Withdrawal Strategies During Retirement
By Echo Huang, CFA, CFP®, CPA
You may have heard of the 4% rule for withdrawals during retirement as you approach your retirement. I would like to clarify this rule in this blog post and offer some thoughts on how to withdraw from your nest egg to make the money last for at least your lifetime.
What is the 4% rule?
The rule states that if you begin by withdrawing 4% of your nest egg's value during your first year of retirement, and then adjust subsequent withdrawals for inflation, you'll avoid running out of money for 30 years. If you retire with $2 million, the first year's withdrawal is $80,000 and if the inflation is 2% the second year, you adjust the second year's withdrawal by 2%, that is $81,600. It's simple to use and has been considered as the standard rule for withdrawals for many years. In my opinion, this rule is far from perfect for several reasons:
- This rule assumes that your investment mix is 60% stocks and 40% bonds. If you're conservative and allocate 75% to bonds, your portfolio may not grow enough to last your lifetime. If you are more aggressive and have 80% in stocks, your portfolio value may decline sharply during stock market crashes and won't have enough time to recover. Your investment mix should be designed based on all your factors: risk preference, loss capacity, time horizon and market conditions.
- The time frame of 30 years of retirement may not be long enough for some people and may be too long for others. If you retire early at age 50, your portfolio may have to last more than 30 years. If you retire late at age 70, you may limit your lifestyle spending too much by sticking to the 4% rule if you don't expect to live past age 85 based on your health conditions and family history. There is no do-over in retirement - running out of money even a year before you die is a failure and you simply cannot go back to work at age 89.
- Investment return expectations are outdated. When the rule was introduced in the early 1990s by William Bengen, then a financial planner in California, the historical data used at the time included periods that bonds had a high rate of return. Based on the current and projected interest environment, it is unreasonable to assume bond returns of 5% to 6% for next decade. The current federal funds rate is 2.25%. The federal funds rate's year-end estimate for year 2020 is 3.38%, based on the September 2018 FOMC meeting.
After studying the various methods of deciding the safe withdrawal rates, I can tell you that essentially all methods arrive at the same range of initial withdrawal rates from your assets: between 2% on the very low side for the most conservative approaches, and 6% on the very high side, for the most optimistic approaches. So the recent consensus view on this issue is 3% to 5% for most people.
The 4% rule is just a starting point. It should be used as a guide. Let's explore what other considerations should be weighed to make critical decisions in withdrawal strategies during retirement.
- Guaranteed income. If you have a high level of guaranteed income in retirement - social security, a pension, or an annuity, you probably can withdraw more from your portfolio each year than people can who have smaller amounts of such income. For example, when a client has guaranteed pension of $100,000 starting at age 55 that takes care of basic expenses such as housing and food, she can withdraw more than 4% when she is younger and has time and energy to travel with family internationally. It's important to analyze social security income to choose the best time to start collecting benefits, based on your and your spouse's full retirement age, full retirement benefit, health conditions, life expectancy and other sources of income. For many couples who are likely to live past age 80, it may make sense to delay social security benefits until age 70 based on the customized analysis.
- Guardrails. Where are you in the range now? As you try to decide if your withdrawal rate should be 3% or 5%, ask yourself a few questions to see how flexible you are to make changes. Could you reduce your discretionary spending by 50% for 3 years if necessary? Do you have a plan for obtaining health insurance until age 65? Would you be willing to work a part-time job to bring in an extra $1,000 per month? Are you ready to downsize your house soon? If most of your answers here are yes, then you have more flexibility to adjust during this retirement journey, and you can choose a higher withdrawal rate than 3%. For example, if you have a vacation home that you can decide to sell in the future to supplement the shortfall, you can choose a withdrawal rate higher than 3%.
In addition, you can choose not to adjust your annual withdrawal by inflation when your portfolio's return last year was negative. You can choose to reduce your annual withdrawal by 10% if your portfolio suffered a 20% loss last year. These are the guardrails that keep you on track before your retirement disaster happens. There are no magic numbers and I, as a wealth manager, must combine both the art and the science of financial planning to give customized advice to each client at the beginning of retirement, and as I continue to monitor during retirement by reviewing the annual cash flow carefully.
- V-shaped asset allocation glidepath. Because the consequences of a bear market can be severe when a portfolio's value is at its peak (in the first decade of retirement), it becomes necessary to dampen down the volatility of the portfolio to navigate the danger - a strategy commonly used by many lifecycle and target date funds, which use a decreasing equity glidepath that lets equity exposure drift lower each year. According to the research paper on this topic by Michael Kitces, the optimal glidepath for asset allocation appears to be a V-shaped equity exposure over time, starting out high in the early working years, getting lower as retirement approaches, and then rebuilding again through the first half of retirement. "The prospective retiree builds a reserve of bonds in the final decade leading up to retirement, and then spends down that bond reserve in the early years of retirement itself (allowing equity exposure to return to normal)."
A 20% decline on a portfolio in a bear market vaporizes 5 years' worth of spending at a 4% withdrawal rate. Getting more conservative with the portfolio is not just about reducing equity exposure in the years leading up to retirement, but also in the first decade of retirement. The height that the bond allocation should reach must be further optimized, given today's low-yield environment. There are other fixed income alternatives besides traditional bonds that might be considered as "volatility dampeners". I incorporate floating rate funds, bank loans and certain options strategies to generate income to further diversify clients' portfolios.
"Rising equity glidepath" which is more conservative in early retirement (and gets more aggressive later) can also improve retiree outcomes. If you are age 75 now and expect to live to age 85 with a goal of taking maximum withdrawals to enjoy life without running out of money, you can choose to increase equity allocation (not decreasing equity allocation) because you are living the last decade of your life and your portfolio size effect is minimized.
- Changing economic and financial conditions. Forward P/E (valuation), CAPE, and the Dividend Yield of stocks should be reviewed compared to historical averages. For example, current P/E of the S&P 500 Index is 16.8, which is in line with 16.1 (25-year average). CAPE (Shiller's P/E) is 33.2 now which is higher than 26.7 (25-year average), indicating it's slightly over-valued. As I mentioned earlier, bonds' projected returns may be lower than the historical average. I would prefer to be a little conservative in recommending the safe withdrawal rates - not more than 5% for most people.
- Do you wish to leave some money to your beneficiaries? The safe withdrawal rates research focuses on not running out of money before you die. If you die with $1 left, it's considered a success. If you wish to leave some money to your children or grandchildren, then you can choose to reduce withdrawal rate to be more conservative. You can also choose to earmark a specific account to someone or charities so that you don't count this account as part of your portfolio when you apply your own withdrawal rate. If you want to leave money to charities upon your death, it may be better to name the charities as primary beneficiaries of your IRA because it's more tax efficient for individuals to inherit taxable accounts in which they get "step-up" basis.
- Which accounts should I withdraw first? The answer is "It depends". If you have all three types of accounts (taxable, tax-deferred and tax-free), then you can maximize the flexibility in tax planning during retirement by taking withdrawals based on the impact of taxation. For example, if your youngest child is applying to go to an expensive private college (over $50k per year) and you are trying to minimize taxable income for the next three to four years to qualify for financial aid, then you should review the cost basis of the securities in your taxable accounts to see if you could generate lower taxable income than taking $45,000 distributions from your IRA account (taxed at higher ordinary income tax rate) vs. $10,000 long-term capital gains.
In general, I recommend this withdrawal order: taxable account (individual or trust), tax-deferred account (IRA or 401(k)) and tax-free (Roth IRA and HSA). However, every person's situation is different and needs to be analyzed closely. For example, if you delay collecting social security income to age 70 and RMD (Required Minimum Distribution) from your IRA will start at age 70.5, you may have much greater income than usual after age 70, especially if your IRA balance is large. Therefore, review projected income for the years before age 70 to see if you can consider converting specific amount of IRA money to Roth IRA without getting yourself to the next higher tax bracket. This is more relevant to investors who don't need the entire IRA balance to live on and wish to pass it on to children or grandchildren. If the retirees pay 12% federal tax (less than $77,400 taxable income for married filing jointly in 2018) to convert $10,000 from IRA to Roth IRA per year from age 62 to age 70 and then pass away at age 85. The children of the retirees could inherit the Roth IRA at $291,920 at 6% annualized return assumption and pay no taxes from withdrawals. If the children are in higher tax bracket (i.e. 24% or 32%), they are much better off inheriting Roth IRAs than IRAs. So try not to touch your Roth IRAs early as they are tax free and you don't have to take out RMDs at age 70.5.
I am a big fan of Health Savings Accounts (HSAs) as you can deduct contributions and the distributions are tax free to pay for qualified medical expenses. If you are relatively healthy, it may make sense to choose a high-deductible health insurance plan to save on monthly premiums and maximize pre-tax contributions ($6,900 for a family in 2018 and additional $1,000 if you are age 55+) to your HSA every year. You can invest the balance like Roth IRAs to plan to pay for medical expenses later in life. In this case, don't use the money from HSAs early - give it enough time to work the tax-free compounding magic.
It took many years of disciplined savings and investing to get to where you are. Successful retirement can be achieved through smart and deliberating planning. If you feel that there is so much at stake and there is little room for error, consider looking for the right financial advisor who can guide you through a proven process to analyze your goals and values before making recommendations and implementing strategies. A trusted and competent advisor will liberate you from layers of stress while potentially adding an additional 3% annualized return, based on Vanguard's research paper Advisor's Alpha.