As men­tioned in part I: Sus­tain­able With­draw­al Rates, esti­mat­ing the cor­rect amount to with­draw from your retire­ment sav­ings is crit­i­cal in ensur­ing you make your invest­ments last for your entire life as well as your spous­es.

Part II focus­es on the var­i­ous tech­niques that can be employed to min­i­mize the risk asso­ci­at­ed with out­liv­ing your retire­ment sav­ings. Effec­tive­ly rec­og­niz­ing and man­ag­ing the three fun­da­men­tal risks you will face in retire­ment; mar­ket risk, infla­tion risk and longevi­ty risk, will great­ly increase your con­fi­dence about your finan­cial secu­ri­ty in your gold­en years.

 

Establishing a comfort level with uncertainty

As not­ed pre­vi­ous­ly, set­ting a sus­tain­able with­draw­al rate requires many assump­tions and fore­casts about what will hap­pen in the future. Chang­ing any of the vari­ables may increase or decrease the lev­el of cer­tain­ty about whether your port­fo­lio will last as long as you need it to. Increas­ing cer­tain­ty about the out­come may require reduc­ing your with­draw­al rate or revis­ing your invest­ment strat­e­gy. Con­verse­ly, increas­ing your with­draw­al rate, espe­cial­ly in the ear­ly years of retire­ment, may also increase the odds that your port­fo­lio will be deplet­ed dur­ing your life­time.

The chal­lenge is to bal­ance all fac­tors so that you have an accept­able lev­el of cer­tain­ty about the port­fo­lio’s longevi­ty con­sis­tent with pro­vid­ing the lev­el of income need­ed over your expect­ed life­time and the risk you’re will­ing to take to pro­vide it.

One increas­ing­ly com­mon method for esti­mat­ing the prob­a­bil­i­ty of suc­cess is the Monte Car­lo sim­u­la­tion. This tech­nique uses a com­put­er pro­gram that takes infor­ma­tion about your port­fo­lio and pro­posed with­draw­al strat­e­gy, and tests them against many ran­dom­ly gen­er­at­ed hypo­thet­i­cal returns for your port­fo­lio, includ­ing best-case, worst-case, and aver­age sce­nar­ios for the finan­cial mar­kets. Based on those aggre­gat­ed pos­si­bil­i­ties, the pro­gram cal­cu­lates your port­fo­lio’s prob­a­bil­i­ty of suc­cess. Monte Car­lo sim­u­la­tions also allow you to revise assump­tions about lifes­pan, with­draw­al rates, and asset allo­ca­tion to see how chang­ing your strat­e­gy might affect your port­fo­lio’s chances. Though the process offers no guar­an­tees, it does take into account poten­tial fluc­tu­a­tions in your port­fo­lio’s year-to-year returns. The result is a more sophis­ti­cat­ed analy­sis than sim­ply estab­lish­ing a with­draw­al rate based on a con­stant rate of return on your invest­ments over time.

Some retire­ment income strate­gies tack­le the ques­tion of uncer­tain­ty by includ­ing not only income sources that pay vari­able amounts, but also sources that pro­vide rel­a­tive­ly fixed or sta­ble income, or life­time income that is guar­an­teed. Just remem­ber that the pur­chas­ing pow­er of any fixed pay­ment amounts can be erod­ed over time by infla­tion.

Once you’ve estab­lished an ini­tial with­draw­al rate, you prob­a­bly should revis­it it from time to time to see whether your ini­tial assump­tions about rates of return, lifes­pan, infla­tion, and expens­es are still accu­rate, and whether your strat­e­gy needs to be updat­ed. 

 

Approaches to Ensure a Sustainable Withdrawal Rate

 

Conventional wisdom about withdrawal rates

The process of deter­min­ing an appro­pri­ate with­draw­al rate con­tin­ues to evolve. As baby boomers retire and indi­vid­ual sav­ings increas­ing­ly rep­re­sent a larg­er share of retire­ment income, more research is being done on how best to cal­cu­late with­draw­al rates.

A sem­i­nal study on with­draw­al rates for tax-deferred retire­ment accounts (William P. Ben­gen, “Deter­min­ing With­draw­al Rates Using His­tor­i­cal Data,” Jour­nal of Finan­cial Plan­ning, Octo­ber 1994), looked at the annu­al per­for­mance of hypo­thet­i­cal port­fo­lios that are con­tin­u­al­ly rebal­anced to achieve a 50–50 mix of large-cap (S&P 500 Index) com­mon stocks and inter­me­di­ate-term Trea­sury notes. The study took into account the poten­tial impact of major finan­cial events such as the ear­ly Depres­sion years, the stock decline of 1937–1941, and the 1973–74 reces­sion. It found that a with­draw­al rate of slight­ly more than four per­cent would have pro­vid­ed infla­tion-adjust­ed income for at least 30 years. More recent­ly, Ben­gen used sim­i­lar assump­tions to show that a high­er ini­tial with­draw­al rate–closer to five percent–might be pos­si­ble dur­ing the ear­ly, active years of retire­ment if with­drawals in lat­er years grow more slow­ly than infla­tion.

Oth­er stud­ies have shown that broad­er port­fo­lio diver­si­fi­ca­tion and rebal­anc­ing strate­gies can also have a sig­nif­i­cant impact on ini­tial with­draw­al rates. In an Octo­ber 2004 study (“Deci­sion Rules and Port­fo­lio Man­age­ment for Retirees: Is the ‘Safe’ Ini­tial With­draw­al Rate Too Safe?,” Jour­nal of Finan­cial Plan­ning), Jonathan Guy­ton found that adding asset class­es, such as inter­na­tion­al stocks and real estate, helped increase port­fo­lio longevi­ty (although these asset class­es have spe­cial risks). Anoth­er strat­e­gy that Guy­ton used in mod­el­ing ini­tial with­draw­al rates was to freeze the with­draw­al amount dur­ing years of poor port­fo­lio per­for­mance. By apply­ing so-called deci­sion rules that take into account port­fo­lio per­for­mance from year to year, Guy­ton found it was pos­si­ble to have “safe” ini­tial with­draw­al rates above five per­cent.

A still more flex­i­ble approach to with­draw­al rates builds on Guy­ton’s method­ol­o­gy. William J. Klinger sug­gests that a with­draw­al rate can be fine tuned from year to year using Guy­ton’s meth­ods, but bas­ing the ini­tial rate on one of three retire­ment pro­files. For exam­ple, one per­son might with­draw uni­form infla­tion-adjust­ed amounts through­out their retire­ment; anoth­er might choose to spend more mon­ey ear­ly in retire­ment and less lat­er; and still anoth­er might plan to increase with­drawals with age. This mod­el requires esti­mat­ing the odds that the port­fo­lio will last through­out retire­ment. One retiree might be com­fort­able with a 95 per­cent chance that his or her strat­e­gy will per­mit the port­fo­lio to last through­out retire­ment, while anoth­er might need assur­ance that the port­fo­lio has a 99 per­cent chance of life­time suc­cess. The study (“Using Deci­sion Rules to Cre­ate Retire­ment With­draw­al Pro­files,” Jour­nal of Finan­cial Plan­ning, August 2007) sug­gests that this more com­plex mod­el might per­mit a high­er ini­tial with­draw­al rate, but it also means the annu­al income pro­vid­ed is like­ly to vary more over the years.

Don’t for­get that all these stud­ies are based on his­tor­i­cal data about the per­for­mance of var­i­ous types of invest­ments, and past results don’t guar­an­tee future per­for­mance.

 

How does a sustainable withdrawal rate work?

Per­haps the most well-known approach is to with­draw a spe­cif­ic per­cent­age of your port­fo­lio each year. In order to be sus­tain­able, the per­cent­age must be based on assump­tions about the future, such as how long you’ll need your port­fo­lio to last, your rate of return, and oth­er fac­tors. It also must take into account the effect of infla­tion.

Example(s): John has a $2 mil­lion port­fo­lio when he retires. He esti­mates that with­draw­ing $80,000 a year (adjust­ed for infla­tion) will be ade­quate to meet his expens­es. John’s sus­tain­able with­draw­al rate is four per­cent, and he must make sure that his port­fo­lio is designed so that he can con­tin­ue to take out four per­cent (adjust­ed for infla­tion) each year.

 

Other approaches to withdrawal rates

 

A performance-based withdrawal rate

With this approach, an ini­tial with­draw­al rate is estab­lished. How­ev­er, if you pre­fer flex­i­bil­i­ty to a fixed rate, you might vary that per­cent­age from year to year, depend­ing on your port­fo­lio’s per­for­mance. Each year, you would set a with­draw­al per­cent­age, based on the pre­vi­ous year’s per­for­mance, that would deter­mine the upcom­ing year’s with­draw­al. In years of poor per­for­mance, a port­fo­lio’s return might be low­er than your tar­get with­draw­al rate. In that case, you would reduce the amount you take out of the port­fo­lio the fol­low­ing year. Con­verse­ly, in a year when the port­fo­lio exceeds your expec­ta­tions and per­for­mance is above aver­age, you can with­draw a larg­er amount.

Example(s): Fred has a $2 mil­lion port­fo­lio, and with­draws $80,000 (four per­cent) at the begin­ning of his first year of retire­ment to help pay liv­ing expens­es. By the end of that year, the remain­ing port­fo­lio bal­ance has returned six per­cent, or $115,200–more than the $80,000 he spent on liv­ing expens­es. For the upcom­ing year, Fred decides to with­draw five per­cent of his port­fo­lio, which is now worth $2,035,200 ($2 mil­lion — $80,000 + $115,200 = $2,035,200). That will give him $101,760 in income for the year, and leave his port­fo­lio with $1,933,440. How­ev­er, dur­ing Decem­ber of that sec­ond year of retire­ment, his port­fo­lio expe­ri­ences a sev­en per­cent loss; by the end of the year, the port­fo­lio has been reduced by the $101,760 Fred with­drew at the begin­ning of the year, plus the sev­en per­cent invest­ment loss. Fred’s port­fo­lio is now worth $1,798,099. Fred reduces his with­drawals next year–the third year of his retirement–to ensure that he does­n’t run out of mon­ey too soon. (For sim­plic­i­ty’s sake, this hypo­thet­i­cal illus­tra­tion does not take tax­es in account, and assumes all with­drawals are made at the begin­ning of the year.)

Cau­tion: If you hope to with­draw high­er amounts dur­ing good years, you must be cer­tain that you’ll be able to reduce your spend­ing appro­pri­ate­ly dur­ing years of low­er returns; oth­er­wise, you could be at greater risk of exhaust­ing your port­fo­lio too quick­ly. And be sure to take infla­tion into account. Hav­ing oth­er sources of reli­able, fixed income could make it eas­i­er to cush­ion poten­tial income fluc­tu­a­tions from a per­for­mance-based with­draw­al rate, and han­dle emer­gen­cies that require you to spend more than expect­ed.

 

A withdrawal rate that decreases or increases with age

Some strate­gies assume that expens­es in the lat­er years of retire­ment will be low­er as a retiree becomes less active. They are designed to pro­vide a high­er income while a retiree is healthy and able to do more.

Example(s): Bill sets a six per­cent ini­tial with­draw­al rate for his port­fo­lio. How­ev­er, he antic­i­pates reduc­ing that per­cent­age grad­u­al­ly over time, so that in 20 years, he’ll take only about three per­cent each year from his port­fo­lio.

Cau­tion: Assum­ing low­er future expens­es could have dis­as­trous con­se­quences if those fore­casts prove to be wrong–for exam­ple, if health care costs increase even more sharply than they have in the past, or if a finan­cial emer­gency late in life requires unplanned expen­di­tures. Even assum­ing no future finan­cial emer­gen­cies and no unex­pect­ed increas­es in the infla­tion rate, this strat­e­gy would require dis­ci­pline on a retiree’s part to reduce spend­ing lat­er, which might be dif­fi­cult for some­one accus­tomed to a high­er stan­dard of liv­ing.

Oth­er strate­gies take the oppo­site approach, and assume that costs such as health care will be high­er in the lat­er retire­ment years. These set an ini­tial with­draw­al rate that is delib­er­ate­ly low to give the port­fo­lio more flex­i­bil­i­ty lat­er. The risk, of course, is that a retiree who dies ear­ly will leave a larg­er por­tion of his or her retire­ment sav­ings unused.

 

Income-only withdrawals vs. income and principal

Many peo­ple plan to with­draw only the income from their port­fo­lios, intend­ing not to touch the prin­ci­pal unless absolute­ly nec­es­sary. This is cer­tain­ly a valid strat­e­gy, and clear­ly enhances a port­fo­lio’s sus­tain­abil­i­ty. How­ev­er, for most peo­ple, it requires a sub­stan­tial ini­tial amount; if your port­fo­lio can’t pro­duce enough income to meet nec­es­sary expens­es, an income-only strat­e­gy could mean that you might need­less­ly deprive your­self of enjoy­ing your retire­ment years as much as you could have done. A sus­tain­able with­draw­al rate can bal­ance the need for both imme­di­ate and future income by rely­ing heav­i­ly on the port­fo­lio’s earn­ings dur­ing the ear­ly years of retire­ment, and grad­u­al­ly increas­ing use of the prin­ci­pal over time in order to pre­serve the port­fo­lio’s earn­ing pow­er for as long as pos­si­ble.

Plan­ning to use both income and prin­ci­pal requires care­ful atten­tion to all the fac­tors men­tioned above. Also, in estab­lish­ing your strat­e­gy, you should con­sid­er whether you want to use up all of your retire­ment sav­ings your­self or plan to leave mon­ey to heirs. If you want to ensure that you leave an estate, you will need to adjust your with­draw­al rate accord­ing­ly.

Your deci­sion about income ver­sus income-plus-prin­ci­pal should bal­ance the need for your port­fo­lio to earn a return high enough to sus­tain with­drawals with the need for imme­di­ate income. That can pro­vide a chal­lenge when it comes to allo­cat­ing your assets between income-ori­ent­ed invest­ments, and invest­ments that have the poten­tial for a high­er return but involve greater volatil­i­ty from year to year. You may need to think of your port­fo­lio as dif­fer­ent “buckets”–for exam­ple, one “buck­et” for your short-term liv­ing expens­es, anoth­er buck­et that could replen­ish your expens­es buck­et as need­ed, and anoth­er buck­et invest­ed for the long term.

 

Conclusion

For retirees or near retirees, ensur­ing their sav­ings tru­ly lasts a life­time is of crit­i­cal impor­tance. Devel­op­ing a sus­tain­able with­draw­al rate, and active­ly review­ing it on an annu­al basis, will do a great deal to help retirees over­come the fear and stress of pos­si­bly run­ning out of mon­ey. If this seems daunt­ing and com­plex, talk to a finan­cial advi­sor such as Mack­ey Advi­sors.