Withdrawal methods

When it comes time to start taking withdrawals from your retirement portfolio, there are several methods you can use. What is most important to you? Is it having a constant withdrawal amount? Do you need the amount adjusted for inflation each year? Is protection of your principal more important, or do you want to spend it all and be flat broke just in time for the grim reaper? Maybe you want something in-between. Here we will explain some complicated-sounding strategies, such as “constant-dollar” and “constant-percentage.” But don’t worry - it won't be as difficult as it sounds.

Constant-Dollar
A constant-dollar withdrawal is the most commonly discussed method. The famous Trinity Study considered what annual rate of retirement withdrawals retirees can sustain. In other words, what is the rate at which the retiree is not likely to run out of money?

When you apply this method, you take your first yearly withdrawal based on a percentage of your investment portfolio value (Trinity says 4%). In the second year your withdrawal amount will not be based on your portfolio’s value. Instead, you return to the first year withdrawal amount and adjust it upward at the rate of inflation. For the third and each subsequent year, you go back to the previous year’s withdrawal amount and then adjust it upward using the current rate of inflation.

The advantage of this method is that your withdrawals are predictable and constant in “real dollars.” This means your annual withdrawal amount maintains the same real spending power after inflation. The disadvantage is if the market starts a prolonged downturn just before or during your first few years of retirement, your assets could be substantially or entirely depleted as you continue to take a larger inflation-adjusted withdrawal each year.

You might prefer this method if you have relatively high fixed expenses, and you want the predictability of a constant 'paycheck.'


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 * Figure 1: Graph of constant-dollar yearly withdrawals and remaining portfolio value.
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 * Figure 1: Graph of constant-dollar yearly withdrawals and remaining portfolio value.
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Constant-Percentage
Let’s consider a constant-percentage withdrawal. Do you need to ensure you always have some savings left? If so, withdraw the same percentage annually based on your current portfolio balance. Because the value of your portfolio will change annually with the ups and downs of the financial markets, keep in mind the dollar amount you withdraw will also fluctuate from year-to-year.

Annual withdrawals are not automatically increased for inflation; instead, this method counts on long-term portfolio growth to take care of inflation.

The advantage of this method is its simplicity - just multiply your portfolio balance each year by your withdrawal percentage. Your portfolio still might decrease in value, depending on market conditions and the rate of withdrawal you choose, but you will never run out of money. The disadvantage is your withdrawal amounts will always fluctuate with your portfolio’s value. You'll have to spend less in years when your portfolio value drops, and unless portfolio returns are good, you may not have enough in later years to keep up with inflation. You might prefer this method if you have lower fixed expenses - that is, year-to-year flexibility in spending.


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 * Figure 2: Graph of constant-percentage yearly withdrawals and remaining portfolio value.
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 * Figure 2: Graph of constant-percentage yearly withdrawals and remaining portfolio value.
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Spend Only the Dividends
If you wish to keep your principal investment amount intact, you might consider using a method where you only spend the dividend and interest income from your investments.

The advantage is clear, but like the constant percentage method, it may result in fluctuating income amounts as dividend and interest income rates for your investments change. Also, while having a large bond percentage will increase your interest income with this method, having too few growth investments exposes you to the risk of not keeping up with inflation over the long term. You might prefer this method if your expenses are small in relation to your portfolio size, and if you wish to leave a large amount to your heirs.


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 * Figure 3: Graph of dividends-only yearly withdrawals and remaining portfolio value.
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 * Figure 3: Graph of dividends-only yearly withdrawals and remaining portfolio value.
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Asset Allocation During Withdrawal
When you take money out of your portfolio, you should consider more than just the method of withdrawal. Consider your current asset allocation between stocks and bonds, and decide if your allocation will be changed during the withdrawal phase. Most withdrawal method studies, including the famous Trinity Study, assume annual rebalancing of the portfolio using a constant ratio between stocks and bonds.

However, the reality is many retirees prefer not to keep a static stock/bond allocation throughout retirement. They gradually reduce their stock allocation and increase their bond allocation – they move toward a more conservative allocation. One popular method Bogleheads use is to adjust the stock/bond allocation each year so that the bond percentage is equal to the owner’s age. This means you would make a 1% portfolio allocation adjustment every year.

Constant-Dollar (Age in Bonds)
Let’s look at how changing your allocation each year would work, and particularly what happens when you combine age-in-bonds with the Constant-Dollar method detailed before. First, let’s quickly review Constant-Dollar. Your first yearly withdrawal will be 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 first year’s withdrawal amount, adjusted for inflation each year thereafter.

Look at the Figure 4 below and compare it to the first Constant-Dollar graph, Figure 1 above. You can see the effect from changing the stock/bond allocation each year to be equal to the person's age. The graph shows this change for ages 55-90.


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 * align = "center"|ConstantDollarAgeInBonds.jpg
 * Figure 4: Graph of constant-dollar yearly withdrawals and remaining portfolio value. Bond percentage adjusted each year to equal age.
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 * Figure 4: Graph of constant-dollar yearly withdrawals and remaining portfolio value. Bond percentage adjusted each year to equal age.
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Again, the advantage is that your withdrawals are predictable and constant in real dollar terms - always equal to your first withdrawal, and then adjusted each year for inflation. But a new disadvantage is that your overall portfolio value will decline at a faster rate, especially during the later years. The reason is because each year you are increasing your withdrawals at the same time you are reducing the growth part of the portfolio - stocks. Therefore, you have to use a greater portion of your principal in the later years to keep up with inflation. On average, the more in bonds you hold each year the lower will be your overall returns. If you do not intend to leave a lot on the table for your heirs and you would rather not deal with market volatility in your final years, this might be a good approach.

Constant-Percentage (Age in Bonds)
Next, let’s use the same age-in-bonds approach just demonstrated for the Constant-Dollar method and apply it to the Constant-Percentage method. First, let’s review Constant-Percentage. You withdraw the same percentage annually from your current portfolio balance. Recall that the value of your portfolio will change based on the ups and downs of the financial markets, so the dollar amount you withdraw will fluctuate from year-to-year.

Look at the Figure 5 below and compare it to the first Constant-Percentage graph, Figure 2 above. You can see the effect from changing the stock/bond allocation each year to be equal to the person's age. The graph shows this change for ages 55-90.


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 * align = "center"|ConstantPercentageAgeInBonds.jpg
 * Figure 5: Graph of constant-percentage yearly withdrawals and remaining portfolio value. Bond percentage adjusted each year to equal age.
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 * Figure 5: Graph of constant-percentage yearly withdrawals and remaining portfolio value. Bond percentage adjusted each year to equal age.
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Again, your annual withdrawals aren't automatically increased for inflation; instead, this method counts on long-term portfolio growth to take care of inflation. Since the portfolio allocation becomes more conservative each year, its growth in total value will be less since you have a higher bond allocation each year based on age. However, the year-to-year portfolio withdrawal differences are also minimized because the increased bond allocation improved the stability of returns. Look at the down market of 2000-2002. In this chart example, the person was older and had a larger allocation to bonds. When you combine Constant-Percentage with age-in-bonds, changes in your annual withdrawal amounts are more smoothed than if you use Constant-Percentage alone.

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. Refer to Figure 6. 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).


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 * Figure 6: Graph of the alternative combination method Galeno Strategy yearly withdrawals and remaining portfolio value.
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 * Figure 6: Graph of the alternative combination method Galeno Strategy yearly withdrawals and remaining portfolio value.
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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 Asset Allocation During Withdrawal 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 below 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.


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 * Figure 7: Graph of the standard (100-age) stock allocation versus a glide-path Log(100-age)-1 stock allocation.
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 * Figure 7: Graph of the standard (100-age) stock allocation versus a glide-path Log(100-age)-1 stock allocation.
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As with the similar Bonds Equal Age method in Figure 5 above, following a glide-path stock/bond allocation allows the overall portfolio to become more conservative each year. The results, shown in Figure 8 below, 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.


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 * Figure 8: Graph of constant-percentage yearly withdrawals and remaining portfolio value. Stock percentage decreased each year according to a Log(100-age)-1 glide-path.
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 * Figure 8: Graph of constant-percentage yearly withdrawals and remaining portfolio value. Stock percentage decreased each year according to a Log(100-age)-1 glide-path.
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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.


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 * Figure 9: Graph of 1/N of portfolio value yearly withdrawals and remaining portfolio value. Stock percentage decreased each year according to a Log(100-age)-1 glide-path.
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 * Figure 9: Graph of 1/N of portfolio value yearly withdrawals and remaining portfolio value. Stock percentage decreased each year according to a Log(100-age)-1 glide-path.
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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