For clients, determining the best way to cash out their retirement accounts and ensuring that their money will last as long as they do is a major concern, particularly for those clients without guaranteed pensions.
Although acknowledging that the safe withdrawal rate in retirement isn’t something that can be neatly packaged into a rule of thumb, most experienced financial advisors have a favourite formula of creating retirement income.
A recent study by Chicago-based Morningstar Inc. entitled Optimal Withdrawal Strategy for Retirement Income Portfolio has analyzed five drawdown strategies for retirement savings using Monte Carlo-style simulation analysis.
The study’s purpose was to develop a “withdrawal efficiency rate” (WER) that compares the withdrawals received through following a specific strategy with what could have been obtained had both client and advisor had perfect information at the beginning of retirement.
The researchers determined that one of the most popular methods – withdrawing 4% of the account balance in the first year of retirement, then increasing that amount by the rate of inflation each year thereafter – is often the least efficient. As cash flow in retirement using this method is determined independently of the returns of the portfolio, even modest losses early in retirement can prove disastrous.
And although simply withdrawing a fixed percentage of the portfolio’s value each year, like for an endowment, may seem the most straightforward approach, it also falls short unless the chosen percentage is extremely low.
On the other hand, plans that dynamically adjust for changes in both market and longevity can beat these more traditional methods. The best withdrawal strategy, the research concluded, involves basing the annual withdrawal on the number of years remaining in the client’s life expectancy while maintaining a constant probability of failure for that period.
Withdrawal amounts – which vary depending on the equities allocation of the portfolio, as well as the year – were chosen in order to keep that probability of failure constant through time.
One appeal of this approach is that it can work regardless of where clients find themselves in retirement. By using a duration-based measure that effectively creates a distribution path, advisors can follow up each year with respect to how much retirement income can reasonably be achieved.
Morningstar’s researchers looked at different outcomes for various ages and asset mixes while using this optimal strategy. The initial withdrawal percentages for a balanced portfolio containing 40% equities for couples at the age of 60, 65, 70 and 75, the study notes, start at 4.7%, 4.9%, 5.3% and 6.4%, respectively.
For preliminary “ballpark” discussions with clients, the researchers found another method to be a reasonable alternative. Each year, you would divide the numeral 1 by your client’s remaining life expectancy, as based on standard mortality tables.
For example, say the life expectancy of a couple, both aged 65, is 28 years. Using this approach, the study suggests, the couple could withdraw 3.6% in the first year of retirement. IE
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