Today I’m wrapping up our retirement income series by talking about Dynamic Withdrawal Strategies.
Dynamic strategies are designed to:
- Maximize retirement income
- Greatly lower the chance of running out of money
- Combat inflation and maintain purchasing power
If you want to learn about dynamic withdrawal strategies, their pros & cons, and how to implement them, today’s episode is for you.
How to Listen to Today’s Episode
Episode Links & Resources:
- 👉 Get Your One-Time Retirement Plan
- Decision Rules and Portfolio Management for Retirees: Is the ‘Safe’ Initial Withdrawal Rate Too Safe? [Guyton, 2004]
- Decision Rules and Maximum Initial Withdrawal Rates [Guyton-Klinger, 2006]
- Vanguard’s Dynamic Spending Strategy [Vanguard]
- Setting a Strategy for Retirement Withdrawals [Vanguard]
- Dynamic Retirement Spending Adjustments: Small-But-Permanent Vs Large-But-Temporary [Kitces]
- Floor and Ceiling: Conserving Client Portfolios During Retirement [Bengen]
Retirement Income Part 4: Using Dynamic Withdrawal Strategies to Maximize Income
Taylor Schulte: Welcome to the Stay Wealthy Podcast. I'm your host, Taylor Schulte, and today I'm wrapping up our retirement income series by talking about dynamic withdrawal strategies, what they are, how to implement them, and their pros and cons from the links and resources mentioned.
Head over to youstaywealthy.com/124.
So really quick before we get into today's episode, I just wanted to remind everyone that my team and I specialize in retirement and tax planning for people over age 50 who have accumulated investments of $1 million or more, and we offer what we call a free retirement assessment.
Throughout my career, I realized how difficult it was for people to evaluate financial advisors. We all have similar titles and designations. We advertise similar services on our websites and our brochures, and sometimes we use the same custodian. And this challenge led me to create this free retirement assessment process, which not only provides you with answers to your big retirement and tax questions, but also helps you to properly evaluate our firm.
The assessment allows you to see how we think about our approach and philosophy, the types of recommendations we make, and the value that we can provide before ever paying us a single dollar in fees.
So if you're interested in learning more about our free retirement assessment process, just head over to freeretirementassessment.com. Okay, let's get into today's episode.
When I kicked off this retirement income series, I shared a study that concluded that almost 80% of respondents in their late forties were more worried about running out of money in retirement than dying. And that fear is what most of these retirement withdrawal strategies are based on creating reliable, sustainable income without putting you at risk of running out of money.
However, as we've learned through this series a static approach like the 4% rule means that you have a high chance of dying with a lot more money than you might care for. It's also based on historical data, and one could argue that something like the 4% rule is more risky today than ever before, given the current environment.
There are a lot of unknowns between now and the end of your life. And a fixed rate withdrawal strategy like the 4% rule, while it's simple to understand and it's easy to implement, likely isn't the best way to maximize your retirement paycheck while still mitigating the chances of running out of money while combating those future unknowns.
Enter dynamic withdrawal strategies. A dynamic withdrawal strategy is designed to change your annual retirement paycheck distributions based on market performance and in some cases inflation. It's also designed to provide flexibility, allowing you to withdraw funds from your retirement accounts based on your needs as long as you stay within the parameters that you've established.
One of the drawbacks to something like the 4% rule is that it assumes retirees will spend the same amount of money each year, but as we all know, life typically isn't that straight of a line. If a retiree is willing to be a bit more flexible with their spending and maybe cut expenses when times are tough, well, they may be able to start taking a larger retirement paycheck out of the gates. They will also be able to kick off retirement with that higher withdrawal rate on day one and take part in pay raises during strong economic time periods.
In summary, dynamic withdrawal strategies provide what are often referred to as guardrails to adjust annual withdrawals either up or down depending on the performance of the underlying investments. This really helps to maximize your retirement paycheck while also preventing you from overspending or underspending. One of the simplest versions of a dynamic withdrawal strategy is simply withdrawing a set percentage each year based on the year-end account balance.
For example, let's say you have that million dollars in a retirement savings, and based on your asset allocation and research, you determine that you can take out 5% each year of the account balance.
So in year one, you take $50,000, which is 5% of $1 million in that first year. Your investments perform really well even after taking your $50,000 withdrawal and your starting account balance in year two is 1.2 million.
So in year two, you take an annual paycheck of $60,000, which is that same 5% multiplied by that new account balance of 1.2 million.
But unfortunately, in year three, we went through a deep recession and your starting account balance was $900,000. So 5% of $900,000 is now $45,000. So you had to take a $15,000 pay cut from the year before.
While this type of approach is extremely simple to implement this dynamic approach can, can lead to very dramatic changes in distributions year over year. Historically, the stock market ends the year in positive territory 75% of the time. So you do have that going for you, but a volatile retirement paycheck isn't typically what most people are looking for at that stage of life.
Also, while the stock market is positive more often than negative, those positive returns net of fees don't always outweigh your withdrawal rates. A less extreme dynamic withdrawal strategy and one that's rooted and rigorous academic research and likely more prudent to discuss in more detail today is known as the Guyton-Klinger rule or sometimes called the Guyton guardrails.
This rule was initially based on a paper written by Jonathan Guyton, a fellow financial planner in 2004, and then retested again in 2006 with William Klinger. I'll link to both papers in the show notes if anyone is interested in reading them, which again can be found by going to youstaywealthy.com/124.
The Guyton-Klinger rule in short calculates annual retirement distributions based on the four ideals that most retirees share when taking withdrawals from their portfolios.
Number one, maximize their income, especially earlier in retirement when you're healthy and younger and wanting to travel and spend more money.
Number two, eliminate the chance of running out of money.
Number three, avoid undesired changes to their income stream, so reliability and predictability.
And then number four, maintain purchasing power by combating inflation. One thing to note before we go any further is that unlike the 4% rule, which was based only on a 30-year time period, the original and paper in 2004 was based on a 40-year time period starting in 1973. That date was chosen for its, you know, real life quote, perfect storm characteristics.
The updated paper with Guyton and Klinger added an additional time period from 1928 to 2004. It also provided data on a 30-year time period. But what they found about this two those two time periods is that the two data periods that they use provided virtually identical results. So it wasn't a huge change by introducing that additional time period from 1928 to 2004.
Also, unlike a lot of the research on static or fixed withdrawal strategies, Guyton and Klinger tested different equity allocation percentages and asset class models, allowing you to see how taking more risk and adding more diversification to your portfolio can potentially create a larger retirement paycheck and allow you to see how those changes impact the probability of success.
The Guyton and Klinger rule research concludes that initial withdrawal rates of 5.2% to 5.6% are sustainable at the 99% confidence standard for portfolios containing this is important. At least 65% stocks, a 50% allocation to stocks drops the initial withdrawal rate down to 4.6%. So as you've noticed, I've used this term initial or starting withdrawal rate a few times now because this is a dynamic rule that starting rate can and likely will change. Let me share a simple example here of how this works in action.
Let's say that you have that $1 million in retirement savings and you have 65% allocated to stocks. One adaption of the Guyton-Klinger rule says that you can safely withdraw $54,000 in year one or 5.4%. That's your starting withdrawal rate, 5.4% in year two and beyond. You can increase your withdrawals for inflation at a maximum of 6%, except in years when one, the portfolio is coming off a negative total return, or two, if your withdrawal percentage exceeds the original rate of 5.4% in those years, you would keep the same withdrawal amount from the previous year.
And while inflation can help prop up your retirement paycheck, adverse market conditions can cause pay decreases. This is known as the capital preservation part of the rule, and it says that if your current withdrawal rate is going to be more than 20% of the initial withdrawal rate, well you need to cut your current year withdrawal by 10%.
Let me try to simplify this, since we have a lot of percentages flying around here, let's again assume that your first year withdrawal was $54,000 or 5.4% on your $1 million portfolio. If the market takes a hit that year and your account balance is now $800,000 as you begin year number two, well, your original $54,000 retirement paycheck would be at a rate of 6.75%. That's $54,000 divided by your new account balance of $800,000 in year two.
Well, a withdrawal rate of 6.75% is more than 20% higher than the original 5.4% starting rate. And, and this triggers the capital preservation rule, meaning that your withdrawal and year two would have to be knocked down to $48,600 or 10% less than that original $54,000. It's certainly a healthy pay cut, but you're still well above that 4% from the 4% rule after a sizable market correction.
In a similar vein, what's referred to as the Prosperity Rule and the Guyton-Klinger paper can help provide pay raises during times it produced positive investment results, and it works in the exact opposite way as the preservation rule. It says that if your current year withdrawal rate is going to be less than 20% of the initial withdrawal rate, you can increase your current withdrawal by 10%.
So again, for example, let's say you have that $1 million portfolio and it grows to 1.3 million over the next few years. Well, your original $54,000 retirement paycheck that you were taking would now equate to a withdrawal rate of 4.15% on that new account balance of 1.3 million. That's $54,000. your annual paycheck divided by 1.3 million equals 4.15%. Well, a withdrawal rate of 4.15% is less than 20% of the 5.5, 5.4% starting rate that's far less than you signed up for.
So the prosperity Rule is triggered, and now you get a 10% pay raise and you get to withdraw $59,400. Combining all of this essentially creates an ongoing withdrawal range, aka guardrails between 4.32% and 6.48%, which is that 20% buffer in each direction from the original starting 5.4% withdrawal rate.
And to summarize it all, there are really four possible outcomes depending on the current condition of your portfolio each and every year. The first possible, number one, if the prior year's returns your portfolio returns are negative, you simply apply the initial withdrawal rate, which was 5.4% in my example. Remember, inflation adjustment is not added when the prior year returns are negative.
The second possibility is if prior year returns are positive and the current withdrawal rate remains within 20% of the initial rate, you just simply adjust and increase your prior year retirement paycheck by the rate of inflation not to exceed 6%.
The third possibility is if the current withdrawal rate is greater than 20% of the initial rate, then you apply the capital preservation rule and decrease your paycheck by 10%.
And then number four, if the current withdrawal rate is less than 20% of the initial withdrawal rate, you get to apply the prosperity Rule and increase your paycheck by 10%. As mentioned, Guyton and Klinger they tested multiple allocations to stocks to help show that taking more risk can produce a higher initial withdrawal rate with success.
However, they also tested stock portfolios that contained multiple asset classes like large cap, small cap and international stocks, versus just owning the S&P 500 in your equity allocation. And they found that this further helped to improve the probability of success.
In short, if you wanted to push the Guyton-Klinger rule to its limits, the research concluded that you could have a multi-asset portfolio comprised of 80% stocks, 10% bonds, and 10% cash, and begin with an initial withdrawal rate of 6.3%, which is pretty enticing.
Historically, this triggered four pay cuts, seven pay freezes, and eight pay raises, and had a 94% success rate during the time period tested. If you wanted a virtually bulletproof withdrawal plan, a multi-asset portfolio comprised of 50% stocks, 40% bonds, and 10% cash, and an initial withdrawal rate of 4.6% had a 99% probability of success during those time periods that were tested.
Perhaps you wanna meet somewhere in the middle there, which was also tested and laid out clearly in the paper, which again, I'll link to in the show notes. You can find those by going to youstaywealthy.com/124. They also share what all these success rates look like if you use a 30-year time period instead of 40, which as you might guess would only improve the probability of success.
Before we quickly touch on the pros and cons of using a dynamic withdrawal strategy like guidance's guardrails, I just wanna highlight that there are a number of nuances and other little rules that need to be followed if you want to implement this properly.
For example, the Guyton-Clinger rule says that following a year when stocks are down, your withdrawals should only come from cash or bonds. if you're a client, if you've ever worked with us or talk to us before, we call this your war chest, and on years when stocks are up, gains should be trimmed and added to cash to meet your future withdrawals.
So these little nuances, they lead nicely into one of the only one of the biggest cons of using a withdrawal strategy like this. And that is that it's fairly complex to monitor and implement year over year along with requiring a specific asset allocation and a commitment to keeping your spending within these predefined guardrails. It also requires calculations each year to adjust your payments up and down and to be conscious of what asset classes you're rebalancing in order to produce your retirement paycheck each year.
This can get especially tricky if you take that multi-asset approach of owning more stock indexes rather than just the S&P 500. The other con is that unlike a static rule, like the 4% rule, your paycheck can and will fluctuate if you have spending problems or you don't wanna be put in the position to take pay cuts during difficult market environments. You might prefer something a bit more predictable like the 4% rule.
And the last con that I could come up with is that you'll have some really big decisions to make around your starting point for a dynamic withdrawal strategy that you just may not have the desire or, or knowledge to make. For example, deciding how much to allocate to stocks and, and how much risk you can really handle in this stage of life. How much to allocate to multiple equity asset classes or just keep it simple and own the S&P 500, and also the time horizon that you're gonna commit to.
These are big decisions that can add to the complexity and either require you to hire a professional to help or lean on something that's simpler, that might be less stressful to manage, but maybe produce a smaller retirement paycheck. The pros of a dynamic withdrawal strategy are, are fairly straightforward.
Number one, you're able to combat many of the issues that academics have raised regarding the 4% rule, like a cherry pick time horizon, and an economic future that is unknown and totally unpredictable.
Number two, you're able to begin retirement with a very appealing withdrawal rate.
And number three, most dynamic spending rules are focused on maintaining purchasing power and combating inflation. Two of the biggest threats to retirement, combating inflation while protecting against future unknowns of the stock market and economy, all while enjoying a nice starting withdrawal rate are pretty compelling advantages to using idea dynamic withdrawal strategy like Guyton’s guardrails.
And while I've talked a lot about Guyton and Klinger today, there are other dynamic strategies out there to consider researching. Vanguard has their version of a guardrails type of approach. Michael Kitces, who was in episode one of this series has published a simplified version of the Guyton Rule to his blog, which I will link to.
And Bill Bengen who coined the 4% rule, he offered a new balance between a static approach and a dynamic approach called Floor and Ceiling. I'll add these links to the show notes, which again you can find by going to youstaywealthy.com/124.
And before we part ways and end this series, I just want to emphasize how important it is to take a rules based systematic approach when you're turning your portfolio into a paycheck in retirement. Buying a few random low-cost index funds and, and pulling money from your investment accounts whenever you need it during retirement can be a recipe for disaster. You could be triggering unnecessary taxes and fees, reducing your rates of return, or even worse, putting yourself at risk of running out of money.
So choose the strategy and approach that works best for you, one that you can understand and you can commit to implementing and stick with it through the end of your retirement. You might learn that you need to hire someone to implement or you might enjoy managing this puzzle and, and determine that it's something that you can tackle on your own.
Whatever you decide, just create a system. Follow the rules that are backed by academic research. Stick with it for the long run. Don't try to out guess the markets or the economy and implement year over year without getting distracted by what your friend or neighbor is doing.
I hope you enjoyed this series. For all the links and resources mentioned today, head over to youstaywealthy.com/124.
Thank you as always for listening, and I will see you back here next week.
Episode Disclaimer: This podcast is for informational and entertainment purposes only and should not be relied upon as a basis for investment decisions. This podcast is not engaged in rendering legal, financial, or other professional services.