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LOTS OF RESEARCH has been done on the best way to generate retirement income. It’s one of the most popular topics on HumbleDollar. I think this popularity is driven by two things: its obvious importance—and the fact that there’s no one right answer.
By contrast, figuring out how much we need to save for retirement is relatively easy. It isn’t hard to pick a future retirement date, or at least a range of years during which we’ll likely retire, and then figure out how much we ought to be saving. But when it comes to generating retirement income, none of us knows how long we will live, what markets will do or what our health care needs will be. There are also subjective questions, like how much do we want to leave to our heirs?
Last November, Morningstar released a report analyzing a variety of methods to determine a retiree’s safe portfolio withdrawal rate. At 59 pages, it’s quite extensive, but well worth the read. It analyzes several withdrawal strategies, provides pros and cons for each, and ends with a process to develop an individual retirement income plan.
One of the options it considered is the so-called RMD withdrawal strategy. Under this plan, annual withdrawals are based on your portfolio’s previous year-end balance. You withdraw a percentage of your portfolio consistent with the required minimum distribution (RMD) guidelines provided by the IRS life expectancy tables. Under this scheme, your income would rise or fall as your portfolio’s value changes.
The online financial planning magazine ThinkAdvisor recently asked three retirement planning experts for their views of the RMD withdrawal strategy versus the better-known 4% rule. Under the 4% rule, you withdraw 4% of your portfolio in year one, and then increase that amount by inflation in year two and subsequent years. The 4% rule has been criticized for a host of reasons. Some say 4% is too high given today’s low bond yields and high stock valuations. Others say the strategy is too robotic in the face of plunging financial markets.
Michael Finke, a professor at the American College of Financial Services, doesn’t like the possible income shock of the RMD approach. If a retiree is heavily invested in stocks, a serious down year could slash her income the following year.
“A better retirement plan evaluates how much of the budget is flexible and how much is inflexible,” Finke said. “Then build an investment plan that doesn’t expose inflexible spending to either market or longevity risk.” Finke said his experience shows that about two-thirds of retirees’ expenses are fixed. The RMD strategy might work for just the subset of the portfolio devoted to flexible spending, because the strategy tends to deliver fluctuating amounts of income, Finke argued.
By contrast, David Blanchett, former head of retirement research at Morningstar, likes the RMD approach because it ties withdrawals to a retiree’s age. He recommends that retirees get a realistic estimate of their longevity, however, rather than just relying on the IRS tables.
Blanchett gave this example: If you estimate your life expectancy as 20 years, you could start with a 5% withdrawal rate. If you have 25 years left, then a 4% withdrawal rate is more appropriate. What if you’d previously been withdrawing 8%? The RMD strategy delivers a wakeup call that you need to cut back.
Christine Benz, director of personal finance at Morningstar, said the RMD method is efficient at “helping to ensure that a retiree spends most of his or her money.” But she said the method is “not very livable” because it can deliver extreme fluctuations in income to retirees with higher stock allocations.
Another concern Benz raised: The RMD life expectancy tables are based on average life expectancies. Retirees with longer-than-average lifespans run the risk of running out of money. Also, their balance might dwindle when they’re elderly—just when they may face huge expenses for medical or custodial care.
In short, three of the leading voices in retirement planning gave three different assessments of the RMD strategy. I find this same kind of disparity among my friends, family and colleagues. We each look at the retirement income question through our own lens.
For example, some might take modest withdrawals so they have plenty left to meet high medical costs late in life. Others might hope for the best and spend more freely. Yet others choose to live frugally throughout retirement, in hopes of leaving the maximum amount to their kids.
Each of us must answer questions like these for ourselves and plan accordingly. Figuring out what’s most important to you and your spouse is essential. Many people’s views are based on their experiences with their parents and family. This is useful and should be a part of the analysis. But we should also be open to new ideas. Retirement income planning is such a complex subject that we can all benefit from hearing what others think.
Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. He enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. Follow Rick on Twitter @RConnor609 and check out his earlier articles.
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It’s great to look at the RMD methodology as well as your income streams. Perhaps it’s just me but I am just as desperately looking at our spending projections, both needs and wants-based. I know that at age 80 we will not be able to do some of the things we want to do, so if that means our withdrawal rate for any particular year (within some degree of reason) prior thereto exceeds the magic 4% or any other metric, so be it.
It is interesting reading the replies on how to fund retirement. Two obvious facts: The H.D. readership (whether retired or still working) is extremely well off and so far above the average citizen it is as if we are all in Never-Never Land. Maybe we are. How we choose to invest and to spend is not too important as there seems to be plenty of “dry powder” to go around.
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Although I may be at the lower end of the spectrum reflected on Humble Dollar I am grateful for any advantage that may be available to me now that I am long out of the work force. I believe there is a real need to economically educate a much larger spectrum of America’s workers, but I have no idea how to accomplish that. Thank you all for sharing your ideas.
On a side note, I vaguely recall a HD contributor in the past sharing a table showing the draw-down percentages using the RMD formulas for ages prior to 72 1/2 (% for withdrawals based on IRS life expectancy tables).
For those that buy into the “RMD (or equivalent) drawn-down” approach based on life expectancy (and likely could need to begin TQ account withdrawals prior age 72 1/2) that table was very helpful for simplifying the math on a target % to take annually.
Of course, I cannot find a copy of it anywhere. Would welcome a link from any HD reader who finds it.
Try Appendix B of https://www.irs.gov/publications/p590b#en_US_2020_publink1000231236
Rick, thanks for a very nice review of a complicated subject. One thing I’m thankful for, now that my wife and I are at the withdrawal stage, is that we kept our cost of living modest during our working years. That baseline has made it a lot easier to continue funding a similar amount in retirement.
If you enjoyed work and didn’t retire until 60, like me, there’s a significant chance you’ll never have to worry about withdrawal rates. Social Security alone will pay my wife and me over $70K when we start drawing it in 4 years, and that’s in 2022 dollars. Adding a little to that from our investments is all we will have to do to maintain our current lifestyle. We could spend a lot more but we are already very happy, so why?
Apologies for the basic question, but its one that has dogged me over the years. Why do we equate withdrawal rate with spend rate? I’m not there yet, but the projections on my RMDs point to a high withdrawal amount. I honestly don’t see how I could spend it in addition to all the other income streams, so am planning on just putting it in a taxable brokerage account. As a general rule, do most spend what they withdrawal? To me its just a tax event but it seems thats not the general consensus.
I agree — just because the government says you have to withdraw the money doesn’t mean you have to spend it. But given that most retirees have relatively modest portfolios, I suspect most do.