The big question: Once you retire, how do you begin drawing down your nest egg so that your money lasts for the rest of your life?
Nobel Prize–winning economist William Sharpe called this “the nastiest, hardest problem in finance.” Reason: There are so many variables and unknowables. For starters, how long do you think you will live?…how will the stock market perform in the coming decades?…and how much of a bite will inflation take from your purchasing power?
It’s no wonder many retirees react to this puzzle with extreme frugality, spending far less than they probably need to and often shortchanging themselves in the early retirement years when they should be rewarding themselves for a lifetime of hard work.
To help you make the right decisions about your retirement spending, Bottom Line Personal asked a panel of top financial advisors to explain their most effective strategies for drawing down money from an investment portfolio in one’s golden years…as well as the drawbacks of each approach and for what kind of retiree each strategy is best.
Good news: In many cases, retirees can increase the amounts they draw down by thousands of dollars a year without raising their stock allocations and portfolio volatility…and without the risk of outliving their money.
Of course, retirement spending isn’t just about picking the right drawdown strategy. On page 11, Robert Williams, CFP, one of Charles Schwab’s managing directors, tells you the big mistakes to avoid when you start tapping your portfolio to meet living expenses.
And if you have ever wondered if an annuity—a pricey insurance contract that provides a guaranteed monthly paycheck for life in exchange for a large lump-sum payment upfront—might be the answer for you, wealth advisor Walter Pardo, CWS, reveals the best situations to use annuities on page 12.
Is 4% Still the Magic Number?
For decades, retirees addressed the challenge of retirement drawdowns by using a strategy known as “the 4% Rule,” popularized by Bottom Line contributor and legendary financial advisor William Bengen. Historical data shows that a retiree who withdrew 4% of his portfolio’s value in the first year of retirement, then took the same dollar amount, adjusted for inflation, every year after that would have had a 90% chance of not running out of money in every 30-year period since 1926. Bengen assumed a moderate portfolio allocation of 50% in a broad stock market index and 50% in US 10-year Treasuries, rebalanced once a year.
Example of the 4% Rule: You have a $1 million portfolio, so you withdraw $40,000 in Year One of retirement. At the beginning of Year Two, if the inflation rate for the past year as measured by the Consumer Price Index is, say, 5%, you would take out the same cash amount as in Year One ($40,000), plus an additional 5% ($2,000), for a total withdrawal of $42,000. In Year Three, if inflation ran 2%, you would withdraw $40,000 plus an extra $800, or $40,800.
Retirees like the 4% Rule because it’s easy to understand and use. It offers great stability and consistency of cash flow to replace your work paycheck year after year, so you never have to make big adjustments to your budget. And your annual spending is able to keep pace with inflation.
But the 4% Rule also comes with significant shortcomings…
Retirees may not spend the same amount year after year through retirement. Studies show that seniors spend more money in early retirement when their health is better and they have a pent-up desire to travel. Spending then drops as they age, before rising again at the very end of life due to increased medical expenses.
The 4% Rule doesn’t maximize the total amount of cash you could have withdrawn and enjoyed in your lifetime. Users often are left with large, unspent balances after 30 years.
Going forward, the 4% Rule may not be a safe withdrawal strategy. Recent research from Morningstar suggests that stocks and bonds will have lower expected returns in the coming decades. For the strategy to be sustainable for 30 years, you’ll need to base your annual cash withdrawals on a lower starting rate—3.8%, not 4%.
Four Alternative Drawdown Strategies
Instead of reducing your withdrawal rate and making do with less money each year, consider using a more dynamic, flexible drawdown strategy. The following four strategies utilize the same basic portfolio allocation and time horizon as the 4% Rule, but they provide significantly higher initial safe withdrawal rates, ranging from about 4.4% to 6.75%. That’s because they tie withdrawals, in part, to how the stock market performs. By accepting less cash flow consistency and taking out less whenever the stock market falls, you foster higher returns over time.
Here are the four strategies you could consider…
#1: INFLATION CUT STRATEGY
How it works: This strategy tweaks the 4% Rule, allowing you to start with a higher initial withdrawal rate of about 4.4%. But it requires you to forgo the inflation adjustment if the stock market has negative returns in the previous year.
Example: In Year One, you withdraw $44,000 from a $1 million portfolio. In Year Two and each subsequent year, you start with the same $44,000 drawdown. If the annual inflation rate is 3% and the stock market is positive at year-end, you withdraw $44,000 plus the inflation adjustment ($1,320), for a total of $45,320. If the stock market is negative at year-end, you withdraw $44,000 regardless of inflation.
Drawback: Ignoring inflation adjustments in down markets means that your money will lose purchasing power in those years.
Best for: Retirees who want to withdraw a fairly steady annual dollar amount…have enough left to make bequests at the end of their lives…and want to boost income early in retirement.
#2: RMD STRATEGY
How it works: This strategy mirrors the IRS’s schedule of required minimum distributions (RMDs) starting at age 73 for traditional IRAs and 401(k)s. But you use the approach for your entire portfolio (including taxable accounts and Roth IRAs). You won’t run out of money because the withdrawal amount is always a percentage of the remaining balance. Divide the most recent year-end balance of your portfolio by how many years you have left to live based on the IRS life expectancy tables at IRS.gov/publications/p590b.
Example: Say your investment portfolio is valued at $1 million at the end of 2023 and you are 75 years old. According to the IRS Single Life Expectancy (Table 1), a person your age has 14.8 years to live (until about age 90). To calculate your RMD for 2024, you divide $1 million by 14.8, which comes out to $67,568, a 6.8% initial drawdown.
If you want to be very conservative in your longevity assumptions: Use IRS Table #3, Uniform Lifetime Table, which tacks on about 10 years to average life expectancies. So a 75-year-old man would be expected to live another 24.6 years until nearly age 100. Next year’s withdrawal amount on a portfolio valued at $1 million would be $40,650, a 4.06% drawdown.
Note: If you have a spouse who is more than 10 years younger than you and who is the sole beneficiary of your IRAs, Use Table #2, Joint Life and Last Survivor Expectancy Table.
Drawbacks: Very uneven and volatile cash flows from year to year. Also, since this strategy spends down your assets by your anticipated time of death, there will be nothing left for bequests.
Best for: Retirees who plan to spend all their money in their lifetime. They should have enough guaranteed income (e.g., a large pension), so that cash-flow volatility from their portfolios won’t affect their ability to pay essential living expenses.
Amy C. Arnott, CFA, is a portfolio strategist for Morningstar Research Services LLC, Chicago, which tracks about 630,000 investment offerings. Morningstar.com
The following two dynamic strategies are similar and attempt to give retirees the best of all worlds—stability regarding the amount withdrawn from year to year…sensitivity to both inflation and stock market ups and downs…plus a higher initial withdrawal rate than the 4% Rule. This is accomplished by implementing a floor and ceiling on how much you can withdraw in any given year depending on stock market conditions.
Helpful resource: The calculations to figure out withdrawals with these strategies are more complex. But there is a free calculator at FiCalc.app designed specifically for each.
#3: VANGUARD DYNAMIC SPENDING STRATEGY
How it works: Vanguard analyzed the withdrawal patterns and activities of one million retail customers. Its strategy allows you to use about a 5% initial withdrawal rate.
Example: On a $1 million portfolio, that’s $50,000 your first year, leaving you with $950,000. To calculate Year Two and each subsequent year: Take Year One’s withdrawal amount, and adjust it for inflation. So if the inflation rate was 3%, then your drawdown would be $50,000 plus a $1,500 inflation adjustment, or $51,500.
Next, establish a “ceiling”—the most you are willing to reward yourself above $51,500 if the stock market does well…as well as a “floor”—the lowest amount below $51,500 that you are willing to take in a bad market. Vanguard research shows that you can sustain a portfolio for 30 years by setting a withdrawal ceiling of 5% above $51,500 ($54,075) and a withdrawal floor of 1.5% below $51,500 ($50,727.50).
How much do you actually withdraw for Year Two? Let’s say at the end of Year One the stock market has risen 10%. You had $950,000 in your portfolio, so your ending balance is $1.045 million. Multiply that by your annual target withdrawal rate of 5%, and you get to withdraw $52,250 in Year Two. Since that amount is between your floor and ceiling, there is no need for any adjustments.
But if the stock market drops 10% in Year One, you would cut back your annual withdrawal to $42,750 in Year Two. Since that’s way below your floor, the strategy dictates you cut back only to $50,727.50.
Drawbacks: Some cash-flow fluctuations from year to year. Also, the emphasis on maximizing spending in your lifetime means there’s little money at the end for bequests.
Best for: Retirees who don’t mind some annual fluctuation in their standards of living to get substantially higher initial annual portfolio withdrawal rates.
Samuel Lichtman, CFP, is founder and president of Achieve Wealth Management, an advisory that does retirement planning for high net worth clients. Ontario, Canada. AchieveWealthManagement.com
#4: GUARDRAIL STRATEGY
How it works: While the Vanguard strategy withdraws a constant percentage of the portfolio but limits it by seeing how much it varies from last year’s inflation-adjusted withdrawal, this strategy takes a constant inflation-adjusted withdrawal but limits it by checking the percentage of your portfolio that it would represent. It also awards a bonus in unusually strong bull markets, and a cut in unusually tough bear markets. For this method, according to Morningstar research, you can start off with a safe initial withdrawal rate of up to 5.3% in Year One.
Example: On a $1 million portfolio, that’s $53,000, leaving you with $947,000 in your portfolio. At the start of Year Two, inflation is 3%, so you would take $53,000 plus an additional $1,590, or $54,590.
Now say the stock market ends Year One with a fairly strong gain. That increases your portfolio to $1.09 million (up about 15%). Divide the withdrawal amount ($54,590) by the $1.09 million current portfolio balance, and you’ll find that the withdrawal rate is 5%.
Now compare the two withdrawal percentages. The first year was 5.3% and the second was 5%. That 0.3% difference is about a 6% decrease. Had the decrease been 20% or more, you would give yourself a bonus by increasing your annual withdrawal by another 10%. But since it was only 6% less in our example, there would be no bonus, and your Year Two withdrawal would be $54,590.
The guardrail rules also apply in the reverse. If your withdrawal rate is a 20% (or more) increase of the previous year’s withdrawal rate, you would cut your inflation-adjusted withdrawal by 10%.
Important: The guardrail approach has several other rules you can apply that are meant to improve the amount you can withdraw and protect you from bear markets early in retirement. For more details, go to CornerstoneWealthAdvisors.com, and enter “Decision Rules” into the search box, then click on “Decision Rules and Maximum Initital Withdrawal Rates” for a PDF of the article.
Drawbacks: It’s a complicated strategy with multiple variables to input each year. To know the next year’s withdrawal amount, you would need to know the inflation rate, your current portfolio value and rate of return…and then do some basic math. Then follow the rules to see if you get a 10% bonus…an inflation raise…a freeze…or a 10% cut.
Best for: Retirees who are good at number crunching and who want the highest initial withdrawal rates among the drawdown strategies presented here.
Jonathan Guyton, CFP, is a principal of Cornerstone Wealth Advisors, a financial-planning and wealth-management firm, Minneapolis. His original research is the basis for the guardrails approach, also known as the Guyton-Klinger strategy. CornerstoneWealthAdvisors.com
