Managing Money in Retirement IV: A Simple Withdrawal Strategy Works Best
This is the fourth of a series of posts on retirement withdrawal strategies. If you haven’t read Managing Money in Retirement I, II and III, you may want to read them first.
In previous posts, we reviewed the sustainable withdrawal rate (SWR) and safety first schools of retirement planning, one focusing on portfolio withdrawals that will work through thick and thin, the other on establishing reliable income for essential needs. We worked our way through the options for building a fail-safe source of lifetime income – perhaps the floor of a floor-and-upside retirement strategy. Delayed social security and pensions fit the bill, other mechanisms have their pluses and minuses. Is there a way to pull these ideas together and create a strategy that balances safety, a high standard of living and, if desired, a legacy for heirs?
Stanford Study Finds Uncomplicated Strategy is Best
Recent research at the Stanford Longevity Center has identified a surprisingly straightforward strategy, rather prosaically called Spend Safely in Retirement, that may work well for most people. Financial planners Steve Vernon, Wade Pfau and Joe Tomlinson examined different retirement income strategies, including:
- Starting Social Security at 65 and at 70;
- Various annuity types, including single premium immediate annuities (SPIAs), Guaranteed Lifetime Withdrawal Benefits (GLWBs) and Fixed Index Annuities (FIAs);
- Systematic withdrawal plans, including 3%, 5% and 7% withdrawal rates and use of Social Security’s Required Minimum Distributions (RMDs);
- Reverse mortgages; and
- Combinations of the above.
In all, they evaluated how well 292 different retirement income strategies (!) did at providing retirement income, wealth/accessible assets, ending legacy, and likelihood/magnitude of any shortfalls, using probabilistic modeling of the behavior of stocks, bonds and inflation.
Their conclusion? For most middle income people (those with $100k to $1M in savings), the best strategy is a combination of delaying Social Security until age 70 and withdrawing from savings using the IRS’s Required Minimum Distribution tables.
the best strategy is… delaying Social Security until age 70 and withdrawing from savings using the IRS’s Required Minimum Distribution tables
Defer Social Security Benefits
The Stanford study reinforces the critical importance of Social Security to retirees and the superiority of delaying Social Security benefits as compared to other means of creating retirement income, such as annuities. (See my previous post.) The study authors also find that deferred Social Security benefits may be a sufficient floor for most people (i.e., adding an annuity on top of delaying Social Security doesn’t improve the financial outcome).
High Stock Allocations
This study found that results were best for portfolios with high stock allocations — up to 100%! While an all-stock portfolio may be too risky for most retirees – at least, those without ice in their veins — this finding underscores the importance of maintaining a substantial stock allocation in retirement. William Bengen, in his study originating the 4% Rule, found that a stock allocation between 50 and 75% struck the best balance between safety and growth, a result largely confirmed by subsequent Sustainable Withdrawal Rate analyses.
Withdrawal Rates – Let the IRS Decide
What about sustainable withdrawals from a retirement portfolio? The study examined 3, 5 and 7% withdrawal rates, and concluded that 3% was best (presumably because there were fewer instances of running out of money). Of course, your standard of living is also lower at 3%. [Note that this study examined fixed percentage withdrawals – withdrawing the same percentage from a portfolio each year – which are not the same as the constant dollar withdrawals studied by Bengen and others.]
Interestingly, the researchers found that making withdrawals according to the IRS RMDs (the amount the IRS requires all IRA/401(k) holders to withdraw each year once they reach age 70) was the best withdrawal strategy, beating out all the straight percentage strategies. The IRS withdrawal tables specify that 70 year-olds must withdraw at least 3.65% from their IRAs/401(k)s – very close to Bengen’s 4%. This is just a coincidence, however; the IRS percentage is not based on any financial analysis but is simply the reciprocal of (joint) life expectancy. If your life expectancy is 28 years, they want you to withdraw 1/28th of your IRA savings.
Use of RMDs has some advantages over using the 4% rule as a sustainable withdrawal guideline. First, it is applied to the current savings amount (rather than derived from savings at the beginning of retirement), which helps to keep withdrawals from getting out of sync with assets. (Withdrawals can, however, vary from year to year, which might be problematic for some.)
Second, RMDs go up as you age: at 85, for example, the RMD is 6.76% – quite a bit higher than the 3.65% required at 70. This allows a realistic but still prudent increase in withdrawals from savings that takes remaining life expectancy into account. Retirees are better able to use their assets during their lifetimes, as it becomes clear they are not going to run out. The required IRS withdrawals for couples within ten years of each other’s ages are shown below.
Comparing the RMD variable percentage withdrawal strategy with a constant percentage withdrawal strategy is straightforward (just imagine a straight line in the graph above that stays at 4%), and shows that the RMD strategy allows greater withdrawals as you get older.
Comparing RMDs to Bengen’s 4% constant dollar strategy is more difficult, since the percentage withdrawal in that case depends on how the underlying portfolio is doing. However, it is possible to compare the RMD strategy with a Bengen-like withdrawal strategy that is recalculated every year for a shorter timeframe. (Bengen and others typically looked at a 30-year timeframe, assumed to be long enough to cover most retirements.)
Wade Pfau has done this analysis, with the result shown below. Interestingly, the SAFEMAX (Bengen’s name for the minimum safe withdrawal percentage) and RMD rates are fairly similar. (Ignore the very steep right-hand side of the blue SAFEMAX curve; this is an artifact of cutting off the analysis at age 100.)
One final advantage of the Spend Safely in Retirement strategy is that it is almost effortless to implement, since RMDs from retirement accounts are required starting at 70. Many banks and brokerages will calculate and distribute these amounts to their customers automatically. Let them do the work! You can make withdrawals from non-retirement accounts using the RMD percentage, or simply use the 4% rule.
The Downside – Bridging the Gap Until 70
Are there any disadvantages to the Spend Safely in Retirement Approach? Yes – probably the biggest issue for most people will be how to support themselves until 70 without any Social Security income. If you follow this strategy, you will likely need to draw more than 4% of your savings – maybe a lot more — during this period. You may also have high health costs if you retire before age 65 (when Medicare kicks in). A bit of a silver lining is that there may be a tax benefit to taking more of your IRA/401(k) savings out earlier and less later, when you’re also taking Social Security.
If you’re contemplating this strategy – or any approach that involves delaying Social Security – there’s really no alternative to sitting down with a sharp pencil or spreadsheet and mapping out your finances in the years up to age 70. Estimate your living costs and how much you will need to withdraw from retirement savings each year. Now — once you reach 70, do you still have sufficient resources to live on the expanded Social Security benefit plus 4% of your remaining savings?
If so, you’re in good shape. If not, you may need to consider how to bridge the gap – work a little longer, get a part-time job, downsize, migrate to a cheaper area, move in with the kids…
That’s it – a retirement withdrawal strategy that’s elegantly simple, easy to implement and makes the most of your hard-earned retirement savings!
I hope you’ve found these posts helpful in creating your own retirement plan — one that lets you make the most of your time without worrying too much about money.
References
Bengen, William P. (1994, August). Determining Withdrawal Rates Using Historical Data, Journal of Financial Planning.
Department of the Treasury, Internal Revenue Service. (2017). Publication 590-B: Distributions from Individual Retirement Arrangements (IRAs).
Pfau, Wade. (2013, January). Time Horizon vs. the retirement 4% rule. MarketWatch.
Vernon, Steve. (2018). A Smart Way to Develop Retirement Income Strategies. Securing Future Retirements Essay Collection, Society of Actuaries. [Short version]
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