Published On: February 16, 2021
Written by: Ben Atwater and Matt Malick
Over the last few weeks, we have touched on retirement income planning, first with a broad look at the subject and then with an examination of required minimum distributions (RMDs). Today, we are going to explore sustainable withdrawal rates, including several strategies we can consider employing.
Over the last twenty-five years, the consensus on sustainable withdrawal rates from investment portfolios fell in the range of 3% to 5%. Leading up to the dot com bust, decades of robust capital market returns gave folks confidence in the idea that 5% was rock solid. After the 2000-2002 bear market, investors became more sober and then got another reminder of the fickle nature of capital markets in 2008-2009.
Today, although market participants are seemingly optimistic about risk assets, experts fear that the ultra-low interest rate environment will retard future returns and, therefore, most retirement gurus today advocate for a 3-4% withdrawal rate.
Sustainable withdrawal rates are more subtle though than a simple percentage. We will look at four withdrawal strategies – the static strategy, the guardrails strategy, the RMD strategy and the unitrust strategy.
The static strategy goes like this. At your retirement, you take your asset values and multiply them by your withdrawal rate, say 4%. If you have $2,000,000, then you get $80,000 per year. Then, each year you can increase this $80,000 by the inflation rate. Say in year one the consumer price index (CPI) rises by 3%, then your year two distribution is $80,000 x 1.03 = $82,400, and year after year you simply compound at the annual inflation rate.
A guardrails (or flexible) strategy is a hybrid strategy that has a static and a dynamic aspect to it. Assume you use 5% as your withdrawal rate and you start with $2,000,000. In year one you take $100,000. But, during year one the market falls, leaving you with $1,500,000 (a 20% investment decline plus the $100,000 withdrawal).
In this case, in year two the $100,000 is now a 6.67% withdrawal rate. Assuming your guardrail is 6%, then you will need to employ a formulaic reduction in your withdrawal rate, such as reducing it by 10%. Therefore, you would only be able to withdraw $90,000 in year two. If the market does not rebound and you are still above the 6% guardrail, then you will need to continue to reduce your withdrawal by 10% per year. However, if the market rebounds and your withdrawal is now below 6%, then you can keep the $90,000 (your last withdrawal amount) and increase it by the prior year’s inflation rate.
With the static and the guardrails (hybrid) strategies, we implement a specific inflation adjustment.
We will begin examining the purely dynamic (non-static) methods with the RMD strategy. The uniform life table on which the IRS bases RMDs is forgiving. The IRS computes the distribution period that determines the RMD divisor using the account owner’s life expectancy plus ten years. The upside of this conservative assumption is that if the RMD owner abides by (and does not exceed the RMDs) and has an appropriate investment strategy, he will not run out of money unless he lives a very long life.
Given that the actuarial assumptions in the RMD table will likely keep you from running out of money in your IRA, you can be comfortable using the same divisor for your other investable assets. Under this dynamic strategy, just like with an IRA, use your December 31st year end values, consult the uniform life table and divide. Bam. You have your withdrawal amount for the year.
One downside of the RMD method is that it can lead you to extremely lumpy cash flows, particularly when your numerator (the asset value) swings wildly in certain years while your denominator (the uniform life table) only slightly falls from one year to the next. A significantly lower numerator with a stable denominator will hit your wallet hard.
Now we will look at the last of the dynamic strategies, the unitrust strategy. Given relatively low interest rates for decades now, many trusts that traditionally paid “income” – interest and dividends only – have had to find statutory relief to better compensate current “income” beneficiaries. To accomplish this, trustees now commonly look to a “total return approach” to investing, meaning we consider interest, dividends and appreciation.
In this world, trustees also use a withdrawal rate of 3% to 5%, depending on one’s judgement, tolerance for risk and capital market assumptions. Trustees also tend to use an average balance when they multiply by the withdrawal rate.
To mimic this strategy, a retiree would look at the balance of their investment accounts on December 31st of the prior four years (e.g., 2020, 2019, 2018 and 2017) and multiply that average balance by a withdrawal rate like 5%.
Examining the two purely dynamic strategies, you will observe there is no explicit inflation adjustment, rather you instead rely on the underlying investment portfolios themselves to grow at the distribution rate plus the rate of inflation.
With a static withdrawal strategy, you should use a lower percentage because your payment never goes down, it stays the same plus compounds at an inflation factor. The good thing about this method is that you will never face an unplanned reduction in your retirement income. The number always increases at the rate of inflation. However, because it never decreases, years when market returns are negative will have an outsized impact on the ability of your portfolio to recover. Hence, for your money to last, you need to use a lower rate.
With the guardrail strategy you should be able to use a higher rate and at the same time somewhat control the variance of your annual distributions using your preset percentage reduction in your distribution when you hit the guardrail.
With dynamic strategies, in years where the market does poorly, you will see a reduction in your annual distribution that can be wide (widest with the RMD strategy and a more gradual average with the unitrust strategy).
When having a market-based retirement withdrawal strategy, you can maximize your withdrawal rates if you are willing to reduce the actual dollar amount of your withdrawal in years when markets perform poorly. Not everyone has this luxury, but for those who do, in aggregate, they will most likely be able to get more money from their retirement corpus than those facing a strict minimum annual dollar requirement. At the same time, their assets will almost surely last longer.