Retirement is a time to enjoy the results of your hard work, but deciding how to turn your savings into steady income can feel challenging. Many retirees experience stress and anxiety about transitioning from accumulating to spending their hard-earned savings. This post simplifies some of the most popular retirement income strategies to help you feel confident about your financial plan.
The Importance of a Disciplined Withdrawal Strategy
Having a clear withdrawal plan in retirement provides guidance during the ups and downs of the stock market and helps minimize the chance of outliving your savings. It’s about balancing your income needs, risk tolerance, market volatility, and long-term goals like leaving a legacy or supporting charitable causes. A good strategy offers direction and confidence, ensuring you can cover your essentials while adapting to changes and enjoying the lifestyle you’ve worked so hard to achieve.
Common Retirement Withdrawal Methods
Here are a few widely recognized strategies, presented in a straightforward manner:
1. Constant Dollar Withdrawals
This method involves withdrawing a fixed amount from your portfolio each year, adjusted for inflation, regardless of market fluctuations. A popular example is the 4% rule, where you withdraw 4% of your portfolio in the first year of retirement and adjust that amount annually for inflation. For example, with a $1,000,000 portfolio, you would withdraw $40,000 in the first year. Each subsequent year, you increase the withdrawal slightly to account for inflation, maintaining your income level regardless of how the markets perform.
Pros: Provides predictable income, as long as your portfolio grows sufficiently to support withdrawals.
Cons: Doesn’t adjust for stock market performance, so if your initial withdrawal rate is too high, there’s a risk of depleting your savings over time. However, historically, many retirees have ended up with significantly more assets than they started retirement with when using this method. This outcome might suit those with a substantial legacy goal, but for retirees aiming to spend more of their savings during their lifetime, it could result in leaving too much money on the table.
2. Percent of Portfolio Withdrawals
Instead of withdrawing a fixed amount, you take a set percentage of your portfolio’s value each year. For example, if your portfolio is worth $1 million and you withdraw 4%, you’d take $40,000 that year, leaving $960,000 in the portfolio. If the stock market increases by 10% the following year, your portfolio would grow to $1,056,000, and your withdrawal for that year would rise to $42,240 (4% of the new balance). On the other hand, if the market drops by 10%, your portfolio would decrease to $864,000 after the decline, and your withdrawal would drop to $34,560 (4% of the new balance). This approach adjusts withdrawals based on portfolio performance, preserving your savings during downturns but resulting in variable income.
Pros: Adjusts to market fluctuations, helping to ensure you don’t deplete your portfolio.
Cons: Income varies, which might be challenging for budgeting, especially if you have high fixed costs with little wiggle room.
3. 1/N Strategy
N represents the years of your estimated remaining life expectancy. With this approach, you divide your portfolio balance by the number of years you expect to live. For example, if you have $500,000 and estimate 25 years of retirement, you would withdraw $20,000 in the first year. Next year, you divide the remaining balance by 24 years, and so on.
Pros: Tailors withdrawals to your remaining savings and expected lifespan. Generally allows you to spend more during your lifetime compared to other withdrawal methods.
Cons: Requires frequent recalculations and relies on accurate life expectancy estimates. This approach is best suited for retirees with fixed income sources, such as Social Security, pensions, or annuities, that cover essential living expenses while using their portfolio to cover discretionary expenses. However, it may not be ideal for those with a legacy goal or a strong desire to leave significant assets to heirs or charities.
4. Variable Percentage Withdrawal (VPW)
The Variable Percentage Withdrawal (VPW) method integrates features of various withdrawal strategies, including constant-dollar, constant-percentage, and 1/N approaches. It calculates withdrawals based on your remaining life expectancy, asset allocation, and portfolio size. Withdrawals are adjusted based on your portfolio value monthly, quarterly, or annually, depending on your preference, offering flexibility while helping to manage the risk of depleting your funds over time.
Pros: Adapts to market conditions, allowing for a sustainable plan tailored to portfolio performance. The VPW spreadsheet is user-friendly and includes a “required flexibility” section that illustrates how much you might need to cut back during market downturns. It also models the impact of your asset allocation on retirement spending, highlighting trade-offs like the possibility of higher potential income with more aggressive allocations also requiring sharper income cuts during market declines.
Cons: Income can fluctuate significantly from year to year based on market performance. Additionally, VPW assumes you plan to spend down your entire portfolio. If you have legacy goals and wish to leave assets to heirs or charities, you may want to exclude those amounts from your portfolio when applying the VPW method.
5. Guardrails Approach
The guardrails approach, introduced by researchers Jonathan Guyton and William Klinger, enhances the classic ‘4% rule’ by adding flexibility based on market performance. This method adjusts withdrawals using predefined “guardrails”: you increase spending after strong market years and reduce it during weak ones. For example, if your withdrawal rate falls below 20% of the initial rate, you might increase withdrawals by 10%. Conversely, if your withdrawal rate exceeds 20% of the initial rate, you might decrease withdrawals by 10%. Additionally, you could incorporate an inflation adjustment rule, skipping inflation increases after a down year in the market.
Pros: Offers a balance of flexibility and sustainability, particularly when withdrawals are recalculated frequently to respond to market changes. This approach helps preserve your portfolio during downturns while allowing for higher spending in favorable markets. By adapting to market performance, it often enables retirees to spend more than the traditional 4% rule, especially when markets perform strongly over time.
Cons: Requires consistent discipline to follow the rules, especially during challenging years. The method’s complexity may overwhelm some retirees who prefer simpler strategies.
6. CAPE-Based Withdrawals
This method ties withdrawals to the Cyclically Adjusted Price-to-Earnings (CAPE) ratio, a measure of market valuation. Historically, high CAPE ratios have often been followed by market downturns, such as in 1929 or 2000. However, some critics question its reliability, as market valuations have remained high in recent years without a major crash. With this approach, you withdraw less when valuations are high and more when they are low, aiming to align withdrawals with market performance. Karsten Jeske has extensively covered the CAPE-Based Withdrawal method in his ‘Safe Withdrawal Rate’ series and provides a helpful spreadsheet for implementing this strategy.
Pros: Adjusts withdrawals to market conditions, potentially reducing the risk of depleting savings during high-valuation periods.
Cons: More complex and requires an understanding of market valuation metrics. If the CAPE ratio fails to be predictive, you may either spend too much and risk depleting your savings or spend too little and leave significant resources unused.
Choosing the Right Withdrawal Strategy
The best distribution strategy depends on your unique situation, including:
- Your spending needs and flexibility.
- Your risk tolerance and market outlook.
- The size and composition of your retirement accounts.
- Other income sources, such as Social Security, pensions, or annuities.
Final Thoughts
Retirement is meant to be enjoyed, not spent worrying about your finances. By selecting a withdrawal strategy that fits your unique goals and circumstances, you can focus on making the most of this exciting phase of life. Speaking with a financial planner can help you determine the approach that aligns with your needs, whether it’s balancing income requirements, market volatility, risk tolerance, or long-term objectives like leaving a legacy or supporting charities.
There are also many withdrawal methods beyond the ones discussed here, each with its own merits. The key is finding a strategy that provides guidance through market ups and downs while minimizing the chance of outliving your savings. If you’re unsure where to start, consulting a financial planner can give you clarity and confidence as you navigate your retirement journey.
