Most new retirees face the same conundrum: how best to spend down their assets. One rule of thumb is to only spend portfolio interest and dividends. Another popular strategy is to withdraw 4% of the initial retirement balance and adjust the dollar amount annually to keep pace with inflation. Recently, studies have shown that a third spend-down option is more beneficial for many retirees. The new approach bases annual spending on the required minimum distribution (RMD) rules that apply to traditional IRAs.
Rather than relying on any generality, retirees should understand each strategy’s trade-offs and custom build a spending plan to match their financial goals in retirement, which may include maintaining a stable cash flow throughout retirement or leaving money to heirs. Any strategy chosen should focus on these goals while keeping expenses covered and minimizing the risk of running out of money. It’s a complex challenge, hence the appeal and widespread use of generalized spending guidelines. It’s of utmost importance for retirees to avoid blindly follow any of these overly simple rules.
Consider a retiree spending only the portfolio’s interest and dividends. His or her need for income may influence the asset allocation, leading him or her to a portfolio full of risky investments. Leaving the principal untouched may fit with a retiree’s goal of leaving money to heirs at the cost of hindering his or her lifestyle.
As for the popular 4% rule, the major issue is that it doesn’t respond to changes in market performance. For example, retirees drawing fixed dollar amounts from sinking portfolios due to poor market conditions will soon run into trouble funding their retirement.
A spend-down strategy based on RMD rules side-steps the issue raised by the 4% rule. Owners of traditional IRAs must draw minimum amounts from these accounts after age 70 ½. These amounts are calculated by dividing the year-end balance by a life-expectancy factor listed in IRS publication 590-B. Retirees of any age can use RMD calculations as a spending guidepost by dividing their total year-end portfolio balance by the listed life expectancy factor for their age.
A recent study by the Center for Retirement Research at Boston College found that the RMD strategy outperformed the other two strategies discussed, given a typical retiree’s asset allocation. Since the RMD approach calculates the annual withdrawal as a percentage of the remaining portfolio, it is responsive to investment returns, and the withdrawal percentages increase with age allowing retirees to use more of their portfolio as life expectancy decreases. However, this strategy isn’t perfect. It may result in withdrawal rates that are too low, particularly early in retirement causing retirees to leave behind money that they would’ve preferred to have spent. If the market is entering an extended period of low returns, retirees may want to keep spending rates conservative.
The problem with these types of “simple rules” is that while they work well for the average retiree, very few people actually have the asset allocation and retirement funding of the “average retiree”. Even if you fall perfectly at the top of the bell-curve, these guidelines can lead you astray: one key factor that all of these common suggestions ignore is the tax implication of how, when, and from which accounts retirees withdraw their money.
Part of the value we bring to our clients is the ability to help them determine and implement a means of accessing their savings tailored to their individual finances and goals while minimizing tax consequences during retirement.