The best retirement withdrawal method depends on what’s most important to you.
That’s one of the conclusions from our recent annual study on safe withdrawal rates. Every spending method involves some trade-off—simple versus complex, higher starting withdrawal rate versus more volatility in cash flows, or maximizing lifetime spending versus leaving money behind for heirs.
My colleagues Tao Guo, Jason Kephart, Christine Benz, and I examined nine different strategies, many of which allow for higher withdrawal rates than the well-known “4% rule” originally developed by Bill Bengen.
Over the next few weeks, I’ll discuss which methods are the best fit depending on what’s most important to you as an individual. (In last week’s article, I covered some strategies that can help you maximize your legacy.)
The Best Strategies for Maximizing Lifetime Spending
For some retirees, making the most of their nest egg means spending as much as possible before passing away. As the saying goes, “You can’t take it with you.” And after spending decades working and saving, retirement can be the perfect time to enjoy the fruits of your labor.
For every strategy we looked at, we used forward-looking return and volatility assumptions to test 1,000 hypothetical return patterns over a 30-year period. We then tested each strategy to estimate the starting safe withdrawal rate that would have supported spending over 30 years with a 90% probability of success.
We assumed a $1 million starting portfolio balance and added up all of the annual withdrawal amounts (factoring in any upward or downward adjustments dictated by flexible strategies and discounted by the inflation rate) for each of the 1,000 trials. After calculating all of the totals, we came up with the median lifetime withdrawal amount.
Three of the strategies we looked at were standouts based on lifetime spending over the 30-year period, as shown in the graph below.
Probability-Based Guardrails: $1.55 million in Median Lifetime Spending
How it works: This method involves continuous testing and course correction, but it emerged as the best way to maximize lifetime spending based on our tests. By reassessing the spending plan’s probability of success on a regular basis and making adjustments as needed, retirees can spend more than they’d be able to with a more static strategy.
We tested this approach by recalculating the probability of success after each year of the test period. If the probability of success dropped to 75% or below, we reduced the proposed spending amount for the year by 10%. If a strong market environment boosted the probability of success to 95%, we increased the proposed spending amount for the year by 10%. Because this method sometimes led to extremely high spending amounts following a period of above-average portfolio returns, we capped the annual spending amounts at 120% of initial spending, adjusted for inflation. To prevent large reductions in the withdrawal amount, we also applied a floor to prevent annual spending from dropping below 90% of the initial withdrawal amount.
Example: In the first year of retirement, Alice withdraws 5.1% of her $1 million portfolio, or $51,000. She adjusts this withdrawal amount for inflation and then recalculates the probability of success each year using an online tool. After several years of favorable market returns and modest inflation, her probability of success jumps to 130%. Because that’s higher than the upper limit, she bumps up her annual inflation-adjusted spending amount by 10%.
Required Minimum Distributions: $1.50 Million in Median Lifetime Spending
How it works: This is the same framework that underpins required minimum distributions from tax-deferred accounts like IRAs. In its simplest form, the RMD method is portfolio value divided by life expectancy. For life expectancy, we used the IRS’ Single Life Expectancy Table and assumed a 30-year retirement time horizon, from ages 67 to 97.
This method is inherently “safe” and designed to ensure that a retiree will never deplete the portfolio because the withdrawal amount is always a percentage of the remaining balance. However, this method still allows for greater total spending over a 30-year period because the RMD system incorporates two key variables that change every year: remaining life expectancy and current portfolio value.
Example: In her first year of retirement, Claire takes out 4.7% of her $1 million portfolio, or $47,000. By the end of the year, the portfolio’s value is $991,120 after accounting for the withdrawal plus a 5% gain on the underlying holdings. She uses her current age of 67 to find the corresponding life expectancy figure in the IRS table, which is 21.2 years. She divides $991,120 by 21.2 to calculate the required minimum distribution of $46,750.
Guardrails: $1.36 Million in Median Lifetime Spending
How it works: Originally developed by financial planner Jonathan Guyton and computer scientist William Klinger, the guardrails method sets an initial withdrawal percentage, then adjusts subsequent withdrawals annually based on portfolio performance and the previous withdrawal percentage.
As with the other two methods discussed above, the guardrails method helps enlarge lifetime spending because it continually adjusts withdrawal amounts to avoid spending too much when the portfolio is down and allows for more generous spending when things are going well. The guardrails attempt to deliver sufficient—but not overly high—raises in upward-trending markets while adjusting downward after market losses. In upward-trending markets, in which the portfolio performs well and the new withdrawal percentage (adjusted for inflation) falls below 20% of its initial level, the withdrawal increases by the inflation adjustment plus another 10%.
Example: In the first year of retirement, Bob withdraws 5.2% of his $1 million portfolio, or $52,000. If the portfolio increases to $1.4 million at the beginning of year two, the calculated withdrawal amount would be $52,000 plus an inflation adjustment—about $53,280, based on a 2.46% inflation rate. Dividing that amount by the current balance—$1.4 million—tests for the percentage. The amount of $53,280 is just 3.9% of $1.4 million. As that 3.9% figure is about 25% less than the starting percentage of 5.2%, he can make an upward adjustment of 10%. The new withdrawal amount becomes $58,608—the scheduled amount of $53,280 plus the additional 10% of $5,328.
Other Benefits of These Three Methods
In addition to higher lifetime spending, the built-in flexibility of all three of these methods allowed for higher spending rates at the beginning of retirement compared with our base-case starting safe withdrawal rate of 3.9% of assets.
We estimate that retirees following the guardrails method could safely withdraw 5.2% of the portfolio value at the beginning of retirement. The probability-based guardrails method allowed for a 5.1% starting withdrawal rate, and the RMD method allowed for 4.7%. With a starting portfolio value of $1 million, those higher percentages would allow for a decent boost in first-year spending (ranging from $8,000 to $13,000) compared with the base-case strategy.
Drawbacks for Spending Methods That Maximize Lifetime Spending
But there are some trade-offs. Maximizing lifetime spending involves drawing down assets at a faster rate, which in turn leads to less money left over at the end of the 30 years. The RMD method ended up with a median ending portfolio balance of just $120,000, and the probability-based guardrails method ended up with $230,000. The guardrails method resulted in a slightly higher ending value of $700,000, but still might not be the best fit for retirees who want to leave a larger legacy behind for family members or charity.
All three methods also ended up with a below-average spending + ending value (the sum of median lifetime spending and the median portfolio value remaining after 30 years). In that respect, they don’t maximize the total dollar value created by a retirement nest egg.
These approaches also involve some variation in spending from year to year, which could be tough to live with for retirees who like the idea of a consistent “paycheck equivalent” to cover their spending needs. The RMD method, in particular, showed the most dramatic swings in spending, with potentially large cutbacks in spending in the event of a portfolio decline.