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Retirement: Dynamic Withdrawal Theory Matures with Boomers

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April 27, 2015
dynamic withdrawal for retirement

Nine years after a couple of professors at Central Michigan University upended retirement planning with the notion of dynamic withdrawal instead of fixed withdrawal, the concept continues to gain traction. That’s because many baby boomers, who make up the largest population wave in U.S. history, are living longer and may need to rewrite the retirement playbook more than once. 

Longevity is the payoff of medical technology and cleaner habits. But it packs consequences, as traditional portfolio makeup and the inflation-beating market performance needed to fund those bonus years are not always available. Boomers who may have had a large portion of retirement assets tied up in stock may still be stinging from the stock market letdown of 2007, even though the market has come roaring back since. It's interesting to think that the youngest boomers are staring down 50; they know their retirement could look much different from that of their parents and grandparents.

It makes sense that a dynamic generation needs dynamic retirement thinking.

Dynamic How?

At its core, dynamic withdrawal factors in remaining life expectancy and portfolio performance. That means if the market is underperforming, you’ll need to adjust your retirement “consumption” (as the profs like to say). More people may be warming to the pitch in recent years. Ultra-low interest rates and stronger correlation between stocks and bonds have fueled the change in thinking.

Dynamic withdrawal also lets retirees adjust their expenses in order to take advantage of the sweeter side of life when markets are performing exceptionally well. Think of this as withdrawal changes that let you "maximize happiness."

But is dynamic withdrawal the game changer that proponents claim? Consider that the most prominent fixed strategy, the 4% rule, is itself only a few decades old. It looks like this: the first-year retirement withdrawal is set at 4% of the initial portfolio. Withdrawals increase at the inflation rate each year thereafter.

Plenty of folks think this fixed strategy works just fine, or at least as well as can be expected when unforeseen expenses hit or the market disappoints. And the math is relatively simple.

Say What?

But those CMU professors—R. Gene Stout and John B. Mitchell—and the legions who learn and promote dynamic withdrawal (Morningstar, for one, has crunched quite a few models) believe it can potentially position retirees to better face the unexpected.

The conversation gets a little wonky when talking about dynamic withdrawal, but the math and science of retirement planning is important to their case. The primary performance measure for a retirement strategy is the failure rate—that is, the percentage of Monte Carlo runs or historical simulations where the retiree depletes savings over a specified time frame. Tests with different asset allocations determine the allocation that results in the lowest failure rate. Those tests can, and should, be repeated throughout retirement.

In their report, Stout and Mitchell noted that the inclusion of mortality in fixed planning horizon models reduces the probability of retirement-portfolio ruin by almost 50%. And when compared to fixed withdrawal rate models, dynamic withdrawal management incorporating mortality reduces the probability of ruin by another 35% to 40% while increasing average lifetime withdrawal rates by nearly 50%. Ideally, this approach allows retirees and financial planners to improve the probability of retirement portfolio success, while simultaneously increasing the average withdrawal rate.

Joe Tomlinson, actuary and financial planner with ValueWalk, stresses in a blog post that dynamic calculations should not be simplified to only re-running fixed strategies each year with updated figures. Instead, plenty of factors come into play. His tables may help you fill in some of the blanks, but see his full analysis, where Tomlinson factors in age, expenses and other details.

Fixed withdrawal

FIGURE 1: FIXED VIEW. This table offers a comparison by stock/bond mix based on a fixed withdrawal strategy, or the 4% rule. The average consumption column shows the average yearly consumption based on 10,000 Monte Carlo simulations. The failure percentage—the standard downside measure used in retirement research—is included, plus a Tomlinson-crunched average shortfall that combines the probability, magnitude, and duration of failure. The final column shows the median bequest. Source: Joe Tomlinson. For illustrative purposes only. Past performance does not guarantee future results.

Dynamic withdrawal

FIGURE 2: DYNAMIC VIEW. This table is based on a strategy where each year's withdrawal depends on the retiree's current age and remaining savings. Included is a pricing model to calculate an inflation-adjusted withdrawal rate. If that amount plus Social Security is insufficient to meet an assumed $50,000 of basic living expenses and there are remaining savings available, the withdrawal increases to fill the gap. The process rolls forward each year with stochastically generated returns on savings, causing the withdrawals to vary. Source: Joe Tomlinson. For illustrative purposes only. Past performance does not guarantee future results.

Dynamic is Not Without Detractors

It isn’t always simple to anticipate spending needs, let alone the challenge of fine-tuning the investment combo needed to outrun inflation or low-interest returns without potentially jeopardizing the relatively low-risk bias desired in retirement. So, the math and even the formula for dynamic may have to be adjusted with any social changes and market fluctuations, begging the question, how often should we tinker?

In an interview earlier this year with MarketWatch, Stout and Mitchell were asked to look back on the formula. They stressed, “as retiree utility functions are quantified, mortality is predicted, and returns are forecasted, models will have to be updated to incorporate changes in national and international financial markets, changes in mortality, and returns heteroscedasticities.”

How’s that for a $25 word?

We said this stuff isn’t exactly easy. But it’s not rocket science, either, especially with a little help from your finance professional who might get you started with a budget plan today.

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