons ranging from 10 years to 40 years, and we looked at conservative, moderate and aggressive allocations. So 20% bonds and 80% stocks would be the aggressive, and 50-50 would be moderate, and then conservative would be 20% stocks and 80% bonds. So we try to get a broad range of time horizons as well as risk tolerances.

Benz: Okay. So, that's strategy one. That's a common one. It seems very popular.

Strategy two is using a fixed percentage amount. Let's discuss that one, and what you found about the viability of that strategy.

Jaconetti: When people spend a fixed percentage of their portfolio each year, it's actually highly responsive to the markets. So each year if the market goes up, the amount that they spent from the portfolio will go up and vice versa.

Benz: Lean years in a year like 2008.

Jaconetti: Right. People would be cutting back their spending. So what we find is sometimes retirees can't handle that much volatility in their spending. So sometimes their fixed expenses are such that they need to spend more when the lean years come.

The nice thing about that method is that you can't run out of money. So a percentage of the portfolio, you always take a percent of what you have left over at the end of the year. So you would not prematurely deplete your portfolio. It could drop over the time, but it would never be depleted.

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Benz: So you looked at what you call a hybrid strategy. Let's discuss that and why you think that can be a nice alternative to these other two strategies that we've discussed so far?

Jaconetti: So the hybrid strategy actually is similar to the percent of portfolio, so each year you'll take a percent of the portfolio, but then you would actually put a band around it, a ceiling and a floor. So you would never let your year-over-year spending change by more than the ceiling amount or drop by more than the floor amount.

If you have a good year where the market, say, is up 10%, and you want to say your year-over-year spending will never go up by more than 5%, you'd actually invest the extra back into the portfolio. So if there is a time when the portfolio, say your spending amount would drop by 10%, but you only want it to drop by 5%, you would actually be able only drop it by 5%, you would be able to spend a little more. So it keeps spending within a certain range. So you would have more control over the short-term spending, but you'd still be taking into account what happens with the markets.

Benz: So you're essentially letting the good years make up for some of the lean years to help smooth out your overall spending.

Jaconetti: Right.

Benz: That sounds like a very useful piece of research.

Next, Colleen, I want to talk about sequence of withdrawals. This is another thing that retirees wrestle with--most people come into retirement, they've got money in different pots, they've got maybe IRAs, maybe company retirement plans as well as taxable assets. I'd like you to talk about what your research shows in terms of how retirees should sequence those withdrawals?

Jaconetti: The point of the decision is really to try to minimize the tax liability over the whole course of the horizon for retirees. So, we would say, generally, spend from your required minimum distributions first. So any retirees over 70 1/2 is required to take money from tax deferred accounts each year. So it will be the first monies that they should probably spend from.

Benz: If you don't take that, you'll pay a big penalty, so you've got to do that.

Jaconetti: Exactly. Then after that, we'd say investors should spend from their taxable portfolio, and then followed by the tax advantaged. So within the taxable portfolio, we would first say they should spend the interest, dividends, and capital gains distributions on assets held in a taxable account. So these monies are taxed to the investors whether they are spent or reinvested. So it's best to use those next for spending purposes rather than reinvest it and spend later and possibly have to incur capital gains to meet spending needs.

Benz: Then you would save the tax-deferred vehicles until last.

Jaconetti: Right, and actually after we do the taxable flows, we'd actually start spending from your taxable portfolio in a way that minimizes gains. So if you have assets in your taxable account, you would try to minimize the amount of capital gains. So, maybe selling assets at a loss or matching gains and losses.

And then after that you would go to the tax-advantaged accounts, and that would include the tax-deferred accounts, so the IRAs and 401(k) plans, or tax-free accounts, such as Roth. And which one you would spend from would really depend on the expectation of your current tax rate relative to your future tax rate. So if you think your taxes in the future will be higher, you would spend from your tax-deferred accounts today, locking in the lower tax rate. And if you think your future taxes will be lower, then you would spend from your tax-free accounts today, and then you would spend from tax-deferred accounts later when your tax rate is lower. So we're hoping that by minimizing the taxes you pay over the course of someone's retirement, it would actually help them have either more money to spend or extend the longevity of their portfolio.

Benz: So a related question that people grapple with is, how do I know what my tax rate will be in the future versus what it is now on the day that I am retiring. And it seems like you've really got two things in the mix: your own personal tax rate as well as what happens with taxes at large. I think a lot of people look at the current taxation and see that maybe it's low relative to where it's been historically, and could that get worse? How do you suggest that people try to get their arms around those complicated questions?

Jaconetti: Right. It is very difficult. Really, there is no crystal ball to tell us what the future of tax rates will be, but people can estimate, generally what their social security income would be, or their pension income or the income from their portfolio, and have a general idea of where they may fall.

Now, how they will be taxed on it in the future is a little bit more uncertain. So one thing we would say is to maybe have a little bit of tax diversification ... consider spending a little bit from your tax deferred and a little bit from your tax free, so that you have flexibility going forward.

Benz: So hedge your bets--just in case things unfold in a different way than you thought they would, you'd be protected.

Jaconetti: Exactly. At least give yourself some flexibility.

Benz: Well, Colleen, thank you so much for sharing this research. I know retirees are always really hungry to get concrete strategies for managing these really difficult decisions. Thank you.

Jaconetti: Great. Thank you.