When Chrystal and I got married, I soon realized there were some activities I thought I had long mastered but had actually been doing wrong. A case in point was loading the dishwasher. B.C. (Before Chrystal), I thought that if the dishes came out clean, the dishwasher had been properly loaded. After we got married, I found there was another criteria just as important as dish cleanliness – Her satisfaction that it had been loaded correctly.
After some remedial training, which included studying diagrams, I learned that while there may seem to be many equivalent approaches to dish loading, some are ‘more equal’ than others.
The same can be said for taking withdrawals from an investment portfolio. Although there is no one “best” strategy for taking distributions from your investments in retirement, research has shown that some are better than others. And, unlike washing dishes, if you find out the strategy being used is not optimal, you may not be able to just reload the machine and start over.
For many investors, there will come a time when the strategy for managing their portfolio switches from accumulation to distribution. The goal at that point will be to properly manage the portfolio so that it has a strong chance of meeting distribution requirements that can last 30 years or more.
There are many factors to take into account when managing a portfolio for distributions. The two main questions discussed in this piece are: 1) How much to take from the portfolio each year and 2) Which assets to take it from.
There are other items not addressed here which should also be considered in a withdrawal strategy. One is what should the initial asset allocation be. And should the asset allocation stay constant or adjust as the investor gets older and/or the portfolio is depleted?
Tax consequences of the withdrawals and estate planning goals are two other areas to address as they can be very costly to the nest egg if poorly handled. It would be wise to consult with professionals in those areas when designing your plan.
How much can you take annually from a portfolio and still have it last 30 years or more? Just as with most questions about the future, the answer is it depends. In this case there are also a couple of other considerations, only one of which you can control.
The first consideration is how you want those distributions to look. Do you want to receive the same amount every year with regular increases to keep up with inflation? Or would you like to start off with a larger distribution knowing that you may have to take less in some future years if the markets don’t perform?
The second factor, the one you cannot control, is how the stock and bond markets are going to perform over the first 5 to 10 years of distributions. When a portfolio is in distribution mode, the sequence of returns over time is just as important as the overall average return. Strong performance in the first few years of distributions will allow the portfolio to weather poorer performance in later years. On the other hand, substantial negative portfolio returns in the early years could drive the portfolio value low enough to deplete it prematurely, even with better returns later on.
3 Types of Withdrawal Strategies
Interestingly enough, not a lot of academic work on how the sequence of returns impacted a distribution portfolio had been done in this arena until 1994 when William Bengen published his seminal article. Using actual historical returns dating from 1926, he found that beginning with a 4% withdrawal rate indexed for inflation, a balanced portfolio would have lasted a minimum of 30 years.
Since then, that study has been updated and a substantial number of alternative strategies have been put forward and rigorously researched. These generally fall into 3 categories.
- Systematic Withdrawal/Rebalance Strategies
- Bucket Strategies
- Essentials and Discretionary (E&D) Strategies
Systematic strategies include Bengen’s 4% rule along with several variations which adjust the beginning distribution or allow for adjustments in subsequent years based on different criteria such as recent investment performance or whether the stock market is considered expensive or cheap.
Most bucket strategies are based on a systematic withdrawal rule but differ in portfolio allocation and rebalancing rules. A bucket strategy splits the retirement portfolio into separate accounts based on when the money will be used. The most common approach is 3 buckets. The first is invested very conservatively (cash) and holds 3-5 years of expected distributions. The 2nd is still invested fairly conservatively (bonds) and will hold the next 5 to 10 years of spending. The final bucket may not be tapped for 15 years or more and so is invested aggressively (stocks).
E&D strategies separate retirement income into 2 areas, money for life’s basic needs and then additional income for the extras. Enough money from the portfolio is used to create a guaranteed income stream to cover the needs portion. Typically this would be either a bond ladder or a fixed annuity. The rest of the portfolio would use a systematic or bucket strategy to generate distributions that could be used for discretionary spending.
If following a systematic withdrawal strategy, research shows that as long as the portfolio is rebalanced back to it’s intended allocation, it doesn’t matter where the funds are raised. In practice, the best time to take a distribution is during a rebalance as funds are being raised anyway.
Let’s say you take annual distributions and rebalance at that time. Let’s also assume the portfolio target is 60% stocks/40% bonds and that in the past year, the stock market has done better than bonds, moving the portfolio to 65% stocks/35% bonds. To get back to the 60/40 target you would need to sell stocks and buy bonds. Since you are taking a distribution, the money coming out of the portfolio is from the stock sales. The rebalancing step forces you to sell high and buy low and taking the distribution at the same time forces you to take funds from the best performing assets.
Systematic Withdrawal/Rebalance = Buy Low, Sell High
As part of their design, bucket strategies have rules which typically state that distributions will come from the cash and bond buckets during the first several years to allow the stock bucket a chance to grow. When the stock bucket does grow, profits are then taken from it and used to “refill” the more conservative buckets. As long as this is the case, the strategy looks very similar to a systematic withdrawal/rebalance strategy.
The difference between the 2 strategies comes to light when stocks enter a bear market. In a systematic strategy, bonds would be sold to generate the distribution and stocks would also be bought to bring the portfolio allocation back to target. The rebalance still forces you to sell high, buy low.
In a bucket strategy however, funds would be taken from the conservative buckets but the stock bucket would not get replenished. Psychologically, this may feel good. When the stock market is falling, our prehistoric brain takes over and tells us to seek safety. For most people, that would mean selling stocks instead of buying them. In this case doing nothing seems like a nice compromise.
Although they may be more comfortable emotionally, Bucket Strategy rules are inferior to Systematic Rebalancing
Unfortunately, this strategy also keeps us from buying stocks when they are on sale. The result is that, at best, the bucket strategy will do as well as systematic withdrawals. More likely, it will do a poorer job of protecting the portfolio, causing it to ultimately be drawn down faster.
Last, with the E&D approach, the ‘where’ is pretty simple also since everyday living expenses are already accounted for. For the reasons noted above, a systematic withdrawal and rebalance strategy should be used for the discretionary portion of the portfolio.