This is the third and final posting that summarizes the presentation I gave with Bob Finke at the Scotts Valley Financial Planning Clinic on February 4, 2012.
Retirement Spending and Withdrawal Goals
Retirement spending is typically funded by social security, employer pensions/retirement accounts and your own savings. The amount you need to withdrawal from your investment portfolio is the amount of your retirement spending that is not covered by passive income streams outside of your portfolio.
The typical goals for retirement withdrawals are
- Maximize withdrawals, especially in early retirement
- Eliminate the possibility of running out of money
- Avoid undesired reductions or freezes of withdrawals
- Maintain purchasing power
There are many different approaches that can provide a secure retirement. The ones discussed here all assume that your investment portfolio is invested with an appropriate asset allocation that is rebalanced once or twice a year
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Bucket Methods
One popular method is the Bucket Method. This involves separating short and long term funds into separate accounts. Funds are moved periodically from longer term to short term buckets. This method provides the benefit of feeling more in control but may require more work to manage multiple buckets.
The simplest bucket approach is with 2 buckets: one holds cash for 1 or more years. The other is a fully diversified portfolio for longer term funding, that may also contain a cash allocation
With a 3 bucket approach the first bucket is the same, a second bucket holds low risk/return assets to be used in 5 – 10 years, and the third bucket holds higher risk/return assets for longer term.
I have heard of methods with up to 5 buckets. If you like the bucket approach you should pick that one that will work best for you.
Single Asset Allocation Methods
Another approach is to have a single diversified asset allocation for the whole retirement portfolio. This would include a cash allocation that would 1 or more years of spending. Cash is withdrawn directly for current year spending, and is replenished when you rebalance to the target asset allocation.
Safe Withdrawal Amount
Once you have selected how you will organize and manage your retirement portfolio you still need to determine how much is safe to withdraw. First you need to do a cash flow and retirement plan to determine how much you will need to withdraw. Divide this amount by your portfolio value to get your Withdrawal Rate. The typical default safe withdrawal rate is 4%. Some of the methods discussed below may allow it to be somewhat higher safely. If your rate is higher than that you need to go back to the drawing board and find a way to reduce your spending!
Note that we are talking about the Initial Withdrawal Rate. Over the course of your retirement that rate will increase, and can do so safely. So if you are already well into retirement the current safe withdrawal rate needs to be determined with additional analysis.
Safe Withdrawal Strategies
The approaches discussed here assume a 2 Bucket approach in which the current year’s spending is withdrawn at the beginning of the year and held in a separate cash account. The single investment portfolio is invested with an appropriate asset allocation that is rebalanced once or twice a year.
Lifestyle Policy Method
This is also called the Inflation Adjustment Strategy, After the initial year the annual withdrawn amount is increased by inflation (CPI) each year. There is not adjustment for performance or portfolio value
Here is an example:
- $500,000 portfolio
- $20,000 initial withdrawal amount
- 4% initial withdrawal rate
- 3% inflation
- $20,600 2nd year withdrawal amount
- $21,218 3rd year withdrawal amount
- $21,855 4th year withdrawal amount
Endowment Strategy
This approach was developed by Thornburg Investment Management based on work by William Reichenstein. Annual withdrawals are inflation and performance adjusted which keep the overall portfolio on a sustainable path.
The Annual Withdrawal Amount is calculated each year as the sum of:
- 90% of previous year’s withdrawal amount
- 10% of the start of year portfolio value, times the initial withdrawal rate
- Actual annual inflation (using CPI), times the sum of the previous two parts
This calculation gives a moderate boost after good years and a moderate reduction in the annual increase after a year of poor performance. The overall effect is to allow a 25% - 35% increase in your withdrawal rate while still being sustainable and secure.
Guardrails Strategy
This approach was developed by Jonathan T. Guyton, CFP® and William J. Klinger. It establishes a set of decision rules for portfolio management and withdrawals. Annual withdrawals are inflation and performance adjusted as with the Endowment Strategy.
Decision Rules Summary
| Condition | Action |
| Prior Year’s Return is Negative | Apply Withdrawal (W/D) Rule - No increase if W/D rate > initial W/D Rate |
| Current W/D Rate more than 20% Above Initial W/D Rate | Apply Capital Preservation Rule - Reduce W/D rate by 10% |
| Current W/D Rate more than 20% Below Initial W/D Rate | Apply Prosperity Rule - Increase W/D rate by 10% |
| Current Withdrawal (W/D) Rate is within 20% of Initial W/D Rate | Apply Inflation Rule - Increase by Inflation (CPI) |
| Annually | Apply Portfolio Management Rule - Rebalance. Use W/D funding order |
These rules act as financial ‘guard rails’ to prevent portfolio depletion. Analysis indicates a 30% - 43% increase in your withdrawal rate while still being sustainable and secure.
Here are the Decision Rules in detail:
Withdrawal Rule
- No increase in withdrawal following a year when portfolio total return is negative and withdrawal rate would be greater than initial withdrawal rate
- There is no ‘make—up’ for a missed increase.
Capital Preservation Rule
- If withdrawal rate is 20% greater than initial withdrawal rate
- Current year withdrawal rate is reduced by 10%, and then other rules applied
- Decreased withdrawal is basis for next year’s withdrawal
- Rule expires 15 years before life expectancy
Prosperity Rule
- If withdrawal rate is 20% below the initial withdrawal rate
- Current year withdrawal is increased by 10%, and then other rules applied
- Increased withdrawal is basis for next year’s withdrawal
Inflation Rule
- If withdrawal rate is within 20% of initial withdrawal rate, and
- Unless withdrawal rule prevents it
- Then increase previous year’s withdrawal by inflation (CPI)
Portfolio Management Rule
- Asset classes with positive return and above target allocation have the excess sold
- Withdrawals are funded in following order
- Overweight equities
- Cash
- Fixed Income
- Equities in order of highest performance
- If Equities have negative return, no withdrawal from equities if cash and fixed-income can fund the withdrawal
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