Withdrawal Strategies in Retirement
Suppose that you just retired and you are trying to figure out how much can you withdraw per year from your accumulated asset base. Traditionally people used to say “never touch the principal, only withdraw the interest” and that retirees should be invested in guaranteed fixed income instruments only! The problems with these historical approaches are that while fixed income investments reduce volatility of returns and the guarantee of principal gives a feeling of security, unless you are truly wealthy (i.e. your needs are minuscule compare to your assets) the likely result is false security. Over a 20-40 year retirement a 3% annual inflation rate erodes both the principal and the resulting income to the point that your standard of living would be reduced by 45-70%. Furthermore, while an interest only withdrawal strategy may work for some, you may find that your needs cannot be met without invading principal with (or without) a fixed income only approach.
Financial advisors have been using the rule of thumb that you can withdraw 4% annually from a 60:40 stock: bond asset mix with relatively low probability of running out of money over a 30 year horizon.
William Bengen, in an August 2007 article in the Journal of the Financial Planning Association entitled “Baking a Withdrawal Plan ‘Layer Cake’ for Your Retirement Clients”, as well as his excellent recent book aimed at financial planners entitled “Conserving Client Portfolios in Retirement”enumerates four withdrawal schemes:
- 1. Lifestyle– whereby an initial withdrawal percentage is identified and then adjusted for inflation each year, so that your real income remains unchanged during retirement (or until you run out of money)
- 2. Life phase– whereby your retirement is considered to be multi-phased with early retirement phases requiring higher withdrawal rates (reflecting higher spend rates when you are younger/healthier) and lower rates in later retirement years.
- 3. Performance based– whereby a fixed percentage of portfolio’s starting value each year can be withdrawn. So the funds available for spending each year are a function of what the performance of the portfolio each year. So you can expect a significant fluctuation in both real and nominal withdrawals. A floor and ceiling scheme in the real value of the withdrawn dollar values reduces fluctuations somewhat.
- 4. Annuity like – whereby a constant nominal dollar withdrawal level is determined, using historical returns and inflation data on the asset allocation selected and then using a technique described “Conserving Client Portfolios in Retirement” to insure that over the selected time horizon there is a 100% probability of success.
Bengen also introduces a SAFEMAX concept, which is the maximum initial withdrawal rate that will sustain a portfolio of a certain asset mix for a minimum number of years. The performance based scheme with floor and ceiling enhancement turns out to be preferred leading to superior SAFEMAX and lower income volatility.
Bengen’s paper actually looks in detail at other factors entering his ‘recipe’ for the withdrawal plan, including: asset allocation, time horizon, target estate size and probability of success ( i.e. that of not running out of money in selected time horizon).
These schemes, or more likely more than one of these combined or used opportunistically as needed at different points during retirement, are food for thought for developing/changing a workable withdrawal plan for each individual. Changes will be warranted by significant depletions/increases in asset base due to sustained bear/bull markets, individual’s health situation (life expectancy) and estate considerations.