Drawing It Down: Taming Dynamic Retirement Withdrawals

Editor’s note: This is part 4 of “Drawing It Down,” a four-part series on drawdown strategies for current and future retirees. Previous installments looked at tweaks to the 4% rule, protecting against market risk, and dividing your retirement funds into time horizon buckets. This final segment explores dynamic withdrawal strategies.

Funds getting ready to emerge from the nest egg? After years of saving, you've hit or come close to your retirement goals. Congratulations; it's a huge financial achievement. But, as we have explored throughout this series, it may take some planning to make your savings last a lifetime.

The academics have crunched the numbers, and a relatively new approach—“dynamic withdrawal theory”—has gotten the nod from many in the financial advisor community. But the strategy may not be for everyone, as it requires both flexibility and discipline.

"There are different types of dynamic withdrawal strategies, but in general, these strategies are for someone who has the discipline to make changes to spending habits in the future," says Matthew Sadowsky, CRPC®, RICP, director of retirement and annuities at TD Ameritrade.

"Do you have the discipline to tighten the belt and reduce spending if needed—and also have the diligence to monitor investments to determine if they are tracking to the plan or if adjustments are needed?" Sadowsky asks. If so, this approach may be right for you.

Yeah, But … What Is Dynamic Withdrawal?

A couple of professors at Central Michigan University turned the tables on the traditional 4% withdrawal approach back in 2006, and the dynamic withdrawal concept has since gained traction as baby boomers live longer and may need to stretch their retirement dollars for more years. The basic concept factors in both remaining life expectancy and portfolio performance, and then adjusts consumption and spending accordingly.

The CMU professors R. Gene Stout and John B. Mitchell believe the dynamic approach can position retirees to better face the unexpected. In a nutshell, the team factors in remaining life expectancy and portfolio performance. Each year's withdrawal amount depends on the retiree's current age and remaining savings. If you are interested in the math, you can read their paper: Dynamic Retirement Withdrawal Planning.

The team found through their simulations that including life expectancy in the equation can reduce the probability of “outliving” a retirement portfolio, while increasing average lifetime withdrawal rates.

Adding Another Layer of Dynamism

The dynamic withdrawal approach is gaining traction, and others such as Jonathan Guyton, CFP and principal of Cornerstone Wealth Advisors, Inc., continue to fine-tune it.

In essence, Guyton’s work creates "guardrails" on retirement spending. He developed two decision rules—the “capital preservation rule” and the “prosperity rule”—which act as guardrails when market conditions cause the initial withdrawal rate to rise or fall significantly. Cutting withdrawals and spending when your portfolio is down could reduce sequence of returns risk.

To follow this approach, you would:

1. Apply the traditional 4% rule for the first withdrawal in the first year of retirement
2. In subsequent years, divide your current withdrawal amount by this year’s portfolio balance.
3. If that ratio rises by more than 20% from its initial level in a year, you should cut your spending level by 10%. Conversely, if the ratio falls by 20% in a given year, you would be allowed to increase your spending by up to 10%.
4. If the withdrawal amount is not increased or decreased by 10%, the withdrawal amount should be increased by inflation. If the portfolio has a negative return, the withdrawal amount should not be increased with inflation.
   

Is a Dynamic Approach Right for You?

Really, this is all a somewhat complicated way of saying that when your portfolio is performing well, enjoy it, but when it isn’t, a dose of penny-pinching can extend the life of your portfolio.

Of course, it may be best to talk over your retirement strategies with a professional to see what approach could fit best with your unique circumstances.

The bottom line is that, as a current or future retiree, you may wish to go beyond the 4% rule and consider risk management, bucketing, and a dynamic approach in order to maximize the effectiveness of your drawdown strategy.