Get a Lifetime Investment Income From Your Retirement Portfolio
I’ve written quite a bit about the infamous 4% withdrawal rate rule. I say “infamous” because I don’t like it. It may have worked in the past. Now this rule of thumb is more like a rule of “dumb.” We are more prone to black swan market crashes and burdened by less predictable market returns. This requires alternative strategies for procuring a lifetime of investment income from our retirement portfolio. It starts with liability-focused investing rather than pure wealth building.
The 4% rule has been popular for several reasons. First, it helps manage the longevity and inflation risks in retirement. Second, it is simple to use. Third, it provides retirees a steady amount of spending money each year.
But the 4% rule has serious problems. For one, the rule attempts to combine a rigid spending plan with an investment portfolio that can (and probably will) experience substantial changes in value every year. If the markets are strong, a retiree may end with a large stash of money to leave to his or her children. If the markets are weak, that same retiree could easily run out of money halfway through retirement. In the words of Laurence Kotlikoff, economics professor at Boston University: ”This is a prescription for getting people into serious trouble.”
Now here is an explanation of an alternative to the 4% rule – an alternative that is more likely to succeed in providing a lifetime of investment income: Each year the retiree withdraws a fixed percentage of the current value of the retirement portfolio.
Unlike the 4% rule which permanently establishes a fixed dollar amount plus inflation, the fixed percentage approach causes the retiree to adjust spending in response to market performance. Thus, if the size of the investment portfolio grows from the prior year, the withdrawal amount also grows. If the portfolio declines, so does the amount of the withdrawal. Using this technique, the retiree will never run completelyout of money.
The obvious downside to the fixed percentage withdrawal strategy is that there can be significant fluctuations in spending power from year to year. Your standard of living may not be “fixed” the way you would like.
To minimize the risk of extreme fluctuations in spending, you can adopt a more flexible version of this strategy. You do this by placing upper and lower limits on the changes in the dollar amount of your annual withdrawals, based on your prior year spending.
As one example, a retiree may determine to withdraw a fixed 4% of his retirement portfolio each year. That same retiree doesn’t want his spending power to change more than 5% from one year to the next. Assume that a retiree withdraws $40,000 (4%) from a $1 million portfolio balance in year one, and in year two a strong market boosted the portfolio to $1.1 million. A strict 4% withdrawal rule would allow that retiree to withdraw $44,000 in year two. However, by creating a 5% “spending band”, that retiree will limit the withdrawal to $42,000. This is a more balanced approach because spending can remain relatively steady from year to year while also responding to changes in investment performance in a way that will help the retirement investment portfolio to last throughout retirement.
In a further improvement to this fixed percentage withdrawal strategy, you can create spending bands or caps that are not symmetrical. In other words, you allow for more variability on the spending downside compared to the upside. For example, a retiree might might adopt a 3% cap on a yearly increase in the withdrawal amount but allow a larger 5-10% drop if the portfolio experiences a major down year.
I think the fixed percentage yearly withdrawals with spending bands has merit as a strategy for providing a lifetime of retirement income. What do you think?
FREE UPDATES: If you enjoy what you read here, please consider subscribing to receive free updates automatically by RSS feed or by email. (I promise that your email address will not be shared or used for any other purpose.)