Why experts recommend variable withdrawal rates for retirees

Guardrails approach shown to have greatest initial and lifetime withdrawal rate

Why experts recommend variable withdrawal rates for retirees

The director of personal finance and retirement planning at Morningstar, Christine Benz, suggests that dynamic retirement withdrawal plans, which adjust cash flows based on portfolio performance, may be more effective than static withdrawal techniques.

Last year, Jeff Ptak, John Rekenthaler, and Benz discovered through their research that every dynamic strategy they evaluated produced a greater initial safe withdrawal rate than a static withdrawal approach. This implies that dynamic techniques might assist retirees in getting more out of their investments in the initial years.

“Whereas our ‘base case’ system of fixed real withdrawals pointed to a 3.8% starting withdrawal percentage as sustainable for a balanced portfolio over a 30-year horizon, the starting safe withdrawal rates for variable strategies ranged from 4% to 5.3%,” says Benz.

Which dynamic approach generated the greatest initial withdrawal rate? Jonathan Guyton, a financial planner, and William Klinger, a computer scientist, created the guardrails strategy, which had the second-highest lifetime withdrawal rate and highest starting withdrawal rate among the examined systems.

“For a 50% equity/50% bond portfolio, the average safe starting withdrawal rate for a 30-year horizon with a 90% probability of success was 5.3%. In this context, we define 'success' as not running out of funds by year 30,” she added.

The permitted initial safe withdrawal amount was dramatically increased, according to Benz and her colleagues, for portfolios with 80% in stocks, 90% in stocks, and all-equity portfolios at 6.3% and 5.9%, respectively.

In addition, the guardrails approach "had the second-highest lifetime withdrawal rate of any system we tested—second only to the RMD method," according to Benz.

According to the analyst, the guardrails approach allowed for a lifetime withdrawal rate of 4.8% for a portfolio that was 50% stock and 50% bonds and above 6% for a portfolio that was 100% equity.

Benz said that like an RMD-based method, the guardrails system was very efficient since the periodic course corrections enable the retiree to consume more of the portfolio in up markets but not too much in down ones.

Retirement-age individuals must be capable of managing certain changes in their yearly cash flows, both financially and mentally. Of all the examined approaches, the guardrails strategy for withdrawals generated the second-greatest cash flow standard deviation. Additionally, it was most prone to yearly cash flow changes and frequent hikes and reductions in spending. Furthermore, it produced "substantially higher cash flow volatility" compared to methods that do not account for inflation or implement a 10% decrease in any year where the portfolio value declines.

In contrast to employing a guardrails plan, these two strategies only need expenditure modifications after a portfolio has decreased, which Benz said is not surprising.

“By contrast, guardrails may lead to a spending adjustment after both very good and very bad portfolio performance. In other words, the triggers for spending changes are inherently more frequent with guardrails than is the case with some of the other strategies, though few retirees would find getting a ‘raise’ in their paychecks to be disagreeable,” Benz said.

The guardrails approach had a smaller residual balance after 30 years than more static approaches, the researchers discovered. This is not unexpected because it motivates retirees to increase their spending when their portfolios do well, but the cost is a lower median ending balance.

Therefore, retirees who value maximum expenditure above leaving a bequest should use the guardrails strategy. Those who desire a larger bequest, however, must forego larger withdrawals in years when their portfolio performs well.

“Finally, like all variable systems, the guardrails system requires ongoing calibration of the withdrawal amount. In contrast with a fixed real withdrawal system, the guardrails approach does not permit retirees to ‘set it and forget it,’” Benz concludes.