The oldest boomers are grappling with the toughest question in personal finance: How much can you safely withdraw from your savings every year without running out of money during retirement?
If you thought it was hard to figure out how much money to save for retirement during your working years and where to put that cash, I’ve got news for you. The asset allocation decision is a cinch compared to the retirement savings withdrawal calculation, especially when you’re newly retired.
The Retirement Withdrawal Dilemma
The basic dilemma is this: You might have fun during your first years of retirement checking off items on your bucket list by aggressively tapping into your savings, but spending too much, too fast might force you to drastically curtail spending later.
Conversely, if you hoard savings, you’ll risk dying with plenty of money left in the retirement till and accumulating a long list of regrets.
The difficulty of coming up with the right withdrawal strategy is compounded by not knowing when you’ll die — five years into retirement or 30.
There are no easy solutions to the withdrawal conundrum.
The '4 Percent Withdrawal' Rule
As Next Avenue has noted, the best-known withdrawal recipe is what’s known as the 4 percent-plus inflation rule.
With this formula, near-retirees add up all the components of their retirement savings, such as 401(k)s and IRAs, and then plan to withdraw 4 percent of the portfolio’s overall value in the first year of retirement. The next year, the retiree takes out another 4 percent plus the rate of inflation, and so on year after year.
Although it’s called the 4 percent rule, the typical withdrawal range is between 4 and 5 percent of a retirement portfolio. (The study that launched the 4 percent rule literature is William Bengen’s 1994 Journal of Financial Planning article, “Determining Withdrawal Rates Using Historical Data.”)
The Required Minimum Distribution Rule
Another well-known, quick-and-dirty formula for determining the amount of your retirement portfolio to take out annually is the Required Minimum Distribution (RMD) rule.
The RMD is the percentage of retirement-plan assets that the Internal Revenue Service requires you to withdraw each year starting at age 70½; Roth IRAs are excluded from this rule.
IRS Publication 590 explains how much you’re required to pull out each year, but the math is tricky. You might want to use a free online calculator to figure out the amount you’d need to withdraw after hitting 70½. T. Rowe Price has a good one, its Required Minimum Distribution Calculator. After plugging in data for a hypothetical single 72-year-old with a $100,000 retirement plan, the calculator determined the minimum distribution in 2013 would be $3,906.25.
The RMD itself has nothing to do with a safe withdrawal rate, though. It’s just the government’s way to recapture deferred taxes from retirement plans.
Nevertheless, the RMD tables work reasonably well as a withdrawal discipline. (Economists Wei Sun and Anthony Webb at the Center for Retirement Research at Boston College wrote a good explanation of the RMD approach in their article, “Can Retirees Base Wealth Withdrawals on the IRS’ Required Minimum Distribution?”)
How Advisers' Thinking Has Changed
Initially, financial advisers and academics devising strategies for retirees focused on coming up with stable withdrawal rates.
Since then, researchers have adopted a more dynamic perspective, taking into account shifts in personal and economic circumstances, such as health and fluctuating markets. (You can get a sense of this approach by reading “A Dynamic and Adaptive Approach to Distribution Planning and Monitoring” by David Blanchett and Larry Frank, Sr. and “Decision Rules and Maximum Initial Withdrawal Rates” by Jonathan Guyton and William Klinger.)
For example, a retiree might raise his or her withdrawal rate to 5 percent plus inflation when the stock market is going gangbusters and pull back to 3 percent or so in a bear market.
Concerns About This Rule of Thumb
The price for this added realism is complexity, a formidable hurdle for the vast legions of middle-class boomers who don’t work with financial planners.
Another concern is that the safe-withdrawal literature typically assumes you have a large portion of your retirement portfolio in stocks — 60 to 70 percent. Yet many retirees rightly shy away from volatile equities, preferring to invest more conservatively.
I think that these type of withdrawal strategy calculations may be the wrong way for most pre-retirees and new retirees to go.
The 'Safety First' Withdrawal Idea
Instead, I believe you should figure out how to invest and withdraw enough money from your portfolio to maintain your standard of living during retirement. With this “safety first” tactic, you’ll concentrate on building a floor under your lifestyle, a buffer against bad times.
So rather than worry about historic and prospective rates of return, focus on your needs. Then match your financial resources to your necessary expenses.
This way, you’ll be minimizing your downside risk, creating a money cushion to cover expenses without having to worry whether stocks or bonds have fallen into one of their periodic bear markets.
“What we ultimately care about is meeting our goals. You can’t eat a rate of return,” wrote Zvi Bodie, a finance professor at Boston University, and Rachelle Taqqu, a Certified Financial Analyst at New Vista Capital LLC, in their new book, Risk Less and Prosper: Your Guide to Safer Investing.
Investments for 'Safety First' Withdrawals
The basic idea of this safety-first approach is to lock in a stream of income that guarantees you a minimum standard of living. To do so, you’d use investments such as U.S. Treasury Inflation Protected Securities (TIPS), lifetime annuities from blue-chip issuers, federally insured savings accounts and the like. Social Security is a key plank in this type of safety-first portfolio since the retirement benefits are guaranteed and predictable.
Once you’ve created your margin-of-safety withdrawal program, you can then afford to take greater risks with any remaining savings. Ideally, you’ll earn a higher return on riskier assets you can then spend on “aspirational” wants, such as enjoying expensive restaurants and traveling to distant shores.
“You still have your guaranteed income floor in place to meet your needs no matter what happens. With this approach, withdrawal rates hardly matter,” writes Wade Pfau, professor of Retirement Income at the American College of Financial Services, in his article, “The Safety-first, Goals-based Approach to Financial Planning.”)
Low Rates and Retirement Withdrawals
Of course, the current, low interest-rate environment has made it difficult for many new retirees to create a decent guaranteed income for themselves using TIPS, lifetime annuities and other safe assets. Consequently, many boomers – even those with well-funded 401(k)s and IRAs – will bolster their financial foundations by working part-time in retirement.
Nonetheless, the safety-first mindset with its emphasis on building a lifestyle floor seems a wise approach to avoid running out of money in retirement.