How much can you spend in retirement without the risk of running out of money? That is arguably the key consideration of your retirement income plan. This requires you to strike a balance between current spending and future account value to support that spending later.
In simple language, this means that you are deciding how much income to take now, and weighing the risk of withdrawing too much and running out of money, or withdrawing too little and leaving more than you anticipated to heirs. The last part may not seem as bad, and it arguably isn’t, but it’s still something to consider.
Retirement guardrails can help you achieve this balance in a systematic way that removes guesswork.
Establishing Withdrawal Amounts for Retirement Income
One of the most popular, and basic, ways to calculate the income you can take from an investment portfolio is to withdraw a fixed percentage of the portfolio and adjust the withdrawal for inflation each year. Typically, the 4% rule is used. Doing this will provide you with a relatively stable income in retirement. The amount of the withdrawals and your ability to maintain that income for your lifetime are both pretty safe with this method. However, there is some amount of risk involved.
When you take systematic withdrawals from your portfolio you expose yourself to the sequence of return risk. As I have mentioned before this is the risk that you experience poor investment returns early in retirement, which has a significant impact on your savings.
Fortunately, there are ways that you can protect yourself from the sequence of returns risk. In this article I am going to explain a strategy of taking variable withdrawals from your portfolio. In addition to providing some protection from sequence risk, this strategy will help protect your portfolio from higher inflation as well.
Why Should I take Variable Withdrawals from my Retirement Portfolio?
Everything that affects your portfolio will change over the course of your retirement. Inflation, interest rates, investment returns, and taxes will all vary over time. Adjusting your withdrawals to account for these changes will help balance your spending to keep it in line with what your portfolio can support.
In fact, if you follow a retirement income strategy that calls for adjusting your withdrawals you can even afford a higher initial withdrawal. So, instead of taking an initial 4% and just adjusting for inflation you could take, for example, 5%. It may not seem like much, but it’s enough to matter.
Adjusting your withdrawals based on your account value may help you sleep better too. In turn, this could even give you better investment performance. The reason for this is common knowledge in the investment community. If you panic when the markets are bad, you may be tempted to sell and lock in your losses.
Taking smaller withdrawals when the markets are down will likely make you feel less anxious about the risk of running out of money. This may help you stay calm enough to avoid emotional investment decisions that hurt you in the long run.
How do I adjust my withdrawals?
In this section I’m going to explain how to adjust withdrawals based on changes in your retirement account. The adjustments I’ll demonstrate here are formally known as the Guyton-Klinger methodology. I’m going to break the process down into simple language.
There are four guiding rules to this strategy:
- Withdrawal Rule
- Portfolio Management Rule
- The Capital Preservation Rule
- The Prosperity Rule
In reality, the last two work as one rule. Taken together, these two rules help to establish “guardrails” around your withdrawal that keep it from drifting too high or too low.
The Withdrawal Rule
This rule is pretty simple and is very similar to what you have seen with the 4% rule – with a basic modification. Pick a set percentage of your portfolio to withdraw in the first year. For each year after, adjust your withdrawal by the prior year’s inflations. This is exactly like Bengens 4% rule.
The difference here is that you don’t make the inflation adjustment if portfolio returns are negative AND the new withdrawal would give you a withdrawal rate that is higher than the initial withdrawal rate.
The second part of that sentence was only added in the updated research by Guyton and Klinger. Guyton’s original rule simply called for forgetting the inflation increase when your investment return was negative.
Assume you start with a $500,000 dollar portfolio and take a 5% withdrawal in the first year. That’s $25,000.
Then, let’s assume that inflation for the year is 4.3%. You would adjust your withdrawal for the next year upward by 4.3%. You would take a $26,075 withdrawal for the next year.
The rule would be triggered if your investment returns are negative, say -1%, AND the $26,075 is more than 5% of the portfolio.
For this example a 1% loss plus a $25,000 withdrawal gives you a portfolio value of $470,000 for the second year.
$26,075 is 5.5% of $470,000. Since 5.5% is higher than 5%, you would forego the inflation increase and just withdraw the $25,000.
Portfolio Management Rule
The portfolio management rule addresses the way you rebalance your portfolio as the investment values of the different asset classes fluctuate.
Retirement Income Guardrails
The capital preservation rule and the prosperity rule can be taken together. Think of these two rules as establishing guardrails around your retirement income withdrawal rate.
Before we dig into an example let’s think about this conceptually. When you use the guardrails you are in effect placing a buffer around your savings. You adjust the amount of income you take from your portfolio, depending on the value of the account. If the account grows, you will increase your income. If the account value drops too much, you reduce your income.
How it works
To understand how the rule works think first in terms of your initial withdrawal rate from your portfolio. Let’s say that you begin your first year of retirement by withdrawing 5% of your portfolio. Considering a $500,000 portfolio, that would be $25,000. Next, you follow the standard rule of increasing your withdrawals each year for inflation.
The guardrails work like this:
- When your current withdrawal rate exceeds your original withdrawal rate by more than 20%, you reduce the withdrawal by 10%.
- When your current withdrawal rate lags your original withdrawal rate by more than 20%, you increase your withdrawal by 10%.
The Prosperity Rule
So, let’s say that for several years markets have been really good and your investments have performed well. Your account value has grown to $775,000 even though you have taken withdrawals for several years. Further, your withdrawal amount is now $28,000 due to inflation adjustments.
Ok. Here come the numbers…
$28,000 is only 3.6% of $775,000. The rule says to increase your withdrawal when your current withdrawal rate is 20% less than your original withdrawal rate. 20% of 5% is 1%. 5%-1%= 4%. Since 3.6% is less than 4%, you would increase your withdrawal by 10%.
10% of $28,000 is $2,800. You would take a withdrawal of $30,800.
In this case, the unexpectedly high investment gain means you can afford to take a larger amount of income from your portfolio.
The Capital Preservation Rule
This is the mirror image of the prosperity rule. If you account value drops too low you reduce your withdrawals to reduce the risk of running out of money too soon.
Looking at the same scenario from above, you have a $28,000 annual withdrawal. Instead of having really good investment performance, however, you experience an extended bear market and now only have $450,000 in your portfolio.
$28,000 is 6.2% of $450,000.
The capital preservation rule says that since your current withdrawal rate, 6.2% is more than 20% higher than your original 5% withdrawal rate, you need to reduce your spending by 10%.
10% of $28,000 is $2,800. Since your account value has dropped so much compared to your withdrawal amount, you would reduce your withdrawal that amount. Your new withdrawal is $25,200.
Using a variable withdrawal strategy can help you keep your retirement spending more in line with the value of your investments. It provides a prescribed way to spend more when your portfolio can sustain it, and also keeps you from draining your portfolio too quickly when investment returns are poor.