2 Key Decisions for Your Retirement Withdrawal Strategy

Translating your nest egg into a cash flow generator requires careful consideration.

Christine Benz 27 October, 2014 | 10:08
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So, you've accumulated what seems like a sufficiently sized nest egg coming into retirement. The next step is to figure out how to get your money out of it.

At first blush, the answer seems simple: Buy income-producing securities--bonds and dividend-paying stocks--and call it a day. When yields are higher, so is your payday; when they're lower, you have to get by on less.

That's certainly one way to do it, but it's not the only retirement spending strategy out there. To home in on the right one, retirees need to consider two sets of questions: first, the extent to which they're comfortable with a fluctuating payday and, second, whether they want their paycheck to come from income alone, or other sources as well.

Investors often conflate these two sets of questions--for example, they assume that if they're focusing on income production, they'll need to put up with some variability in their payday as prevailing market yields ebb and flow. In reality, it's possible to employ an income-centered strategy that delivers a steady dollar paycheck. Meanwhile, the opposite strategy is also viable: building a total-return-centered portfolio that delivers a variable, market-sensitive payday. (Retirement researchers generally consider variable distribution methods as more sustainable than withdrawing a fixed dollar amount because they're more market-sensitive.)

To arrive at the best decision for you, it makes sense to consider each of the following decisions one by one, in full consideration of the pros and cons.

Decision 1: Will Your Withdrawal Amount Be Fixed, Variable, or a Blend?

Do you want a paycheck in retirement that is more or less static, save for an inflation adjustment to help preserve the purchasing power of what you withdraw? Or are you OK with varying paychecks, depending on how your portfolio is performing? Let's walk through the pros and cons of each of those approaches and also consider a hybrid strategy that blends these two approaches.

The Fixed Dollar Amount: Using this strategy, the retiree takes a specific percentage of his or her portfolio in year one of retirement, then inflation-adjusts that dollar amount in subsequent years. That's the spending approach embedded in the 4% "rule" for retirement spending. For example, say a retiree has an $800,000 portfolio and is using a starting withdrawal of 4%. Year one spending is $32,000; year two spending is $32,960 (the initial $32,000 plus a 3% inflation adjustment).

Pros: A reliable income stream; comes closest to simulating the paycheck that many retirees earned while they were working; is the strategy embedded in much of the academic literature on withdrawal rates.

Cons: Not sensitive to market fluctuations; taking too much in down years could leave less in place to bounce back when the market recovers.

The Fixed Percentage Method: Using this method, the retiree takes a preset percentage of the portfolio per year. Assuming an $800,000 portfolio, the retiree taking a 4% fixed percentage of the portfolio would have $32,000 in year one. But if the portfolio increased in value to $900,000, the payday would also increase to $36,000.

Pros: Ties in with portfolio values and market performance; market-sensitive spending strategies generally considered more sustainable than those that don't consider market performance; virtually guarantees retiree won't run out of money.

Cons: Translates into a fluctuating paycheck, which may not suit retiree's lifestyle considerations; taking a fixed percentage from a shrinking pool may not be enough to live on in some years.

The Hybrid Method: Such strategies--and there are a few variations--attempt to deliver a fairly steady paycheck while also baking in some market sensitivity. One of the simplest strategies to implement, discussed in this T. Rowe Price research, would be to spend a relatively static dollar amount while foregoing the inflation adjustment in down-market years. Another strategy, discussed in this research paper by Jonathan Guyton and William Klinger, assumes a fixed-percentage withdrawal method with "guardrails" to ensure that spending never goes above a given ceiling or floor.

Pros: Attempts to deliver a fairly stable cash flow while also staying sensitive to portfolio fluctuations.

Cons: Can be more complicated to understand and implement; simple methods, like the T. Rowe Price strategy, help improve the odds that a retiree won't run out of money, but they don't guarantee it.

Decision 2: Will You Concentrate on Income, Total Return, Or a Combination?

Once you've homed in on a comfortable spending strategy, the next step is to determine where you'll go for that cash flow. Will you use the traditional strategy of relying on the income that your bonds and dividend-paying stocks kick off? Or are you open to taking a cut of your principal now and then, if your portfolio has performed particularly well? Or perhaps you like the idea of blending these two approaches.

The Income Method: The most familiar method for generating retirement cash flow, this strategy means that you'll spend your bond and dividend distributions as your portfolio kicks them off. This case study considers a very simplistic version of an income-centric approach.

Pros: Easy to understand and implement; ensures that you don't touch principal; embeds a valuation sensitivity, in that yields are often highest when the market is cheapest.

Cons: When yields are low, the retiree can either settle for a smaller paycheck or venture into higher-yielding, higher-risk securities; a portfolio built strictly for income may be less diversified than a portfolio built for total return.

The Total-Return Method: Under this approach, maximizing long-term portfolio growth is the key goal. The retiree reinvests all dividend and capital gain distributions and periodically rebalances the portfolio--i.e., scales back on winning positions--to generate living expenses. That's the approach we used in this back-test of one of our model portfolios.

Pros: Portfolio may be better diversified than the strictly income-centric one, encompassing non-dividend-paying securities and lower-yielding bonds; rebalancing regimen will tend to improve portfolio's risk/reward profile.

Cons: There may be years when rebalancing proceeds are insufficient to meet living expenses (that's one reason I'd recommend that retirees using this strategy also use a cash "bucket" to accommodate near-term living expenses); can be more complicated to implement than an income-centric strategy.

The Hybrid Method: This approach involves spending income and dividend distributions as they occur, while using rebalancing proceeds to make up any shortfalls in income. The portfolio is built for long-term total return as much as it is for income generation. We employed a hybrid strategy in this stress test.

Pros: Spending a baseline of income distributions can provide valuable piece of mind; rebalancing helps improve portfolio's risk/reward profile; generated the best returns of any portfolio strategy examined in our back-tests.

Cons: Slightly more complicated to implement than either the pure income or pure total-return approach.

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About Author

Christine Benz  Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

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