For retirees who want to squeeze more from their portfolios, especially in early years, a dynamic retirement withdrawal strategy that varies cash flows based on portfolio performance may work better than stratgies that produce the same static withdrawal rates year after year, Christine Benz, Morningstar's director of personal finance and retirement planning, says in a new blog.
In fact, in research looking at safe withdrawal rates performed late last year by Morningstar chief ratings officer Jeff Ptak, director of research John Rekenthaler and Benz, every one of the dynamic strategies the three tested created a higher starting safe withdrawal rate than a static withdrawal system.
“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%,” Benz says.
Which dynamic strategy created the highest initial withdrawal rate?
The winner is the guardrails strategy, developed by financial planner Jonathan Guyton and computer scientist William Klinger. Guardrails not only offered the highest starting withdrawal rate, but also the second-highest lifetime withdrawal rate of any of the systems tested, Benz said.
“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.
Portfolios that have more significant equity allocations increased the allowable starting safe withdrawal amount considerably. It jumped to 5.6% for portfolios with 80% in stocks, 5.9% for 90%, and 6.3% for all-equity portfolios, Benz and her colleagues found.
The guardrails method also “had the second-highest lifetime withdrawal rate of any system we tested—second only to the RMD method,” Benz said.
The guardrails methods allowed for a 4.8% lifetime withdrawal rate for a 50% equity/50% bond portfolio and above 6% for a 100% equity allocation, the analyst said.
“Like an RMD-based approach, the guardrails system was highly efficient, as the periodic course corrections help the retiree consume more of the portfolio in up markets but not too much in bad ones,” Benz added.
For this stategy, retirees need to be able to handle—both financially and mentally—some variations in their annual cash flows.
“Whereas our base-case spending system leads to a pattern of fixed real withdrawals with no volatility in cash flows, the guardrails method had a relatively high level of variability in its income stream,” Benz said.
In fact, the guardrails method for withdrawals produced the second-highest standard deviation of cash flows of all methods the Morningstar researchers tested. Only the RMD method had produced higher cash flow volatility.
Also worth noting, the higher the equity allocations in a portfolio, the bigger the tendency toward swings in annual cash flows and frequent raises and cut backs, Benz said.
The guardrails withdrawal method also led to “substantially higher cash flow volatility” than strategies that forego inflation adjustments or those that create a 10% reduction in any year in which the portfolio value dropped.
According to Benz, that’s not surprising since those two methods, unlike using a guardrails strategy, only impose spending changes when a portfolio has declined.
“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 finding getting a ‘raise’ in their paychecks to be disagreeable,” Benz said.
The researchers found the guardrails method left a lower residual balance after 30 years than more static strategies.
The finding is not surprising, said Benz, since guardrails “encourages retirees to spend more when their portfolios perform well, but the trade-off is a lower median ending balance.”
As a result, the guardrails method “would tend to be most appropriate for retirees who prioritize maximizing spending over leaving a bequest to family or charity,” Benz said.
Retirees who want to leave a bigger bequest can use the guardrails system, but would need to pass up bigger withdrawals in years when their portfolio performed 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.