Retirement Withdrawals

The old rule of thumb for safe withdrawal rates from retirement accounts of 4% may not apply in coming decades.  With today’s low bond yields and above-average equity valuations a withdrawal rate closer to 3% may be more appropriate.  Additionally, determining your tolerance for variations in your retirement cash flows should be considered.

When thinking about withdrawals it can be helpful to view it on a spectrum. On one end is a static withdrawal system. Such a system assumes a retiree withdraws a percentage (3 or 4%) in year one of retirement then inflation-adjusts the dollar amount in each subsequent year. For example, if a portfolio is valued at $1 million a retiree would withdraw $40,000 in year one. If inflation was then 2%, the withdrawal in year two would be $40,800 ($40,000 * 1.02). This method delivers a stable inflation-adjusted cash flow.

On the other end would be a fixed percentage system. In this system a retiree would set an initial withdrawal rate and keep the percentage steady. Assuming a 4% withdrawal rate, a $1 million portfolio would yield a distribution of $40,000. If there was a decline in the portfolio value due to a market downturn of 20% in year 2, the withdrawal would need to be reduced to $32,000.  Conversely, if the portfolio had grown 20% the withdrawal would be $48,000. 

There are positives and negatives with each of these systems. The static withdrawal approach has the advantage of simulating a paycheck. At the same time, the static method runs the risk of prematurely depleting a portfolio if there happens to be a weak market near the beginning of retirement. This is called sequence of return risk.  The fixed percentage system addresses the sustainability issue, but cash flows are much more variable year to year. This means in a “lean” year with bad market conditions a retiree might not be able to withdraw enough to fully cover their expenses. 

The good news is that there are a couple of options that sit in the middle ground. One is a method called Required Minimum Distributions (RMD) which means each year a retiree takes a slightly larger percentage of their portfolio (due to reduced life expectancy), based on the previous year’s ending balance. RMD’s begin at age 72.  Another method uses fixed annual percentage withdrawals as a starting point and applies a “floor” and “ceiling”. This means in a bad year a retiree would slightly reduce withdrawals from the base percentage and in good years they would slightly increase withdrawals (dynamic spending strategy).  Small adjustments to retirement spending, guided by actual market conditions, can go a long way toward boosting the probability of long-term retirement success.

Each retiree should consider their tolerance for the risk of depleting their assets prematurely and the variability of cash flows as they design a plan that is customized for their lives.  Issues that should be considered are the size of their retirement assets, other sources of income such as Social Security or pensions, and willingness to adjust your lifestyle each year.