In this series, we will explore some of the most common strategies for retirement income generation. This is by no means a “how-to” guide, but, rather, an attempt to make you familiar with a few of the more prevalent philosophies out there today. With this knowledge, you can begin a discussion with your advisor about which approach may be most suitable for your specific situation.
I’ll begin with a technique called Systematic Withdrawals because it was the most widely utilized (almost exclusively, in fact) up until the early millennial years. Back in 2003, when I was completing my CFP® coursework, it was the core strategy taught to fledgling financial planners. And, today, if you were to ask the average pre-retiree how their income plan will work after work ends, they would likely describe some version of this procedure.
Due to the lingering pervasiveness of systematic withdrawals in retirement, a word of caution is in order: If you anticipate this will be your strategy of choice, you should know there are reasons why it used to be the most common, some of which are described below.
What is the Systematic Withdrawal Strategy?
One nice thing about the technique is that it is simple. You don’t need a degree in finance or access to special investment tools or products to apply it. As the name implies, it merely entails setting up a schedule, or system, of how much you will withdraw for retirement income and when you will choose to do it.
Whether monthly, quarterly, or annually, the mode of distribution is of little relevance to the overall viability of the plan. Instead, the determining longevity factor is striking the delicate balance between withdrawing enough to live comfortably, but no so much that you run the risk of entirely depleting your nest egg before entirely depleting your life.
Basically, the general rule of thumb was that annual portfolio distributions of 4% or less would keep the investor in a statistical safety zone that, assuming the assets were adequately diversified, virtually assured they would not run out of money.
The 4% figure was arrived at by a group of economists in the early 1990s who, at the time, were credited with a stroke of pure brilliance. They employed something called a “Monte Carlo Simulation” which ran hypothetical backtests of investment performance over 30-year market cycles going all the way back to 1926. What they discovered is that, in even the very worst of those periods, and across a wide array of portfolio allocations, a 4% or less annual withdrawal rate resulted in a very high likelihood that an investor would not outlive their money. Furthermore, based on the historical data they were working with, they predicted the average performance of the market would be sufficiently in excess of the 4% withdrawal rate that the overall portfolio balance should continue to grow over time, offering that critical inflation-fighting component.
However, as we moved into the new millennium, something happened … twice … that blew all prior performance assumptions into oblivion.
A Modern Problem for the Systematic Withdrawal Strategy
The historic market crashes of 2000 and 2008 reminded everyone that past performance is not a guarantee of future results. The devastating losses many experienced during these downturns was unprecedented and thus could not be taken into account during prior calculations.
Consider this example: If you had a $1 million portfolio in 2007, withdrawing 4% that year would provide $40,000 in gross income. In you were invested in an asset mix similar to the S&P 500 Index, that same 4% withdrawal rate would have cut your annual income to less than $20,000 just two years later as your portfolio experienced more than a 50% loss by the time 2009 rolled around.
Many retirees, unable to survive on half their previous investment income, were left with two abysmal options to consider. They could either maintain their income level, bumping their annual withdrawal rate to an unsustainable 8% each year or, alternately, they could resign themselves re-entering the labor force.
After experiencing not one, but two, historic crashes in less than a decade, the financial industry recognized the inherent dangers of the existing model for systematic withdrawals. As innovation ran its course, several alternate solutions emerged, some of which I will describe in subsequent posts.
To be fair, the systematic withdrawal approach still has some workable applications, albeit in a revised form. A few years ago, Fidelity, along with the investment research firm, Morningstar, ran the same Monte Carlo simulations with more recent data, arriving at the conclusion that the new “safe” withdrawal rate was just under 2% annually.
For most people, living off 2% or less of their portfolio every year is not realistic. However, I’ve come across a handful of folks whose lifestyle is sufficiently modest and net worth sufficiently high that 2% is enough and therefore brings the systematic withdrawal strategy back onto the table for consideration.