This post was part of a series about managing how you spend your investments, if you aim to live long, live within your means, and, perhaps, leave some for others. The main ideas have been updated and moved to an article on Retirement Income, on the Retired Now menu. If you wish, you can still read the original series, using the links below.
- Retail strategies, using all-in-one mutual funds. Simple solutions that work for some. This post.
- Insurance strategies, using Social Security and maybe some annuities. Part of everyone's plan.
- Endowment strategies, adapted from foundations and universities. Good for a reserve fund.
- Finance strategies, based on life-expectancy and future payments. Really good, simple methods.
- Smooth consumption, a comprehensive method that uses excellent, free software.
- Do-It-Yourself payouts drawn from the best, most accessible aspects of the other strategies.
What's a Retail Strategy for Payouts?
The core ideas for a retail strategy are to use an all-in-one fund from your investment firm, and to withdraw from the fund by a simple method that requires the bare minimum of calculations.
Most investment firms offer an all-in-one fund intended for retirement income. It is typically where a target-date fund will land as it glides to your retirement date. These funds tend to be conservative, with 30% or 40% invested in stocks and the rest in various bonds. For a lengthy period of withdrawals, such as the 30-to-40 years that many retirees may experience, retirement-income funds may be too conservative. If you use our retirement calculator, for example, you will get recommendations for a higher allocation to stocks, given a spending period of, say, 30 years, starting in the current year. To cover a range of options, I ran a study with two simulated all-in-one portfolios:*
To take withdrawals from the simulated all-in-one portfolios, I studied three tractable methods:
Most investment firms offer an all-in-one fund intended for retirement income. It is typically where a target-date fund will land as it glides to your retirement date. These funds tend to be conservative, with 30% or 40% invested in stocks and the rest in various bonds. For a lengthy period of withdrawals, such as the 30-to-40 years that many retirees may experience, retirement-income funds may be too conservative. If you use our retirement calculator, for example, you will get recommendations for a higher allocation to stocks, given a spending period of, say, 30 years, starting in the current year. To cover a range of options, I ran a study with two simulated all-in-one portfolios:*
- 35% U.S. stocks (S&P 500), 50% 10-Year U.S. Treasury Bonds, 15% 2-Year U.S. Treasury Notes
- 65% U.S. stocks (S&P 500), 20% 10-Year U.S. Treasury Bonds, 15% 2-Year U.S. Treasury Notes
To take withdrawals from the simulated all-in-one portfolios, I studied three tractable methods:
- Flat 5%. In December, an amount corresponding to 5% of the portfolio's value was calculated. That amount was then withdrawn in January, to be deposited in a bank savings account and spent over the next 12 months.
- 4%-or-RMD. Instead of a flat 5%, the amount withdrawn was the larger of (a) 4% of the portfolio's December value, or (b) the Required Minimum Distribution (RMD) for a traditional IRA, 401(k), or other retirement account, as defined by the Internal Revenue Service. Investment firms often provide RMD calculators. Before age 70, RMD is not defined for a retiree; after age 72, it exceeds 4% and increases each year.
- Inflated 4%. This method is well-known and much-debated. In the first January, 4% of the portfolio's December value is withdrawn and saved to cover current-year expenses. The next year (and every year thereafter), the annual dollar amount of the withdrawal is increased by the previous 12-month percentage increase of the Consumer Price Index (in the same manner done for inflation-indexed Social Security benefits). In my study, if the previous 12-month period experienced deflation, the withdrawal was decreased correspondingly, to keep the payout aligned with consumer prices. This did happen occasionally in the historical data.
Risks and Results
To understand the advantages and disadvantages of each method, consider the payout risks likely to be of concern to retirees:
1. Inflation. Each annual withdrawal was adjusted for inflation, pegged to the purchasing power of dollars in the first year. As one example, for the 30-year period 1938-1967, which included a stiff round of inflation in the 1940's, here's how the three methods fared, using the 35% portfolio:
1. Inflation. Each annual withdrawal was adjusted for inflation, pegged to the purchasing power of dollars in the first year. As one example, for the 30-year period 1938-1967, which included a stiff round of inflation in the 1940's, here's how the three methods fared, using the 35% portfolio:
- Flat 5% was the worst of the three for 1938 retirees. Over the 30 annual payouts, the median (middle) withdrawal had a value of $63 compared to $100 in the initial year. Had you been able to buy 10 meals at $10 apiece in the first year, then over the rest of the period you typically could afford to buy only 6 meals. Some years, the number was even lower; others, a bit higher, but never more than $106.
- 4%-or-RMD afforded good protection against inflation for 1938 retirees, although with some variation year-to-year. The median (middle) value was $101. In the worst year, it was $70 (sorry, only 7 meals); in the best, $135 (splurge on three more veggie burgers or whatnot!).
- Inflated 4% provided exactly the rock-solid consistency it is designed to offer. Every year, the purchasing power remained steady at $100.
What about periods that started in other years, not just 1938? The charts above and below show the median (middle) real (inflation-adjusted) buying power, across all the time periods studied. The first chart is for the 35% portfolio; the second one, 65%. The message of the charts is that for consistency in matching inflation, the Inflated 4% method is best. It always provided a $100 payout, every year, in every time-period, for both the 35% portfolio and the 65% portfolio. However, on average, the 4%-or-RMD method, although quite variable, was even better. The middle (median) value overall for 4%-or-RMD was $114 in the 35% portfolio, and $141 in the 65% portfolio. Finally, the Flat 5% method was fine overall in the 65% portfolio, with a median of $104, but not in the 35% portfolio, where the median was $78.
Perhaps the main implication is a warning. To protect against inflation, don't use the combination of a conservative portfolio and a flat-percentage rate of withdrawal.
2. Payout Volatility. If a method of withdrawal generates consistent payouts over the years, budgeting is easy. If not, it may be hard to plan your spending. One way to gauge this risk is to look at the spread from the highest to the lowest payout, over a given 30-year period. As a baseline, I used a $100 a payout in year one, and for direct comparison, I pegged all values to year-one dollars. The results were as intimated above. Payout volatility, as measured by the average gap between the highest and lowest payouts in a 30-year period, was ...
3. Longevity. Will you outlive your portfolio? Or will it pay its last dollar before you take your last breath? In the study reported here, this risk can be judged by looking at two indicators:
- Lowest, literally zero, for the Inflated 4% method.
- Middle, and rather high at $71, for the Flat 5% method.
- Worst, and very high at $145, for the 4%-or-RMD method. Note, however, that much of this volatility was on the upside. On average, over all 30 periods, the minimum payout was $84 and the maximum was $229.
3. Longevity. Will you outlive your portfolio? Or will it pay its last dollar before you take your last breath? In the study reported here, this risk can be judged by looking at two indicators:
- Did the payout ever fall to zero, within the 30-year period?
- After 30 years, what percent of the portfolio remained unspent? For this question, I adjusted the final portfolio value for inflation, to express it in constant, first-year dollars.
The answers are in the charts above (for the 35% portfolio) and below (for 65%). Just when you thought the Inflated 4% method was looking good, here comes its ugly side. In the chart above, for 1937 retirees, this method depleted a 35% portfolio after 27 years. It nearly did the same for 1939 and 1940 retirees in the 35% portfolio, and twice again in the late 1960's for the 65% portfolio. Among the three methods, it was by far the most erratic. In comparison, the 4%-or-RMD method did the best job of spending down the portfolio consistently for 30 years and retaining a modest cushion for a longer life-span, while never coming close to depletion. As shown in the two charts, it held a value after 30 years that was between 40% and 100% of the original portfolio.
Bottom line: 4%-or-RMD is best for longevity, neither leaving too much unspent nor falling to zero.
4. Emergency. Which of the methods and portfolios provides the best backstop for unplanned expenses, such as a medical emergency or loss of expected income from a spouse or partner? The best metric for this risk is the minimum value to which a portfolio falls at any point in the 30-year period. The higher the minimum, the greater is the cushion for emergencies. By this criterion, the Inflated 4% method is ruled out altogether, as it allowed the portfolio to fall to zero (or very close) in several of the time-periods. The best method was Flat 5%, where the overall minimum was 40%. The 4%-or-RMD method was not far behind, at 32%.
For any given method, there was not much difference between the minimums for the 35% and 65% portfolios.
The conclusion in this case is another warning: To guard against emergency expenses, don't use the Inflated 4% method.
5. Bequest. If your goal is to leave an inheritance for children or charities, what method best limits the risk of falling short? To quantify the risk, two measurements are needed. One is the minimum portfolio value; if it goes to zero, there's no bequest. This rules out the Inflated 4% method. The other is the average ending value; it should be as high as possible. By this measure, Flat 5% scored higher (89%) than 4%-or-RMD (64%).
Bottom line: To leave a bequest, don't use the inflated 4% method, and view Flat 5% and 4%-or-RMD as you first and second choices, in that order.
4. Emergency. Which of the methods and portfolios provides the best backstop for unplanned expenses, such as a medical emergency or loss of expected income from a spouse or partner? The best metric for this risk is the minimum value to which a portfolio falls at any point in the 30-year period. The higher the minimum, the greater is the cushion for emergencies. By this criterion, the Inflated 4% method is ruled out altogether, as it allowed the portfolio to fall to zero (or very close) in several of the time-periods. The best method was Flat 5%, where the overall minimum was 40%. The 4%-or-RMD method was not far behind, at 32%.
For any given method, there was not much difference between the minimums for the 35% and 65% portfolios.
The conclusion in this case is another warning: To guard against emergency expenses, don't use the Inflated 4% method.
5. Bequest. If your goal is to leave an inheritance for children or charities, what method best limits the risk of falling short? To quantify the risk, two measurements are needed. One is the minimum portfolio value; if it goes to zero, there's no bequest. This rules out the Inflated 4% method. The other is the average ending value; it should be as high as possible. By this measure, Flat 5% scored higher (89%) than 4%-or-RMD (64%).
Bottom line: To leave a bequest, don't use the inflated 4% method, and view Flat 5% and 4%-or-RMD as you first and second choices, in that order.
Summary
Among the methods examined in this study, using all-in-one funds, none of the alternatives was best on all the risks. Each had some weaknesses. The Inflated 4% method was unique, however, in having some risks one might consider to be fatal. Its poor showing on longevity and emergency preparedness would make it ill-advised for many investors and retirees. Happily, as explained in the post on finance strategies, a modified version of the Inflated 4% method can overcome its limitations. For any of the methods, the key may be to adopt a combined strategy, managing some portion of assets with one method and the remainder with a different method. For example, one might establish one account for emergency preparedness and bequests, to be managed in one way, and handle retirement withdrawals in a separate account, by a different method. To learn more, read the related article on Retirement Income, or try our Safe-Payout calculator, or use the links at the beginning of this post.
Disclaimer: Historical data cannot guarantee future results; your results may differ. Although a mixture of bonds and stocks may be safer than investing exclusively in one class of assets, diversification cannot guarantee a positive return. Losses are always possible with any investment strategy. Nothing here is intended as an endorsement, offer, or solicitation for any particular investment, security, or type of insurance.
* Monthly data for stocks and 10-Year treasures came from Shiller. For 2-year treasuries, I did a regression analysis on 10-year treasuries, 2-year treasuries, and 3-month T-bills for the years 1976 to 2014, using data from the St. Louis Federal Reserve (FRED) database. The analysis generated an equation that predicted 2-year treasury interest rates as a function of 10-year treasury rates and 3-month T-bill rates. The regression model explained 99% of the variance in 2-year treasure rates for 1976-2014. I then applied that model retrospectively to historical 10-year treasury and T-bill rates, going back to 1920. A similar model used 10-year treasury rates alone to estimate what 2-year rates would have been from 1871 to 1919. This model, while less precise, nonetheless explained over 90% of the variance for 1976-2014
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