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Retirement-Withdrawal Strategies Quantified

According to a new Morningstar metric, the best approach incorporates portfolio value and life expectancy.

David Blanchett, CFA, 10/19/2012


A significant amount of research has been devoted to determining how much a retiree can afford to withdraw from a retirement portfolio, but surprisingly little work has been done on comparing the efficiency of different types of retirement-withdrawal strategies.

Our study establishes a framework to evaluate the efficiency of several withdrawal strategies. We also use that framework, in conjunction with Monte Carlo simulations, to determine the most optimal strategies for different retirement scenarios.

To establish the framework, we introduce a new metric, the Withdrawal Efficiency Rate. WER compares the withdrawals received by a retiree who followed a specific strategy to what the retiree could have been obtained if he or she had “perfect information” at the beginning of retirement. This measure allows us to quantify the appeal of each retirement withdrawal approach. It thus creates a framework to determine how best to generate income from a portfolio.

Because maximizing retirees’ withdrawals, subject to their budget constraints, is a critical aspect of building a successful retirement plan, this framework should help both retirees and their advisors determine a more secure foundation for retirement spending. In particular, we will show that spending plans that dynamically adjust for changes in both market and mortality uncertainties outperform the more traditional approaches to retirement.

Building the New Framework
Most research on retirement-portfolio-withdrawal strategies has centered on the ability of a portfolio to maintain a constant withdrawal rate or constant dollar amount (either in real or in nominal terms) for some fixed period, such as 30 years. The annual withdrawal is commonly assumed to increase annually for inflation. Bengen (1994) is widely regarded as the first person to study the sustainable real withdrawal rates from a financial-planning perspective. He found that a “first-year withdrawal rate of 4%, followed by inflation adjusted withdrawals in subsequent years, should be safe.” This is commonly referred to as the “4% rule.”

Many experts and practitioners think that the 4% rule is rather naïve, as it ignores the dynamic nature of market and portfolio returns. More-recent research has sought to determine the optimal withdrawal strategy by dynamically adjusting to market and portfolio conditions. These approaches can offer a more realistic path for retirees to follow because they continually “adapt” to the returns of the portfolio. Up until this point, however, there has been no measure to evaluate the effectiveness of these withdrawal strategies (other than probability of failure, which has significant limitations).

Another common assumption in retirement research is the notion of a fixed retirement period, which is typically based on some life-expectancy percentile. For example, if we have a male and female couple, both age 65, the probability of either (or both) member of the couple living 35 more years, past age 100, is roughly 14%, based on the 2000 Annuity Mortality Table. If 14% was determined to be an acceptable probability of outliving the retirement period for modeling purposes, 35 years would be selected as the retirement duration. The fixed-period approach essentially assumes retirees will live through the period without dying. In other words, this approach ignores another important dynamic a retiree faces: the mortality probability. Assuming a fixed retirement period and then selecting a withdrawal rate based on that period is an incomplete methodology because this approach ignores the dynamic nature of mortality.

David Blanchett, CFA is Director of Retirement Research with Morningstar Investment Management.  

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