Most clients approaching retirement struggle with the same issue: how to create a sustainable income from their assets without completely depleting them.
One popular strategy assumes that many retirees simply can spend up to 4% of their savings annually, adjusted for inflation, without worrying about running out of money. Another rule of thumb is to spend only the portfolio’s interest and dividends, leaving the principal untouched.
But there are drawbacks to both these strategies.
A client looking to spend only interest and dividends may take on too much risk, loading up unduly on high-yielding stocks, says Anthony Webb, research economist with the Center for Retirement Research at Boston College.
As for the 4% rule, it doesn’t allow clients to adjust their spending patterns periodically in response to actual investment returns, Webb maintains. More important, retirees drawing fixed dollar amounts from a declining portfolio will soon come up short.
A better option may be to base annual spending on the U.S. Internal Revenue Service’s (IRS) required minimum distribution (RMD) rules (similar to those governing registered retirement income funds in Canada), which force investors to begin taking a minimum amount of money out of tax-deferred savings plans at age 70.5.
In a recent study, entitled Should Households Base Asset Decumulation Strategies on Required Minimum Distribution Tables?, Webb and colleague Wei Sun, of China’s Renmin University, found that an RMD strategy outperformed the “spend only the income” strategy and the 4% rule. The researchers analyzed a hypothetical married couple of 65-year-old retirees having $250,000 in assets, excluding their home.
To compare this strategy with others, they developed a measure called “strategy equivalent wealth” (SEW), which represents the factor by which the value of the couple’s wealth at age 65 would be multiplied so that they would be as well off as a household that followed the optimal strategy.
The 4% rule had an SEW of 1.49, making it the worst method of the strategies analyzed. The RMD formula had an SEW of 1.39, while depending on interest and dividends had an SEW of 1.36.
A modified RMD strategy that utilizes interest and dividends, in addition to the RMD percentage, actually proved most effective, with an SEW of 1.03.
The success of some sort of RMD strategy lies in its simplicity, according to the researchers.
First, it is easy to follow. The IRS stipulates withdrawal percentages based on life expectancy tables.
Second, an RMD strategy allows the percentage of remaining wealth consumed each year to increase with age, as the retiree’s remaining life expectancy decreases.
Third, because spending is not restricted to income, the household is less likely to chase dividends and is more likely to maintain a balanced portfolio.
And fourth, consumption responds to fluctuations in the market value of the financial assets, because the dollar amount of the drawdown is based on the portfolio’s current market value.
One potential criticism of the RMD rule is that it results in relatively low consumption early in retirement. Although this outcome might work for some clients, others might prefer to have more income at a younger age, when they are better able to enjoy it.
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