Withdrawal methods

When it comes time to start taking withdrawals from your retirement portfolio, there are several methods you can use, including inflation-adjusted constant-dollar withdrawals, constant-percentage withdrawals, a don't touch the principal method where you spend only the dividends, or some combination method mixing different elements of the other methods.

Constant-Dollar
A constant-dollar withdrawal is the most commonly discussed method and the one used in the famous Trinity Study of sustainable withdrawal rates.

With this method, your initial yearly withdrawal is based on a percentage of your investment portfolio (say 4%). In subsequent years, the withdrawal is no longer based on your portfolio value, but is your initial yearly withdrawal adjusted for inflation.

The advantage of this method is that your withdrawals are predictable and constant in dollar terms, always being equal to your initial withdrawal adjusted upward for inflation. A disadvantage of this method is that if the market should undergo a prolonged downturn during the first few years of your retirement, your assets could be substantially depleted as you continue to take a larger inflation-adjusted withdrawal each year.

This method may be preferred by someone with relatively high fixed expenses who likes the predictability of a constant 'paycheck'.

Constant-Percentage
With a constant-percentage method, you simply withdraw the same percentage annually from your current portfolio balance. Because the value of your portfolio will change based on the ups and downs of the financial markets, the dollar amount you withdraw will fluctuate from year to year.

Annual withdrawals aren't automatically increased for inflation; instead, this method counts on long-term portfolio growth to take care of adjusting for inflation.

An advantage of this method is simplicity - simply multiply your portfolio balance each year by your withdrawal percentage. And with this method your portfolio may diminish but you should never run out of money. But because your withdrawal amounts will fluctuate with your portfolio value, a disadvantage is that you'll have to spend less in periods when your portfolio value drops.

This method may be preferred by someone with lower fixed expenses who has year-to-year flexibility in spending.

Spend Only the Dividends
Retirees who wish to keep their principal investment amount intact might wish to use a method where they only spend the dividend income from their investments.

This method has the advantage of keeping your principal intact, but like the constant percentage method may result in fluctuating income amounts as the dividend rates of your investments changes. Also, while having a large bond percentage will increase your income with this method, having too little growth investments exposes you to the risk of not keeping up with inflation over the long term.

This method may be preferred by those with expenses that are small in relation to their portfolio size and those who wish to leave a large amount to heirs.

Bond Percentage Equal to Your Age
Most withdrawal method studies, including the famous Trinity Study, assumes annual rebalancing of the portfolio back to the initial stock/bond ratio. This ratio is not changed throughout the period being evaluated.

Many people prefer not to keep a static stock/bond allocation throughout their retirement, but to gradually have their portfolio become more conservative by reducing the stock allocation and increasing the bond allocation. A popular Boglehead method is to simply adjust your stock/bond allocation each year so that the bond percentage is equal to your age. This results in a 1% allocation adjustment each year.

Constant-Dollar (Age in Bonds)
With this method, as in the Constant-Dollar method mentioned above, your initial yearly withdrawal is based on a percentage of your investment portfolio (say 4%). In subsequent years, the withdrawal is no longer based on your portfolio value, but is your initial yearly withdrawal adjusted for inflation.

The difference in the graph here, as opposed to the one above, is that the stock/bond allocation is adjusted each year so that the bond percentage is equal to the person's age. The graph covers ages 55-90.

As in the non-age-adjusted constant-dollar method, the advantage is that your withdrawals are predictable and constant in dollar terms, always being equal to your initial withdrawal adjusted upward for inflation. The disadvantage compared to the non-age-adjusted constant-dollar method is that overall portfolio growth is significantly less as withdrawals are consistently raised each year, but the growth part of the portfolio - stocks - is decreased each year.

Constant-Percentage (Age in Bonds)
With this method, as in the Constant-Percentage method mentioned above, you simply withdraw the same percentage annually from your current portfolio balance. Because the value of your portfolio will change based on the ups and downs of the financial markets, the dollar amount you withdraw will fluctuate from year to year.

The difference in the graph here, as opposed to the one above, is that the stock/bond allocation is adjusted each year so that the bond percentage is equal to the person's age. The graph covers ages 55-90. And, as above, annual withdrawals aren't automatically increased for inflation; instead, this method counts on long-term portfolio growth to take care of adjusting for inflation.

Since the overall portfolio becomes more conservative each year, the growth is less than the non-age-adjusted method. However, the year-to-year portfolio withdrawal differences are also minimized due to the increased bond allocation. During down markets such as 2000-2002, which occured here when the person was older and had a larger allocation to bonds, this method significantly smoothed the year-to-year withdrawal changes compared to the non-age-adjusted method above.

Combination
There are many alternative withdrawal methods. The following method is based on the Galeno Strategy and is intended to be representative of many of the alternative methods which are generally designed to overcome one or more disadvantages of the constant-dollar or constant-percentage withdrawal methods.


 * Constant-dollar
 * Disadvantage : Does not take into account the fluctuations of overall portfolio value. Many people would like to be able to take out a bit more during a big bull market when their portfolio value is climbing. Those same people would also likely feel uncomfortable taking an ever-increasing inflation-adjusted withdrawal during a multi-year bear market.
 * Alternative : Take the market value of your portfolio into account by moving a fixed percentage of your stock allocation over to your bond allocation every year.


 * Constant-percentage
 * Disadvantage : Withdrawal amount may have considerable year-to-year fluctuations.
 * Alternative : Smooth fluctuations by having yearly withdrawals be an average of 7½ years of bond allocation value.

Using this particular example alternative withdrawal method, 7½ years worth of withdrawals are held in bonds, the rest of the portfolio in stocks. As an example, to match up initial withdrawals and initial portfolio allocations with the graphs relating to the other methods, we will start with a $1,000,000 portfolio. The initial allocation being 70% stocks and 30% bonds. The initial yearly withdrawal being $40,000 (or 4% of initial portfolio value). The 30% in bonds would equate to $300,000 of the portfolio, which would be 7½ years worth of withdrawals, assuming $40,000 being withdrawn each year ($300,000 divided by $40,000 = 7½).

In subsequent years, 6% of the stock allocation of the remaining portfolio is sold and moved to the bond allocation. This is done each and every year, and will result in a differing amount being moved each year depending on stock market performance. This is the part of the method that is an alternative to the constant-dollar method not taking into fluctuating account value.

The 6% of the stock allocation that is sold each year is added to the bond allocation. The new yearly withdrawal amount is then figured by dividing the total bond amount by 7½. The fluctuating amount that is moved from stocks to bonds each year is smoothed by having the bond allocation contain 7½ years worth of withdrawals. As stocks go up, the bond allocation will gradually be increased and allow higher yearly withdrawals. Conversely, as stocks go down, the bond allocation will gradually be decreased and slowly result in lower yearly withdrawals. However, since there is a 7½ year buffer of withdrawals in bonds, year-to-year withdrawal amounts are smoothed and do not fluctuate greatly. This is the part of the method that is an alternative to the constant-percentage method having considerable year-to-year fluctuations of withdrawal amounts.

Overall, an alternative method is usually preferred by someone who would like to keep relatively smooth year-to-year withdrawals while also taking into account fluctuations in their overall portfolio value.

Glide-Path Allocation


As mentioned above in the Bond Percentage Equal to Your Age section, many people prefer not to keep a static stock/bond allocation throughout their retirement, but to gradually have their portfolio become more conservative by reducing the stock allocation and increasing the bond allocation as they age. However, the rule-of-thumb method where your bond percentage is equal to your age is sometimes seen as a bit too conservative. Another method, similar to the allocations used by some retirement-date funds is to follow a glide-path allocation change that isn't necessarily directly linear, as is the bonds=age method. Often, a glide-path method will add bonds to the portfolio mix more slowly in the early years before retirement, thus allowing the portfolio more possibility for growth before retirement. Then, after retirement, the glide-path may transition more quickly to a bond-heavy allocation, thus shielding the portfolio from stock market volatility during later retirement years.

Figure 7 shows a graph comparing the (100-age) stock allocation and the Log(100-age)-1 glide-path allocation. The blue (100-age) line is linear, changing the allocation by 1% each year. The glide-path allocation changes more slowly in the earlier years, presumably allowing for more portfolio growth during the accumulation years, and then turns quicker towards a more conservative allocation during the retirement years, eventually becoming more conservative and following a 100% bond allocation for age 90 and later.

As with the similar Bonds Equal Age method in Figure 5, following a glide-path stock/bond allocation allows the overall portfolio to become more conservative each year. The results, shown in Figure 8, are similar to the Bonds Equal Age method, but in the time-period shown in the graph, the slower transition to bonds allowed the overall portfolio to grow a bit more, resulting in slightly more money being withdrawn from the portfolio, while retaining a similar volatility.

1/N Withdrawal Amounts
A common issue when using a typical retirement withdrawal method is that the percentage withdrawn usually assumes the worst-case scenario. That is, the recommended percentage is one that, in the past, would have allowed you to weather the storm of the worst bear market, should it have occurred during your period of retirement. While it is generally considered safe and prudent to assume the worst, what often happens during a retirement period is that the markets perform better than the worst-case scenario, thus increasing your portfolio more than may have been forecast in that worst-case scenario - sometimes much more. If one continues to follow a withdrawal method based on their initial portfolio value at retirement, this unexpected growth may result in their leaving a significant amount of money unspent during their retirement. And while it is often a goal to leave some money to children or relatives, people may also wish that they had spent a bit more money while they had the chance.

One method to allow spending more money from the portfolio during the years you expect to draw from it is to not spend a percentage based on the portfolio's value, but rather spend a percentage based on how long you expect the portfolio to last. A simplistic example which assumes no portfolio growth or inflation concerns would be to imagine that you happen to have a million dollars under your mattress that you wish to make last for 10 years. A 'safe' withdrawal rate would then logically be that you could spend 1/10th of the portfolio each year, giving you a steady withdrawal amount of $100,000 each year for the next 10 years.

A 1/N withdrawal method is similar to this. 'N' being equal to the number of years you need to draw on the portfolio. Each year the 'N' number is readjusted, resulting in a higher percentage being withdrawn from the portfolio. Normally, withdrawing a higher percentage is considered possibly unsafe, as it may result in the portfolio being eventually depleted. However, using a 1/N withdrawal method typically assumes spending the entire portfolio, so large withdrawal percentages aren't a concern. Suppose you had one year to live, then what would a 'safe' withdrawal percentage be? A typical 4%? No, since you know the portfolio only has to last one year, then that means you can, over the course of that year, withdraw 100% of the portfolio.

The N number is readjusted each year, meaning that for a portfolio that you wish to draw from for 20 years would allow a 1/20th of the total portfolio value to be withdrawn the first year, 1/19th the second, and so on. Figure 9 shows a graph of withdrawals over a 37-year period that is the same as shown in the other graphs in this article. One big difference you may notice in this graph is that while the amounts withdrawn are similar to other methods in the early years, the amounts grow rapidly and huge as time goes on. This is due to the fact that with a know expiration date of the portfolio, larger and larger percentages are withdrawn. In order to keep the same Y-axis size as the other graphs in this article, Figure 9 also shows yearly withdrawals only up to $400,000, but in actuality, over the time period in Figure 9, the last eight years all allowed for withdrawals over $400,000, and, in fact, ended in the last year with a withdrawal amount of nearly $600,000, clearly the highest of any method, albeit at the expense of leaving no remaining portfolio.

Now you may have noticed in the last paragraph the one potential monkey-wrench in a 1/N withdrawal method - the N number (i.e. how long you will live) can't be forecast with perfect accuracy. It's all well and good to plan on needing to withdraw from your portfolio for 27 years, but if you spend it all down in that time and then happen to live 28 years, that's certainly going to be a problem! This problem can be solved by considering the 1/N withdrawal amount to be a maximum for the particular year, as in "I can withdraw up to 1/N this year". Since the withdrawal amounts using this method, or any similar method which uses up the portfolio, can become so large, it is quite easy to spend less than the full amount, thus preserving a portion of the portfolio for potential years beyond 'N'. So while this method, like the others, still involves making some assumptions about the future, it can result in your being able to withdraw much more from your portfolio during retirement, as long as you don't plan on leaving a large legacy.

Links

 * Variable Withdrawals in Retirement at Bob's Financial Website