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Should retirement withdrawals fluctuate?

Christine Benz  |  20 Nov 2015Text size  Decrease  Increase  |  

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Christine Benz is Morningstar's US-based director of personal finance. This article was initially published on the Morningstar US website.


In a previous article, I noted that the so-called 4 per cent rule for retirement portfolio withdrawals is a reasonable starting point for calibrating an in-retirement spending rate. It's easy to understand and implement, and it allows for a fairly stable stream of income during retirement--a predictability that's desirable for most retirees.

For example, say a retiree with a $1.5-million portfolio has decided to use the 4 per cent rule for her in-retirement withdrawals, combined with an annual adjustment to help her withdrawals keep up with inflation. That rule doesn't mean that she withdraws 4 per cent of her portfolio in each year of retirement, which could result in wildly differing annual withdrawals, depending on her asset allocation and market performance.

Rather, the 4 per cent rule stipulates that she takes 4 per cent of her portfolio in year one of her retirement, then inflation adjusts that initial dollar amount each year thereafter. Assuming a 4 per cent distribution rate and a $1.5-million portfolio, she would withdraw $60,000 in year one, and that amount would jump up to $61,800 in year two ($60,000, adjusted for a 3 per cent inflation rate).

But sticking with a fixed withdrawal amount, as the 4 per cent rule dictates, can also have some perverse effects in both very good and very bad market environments. Under-withdrawing in buoyant market environments is clearly a better scenario than running out of money during retirement.

However, the net effect of ignoring the strong market performance and sticking with the original 4 per cent withdrawal amount, adjusted for inflation, could be that the retiree lives more frugally than she actually needed to, passing money to heirs that she might have preferred to spend during her own lifetime.

On the flip side, employing the 4 per cent rule during a very weak market environment can also lead to unintended consequences, particularly if the bear market hits early on in one's retirement years. To use a simplified example, say the aforementioned retiree encounters a bear market in year three of her retirement, nudging her original $1.5-million portfolio down to $1 million. Her withdrawal would be $63,654 in year three (arrived at by inflation adjusting her year-two withdrawal amount of $61,800), pushing her total portfolio value down to $936,346 and below $900,000 in year four.

What started as a 4 per cent withdrawal rate in year one would grow to more than 7 per cent by year four. Sticking with fixed-dollar withdrawals during a sustained bear market also limits the pool of assets that can appreciate when the market improves.

Is there a better way to do it? That question has been the subject of much research during the past few decades, with many studies converging around the idea that withdrawal rates should fluctuate during a retiree's lifetime. Some of these studies are complicated and probably best employed by financial advisers.