Retirees have long struggled with a difficult question: How much can you spend each year without going broke? Before the financial crisis, many analysts suggested that it was safe to make an initial withdrawal of about 4 percent of assets. But after markets collapsed in 2008, some advisors began suggesting that the old rule of thumb needed to be amended. “There are times when it is not realistic to stick to a 4 percent withdrawal rate,” says Christine Fahlund, senior financial planner with T. Rowe Price.
To protect portfolios in difficult markets, advisors have developed a variety of flexible strategies. The goal is to reduce withdrawals before the assets run dangerously low. Among the most intriguing systems is an approach developed by T. Rowe Price. Using Monte Carlo simulations, the company’s researchers considered the outlook for someone who retired in 2000 and started with a 4 percent withdrawal rate. In each succeeding year the withdrawal was increased by 3 percent to account for inflation. The investor had 55 percent in equities and the rest in fixed income.
At the beginning of the first year of withdrawals, the data suggested that the portfolio would last for 30 years under 89 percent of the simulations. But then the market suffered through two meltdowns—the downturn that came after the Internet bubble burst and the decline of the financial crisis. By the end of 2010, the portfolio had been depleted, and the odds of lasting for the full 30-year period had declined to 29 percent.
To improve the outlook for success, T. Rowe Price tried a variety of approaches. In one strategy, the retiree reduced withdrawals by 25 percent for three years after the bear market bottom. This would have raised the odds of success to 84 percent, but it could require retirees to trim their lifestyles substantially. For a less severe cutback, the retiree could have stopped taking annual inflation adjustments for three years after a bear market. This would increase the odds to 69 percent. “It is hard to find a guaranteed solution,” says Christine Fahlund of T. Rowe Price. “But it is possible to find strategies that may make clients feel comfortable with the probabilities of success.”
Should clients cut back withdrawals after minor market dips? Yes, says Jonathan Guyton, a principal with Cornerstone Wealth Advisors, a wealth management firm in Edina, Minnesota. He says that investors can start on an optimistic note and take an initial withdrawal of up to 5.5 percent. But if a portfolio suffers an annual loss, the retiree should not take an inflation adjustment during the next year. In addition, the annual payout should be reduced after periods when the market has slumped badly. Say the retiree starts with a 5 percent withdrawal, spending $50,000 from a $1 million portfolio. The next year, the retiree is scheduled to withdraw $50,000 plus an additional $1,000 to account for a 2 percent inflation adjustment. But stocks drop so much that the portfolio has less than $830,000 remaining. If the withdrawal is made according to the original plan, the payout would amount to more than 6 percent of assets, a 20 percent increase above the initial rate. To protect the portfolio, the withdrawal should be reduced by 10 percent.
While market declines can decimate portfolios, they also come with a silver lining, says Michael Kitces, research director of Pinnacle Advisory Group, a wealth management firm in Columbia, Maryland. As stock prices fall, the expected future returns increase. So during periods when stocks are cheap, retirees can take bigger withdrawals. Kitces advises clients to start with a withdrawal of 4.5 percent when stocks are expensive and the price-earnings ratio of the S&P 500 is above 20. If the multiple ranges from 12 to 20, the withdrawal rate can be 5percent.
When the market neared the trough in 2009, Kitces advised clients that they could set initial withdrawals at 5 percent. But now that the multiple has climbed back around 20, he is telling clients to only take 4.5 percent. Some clients who retired in 2008 now worry that they will have to reduce withdrawals. But so far there is no need to tighten belts, says Kitces. “What happened in 2008 was typical of bad stock markets that we have seen in the past, and the downturn should not derail long-term plans,” he says.
If difficult conditions persist for another few years, then Kitces says that he will have to revisit withdrawal rates. He will run the numbers to see if clients face the risk of exhausting assets. Those with skimpy portfolios will have to tighten their belts. But Kitces remains optimistic. He says that balanced portfolios could resume delivering their average annual returns of 8 percent. If such decent conditions persist for five years, then portfolios would swell and clients could consider taking bigger withdrawals. “If markets produce average returns, then you can afford to withdraw 6.5 percent,” he says.