Brandon Renfro is back in the studio with Devin to continue the conversation about retirement income distribution strategies. According to multiple surveys, the number one financial fear in retirement is running out of money. How do you take money out of your accounts in a way that is safe, in terms of running out of money, and is also tax efficient?
Last week, Devin and Brandon talked about some of the nitty-gritty details and a couple of different strategies for taking money out of your accounts based upon the account’s tax status and how it will impact the taxation of your Social Security income.
This week, we’re moving up from the account level to the big question: “How are you going to take your money out so that it lasts?” Then, once you have a plan for which accounts you should access in which order, how are you going to figure out the amount of income to take out from your portfolio?
First, how much do you need? Devin says he is surprised by how many people come in and have no idea how much income they are going to need in retirement. Figuring out how much you need in retirement is a critical part of the planning.
Second, how are you going to make sure that your money lasts? It’s a balancing act: you want to take as much income as possible, while still being relatively confident that you won’t run out of money.
Brandon suggests you think about the different types of distribution methods:
- Investment-based or probabilities-based types of approaches, where you have an investment account, where you take calculated risks and you can model out the likely outcomes.
- Flooring approach, where you establish some sort of guaranteed minimum income level.
- Bucket approach, which is a common way of planning for retirement income.
This week, we’ll talk about the probabilities-based approaches, and next week, we’ll talk about the flooring approach and the bucket approach.
Probabilities-based approach: Calculated risks
First, Devin and Brandon have a conversation about the 4% rule. Here’s how this rule works: You retire. That firsts year’s distribution, you take out 4% of your account’s withdrawal, and you adjust it each year for inflation. The original research that this rule is based on is a 50/50 split of equities and bonds. Further research shows that if you start to drop below the 50/50 ratio of fixed income to equities, that the 4% rule doesn’t work so well. There’s a practical element to this research: As people move into retirement, it is somewhat natural to think that they need to pull back on the aggressiveness of their portfolio, but if you’re not careful, and you pull back too far, then you’re moving backwards. If you’re working through this for yourself, you need to be aware of this.
Why 4%? What the researcher wanted to know was what withdrawal rate would allow the portfolio to last for 30 years. This is important because your retirement may not be 30 years, and you may have to adjust your withdrawal rate to fit the anticipated length of your retirement.
Now, you have to understand that this study couldn’t find a 30 year period where the value of the portfolio would be less than zero. By definition, if we’re saying that this was the withdrawal rate that never depleted the portfolio, that means that there are a lot of times where the portfolio ended at greater than zero, and in fact, in most cases, the ending value of the portfolio is a multiple of the starting value. Why might that be somewhat of a bad thing? You’ve limited your consumption possibilities during retirement to ensure that you didn’t run out of money, but you’ve left a lot of money after you’re gone.
Often, a parent doesn’t want to leave a bunch of money behind. Brandon says, “Everything in finance is a tradeoff.” You can withdraw money in a way that is more likely to preserve your principal, but you have to understand that the negative consequence of that is that you may be leaving a huge amount of money to your heirs. On the other hand, you can withdraw more throughout your lifetime, but you’re increasing the potential chances that you might run out of money. That’s where a good financial educator can help you make an informed decision.
So, how can you monitor a higher withdrawal rate to ensure that you won’t run out of money?
Putting Guard Rails Around the Distribution
There are a couple of different rules within this framework. The general idea is that you take an initial distribution. Instead of adjusting that distribution just for inflation, you also consider how the market is doing.
If at any point, your current withdrawal rate is either greater or less than 20% of the initial withdrawal rate, then you adjust your withdrawal to fall within that amount. So if your initial distribution is 5%, you would never take out less than 4% or more than 6%.
The capital preservation rule has you reduce your withdrawal rate to keep it within the guard rails.
If your portfolio is growing, then the prosperity rule has you increase your withdrawal up to 20% more than the original distribution (after you’ve already adjusted for inflation.)
What’s the trade-off with this scenario? You don’t get a level amount of income from year to year – you could have as much as a 10% variation in income from year to year.
Join Brandon and Devin next week to continue the conversation about withdrawal strategies. They’ll be discussing flooring methods and the bucket method.
How the 4% rule isn’t 4% if you apply it to the Japanese market
How the sequence of return risk can impact your withdrawal strategy
Resources mentioned in this episode:
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