There are three traditional approaches to living on investments during retirement but each has some disadvantages and there is growing attention to a fourth approach, according to a study by the Center for Retirement Research.
One traditional approach is relying only on investment earnings produced by the assets, which “may be desirable for those who want to leave a bequest, but in other cases it unnecessarily restricts retirement consumption.” It also runs the risk that desire or need for more spendable money will begin to drive the investment approach, tilting the retiree into a more aggressive investment mix.
A second approach is to calculate withdrawals based on life expectancy using a formula involving assumptions about investment returns and life expectancy. However, such a calculation is complex and retirees run a 50 percent chance of outliving the investment assets and having to rely solely on other income such as Social Security or an annuity, the study said.
The third strategy is to spend a percentage, commonly 4 percent, of the initial savings. In that approach, a retiree runs a low risk of exhausting the asset, but it “does not permit retirees to periodically adjust consumption in response to investment returns.”
One other option that may work better for many retirees is to base withdrawals on the IRS-required minimum withdrawals that apply to tax-favored retirement assets after an individual turns age 70 1/2. The report said that approach has several advantages:
“First, like other rules of thumb, it is easy to follow. The IRS stipulates withdrawal percentages based on life expectancy tables. A withdrawal schedule at younger ages – percent of assets withdrawn, by age – can be based on the same life tables used for the RMD rules. Second, the RMD strategy provides a superior way to manage wealth, because it allows the percentage of remaining wealth consumed each year to increase with age, as the retiree’s remaining life expectancy decreases. Third, since consumption is not restricted to income, the household is less likely to chase dividends and is more likely to have a balanced portfolio. Fourth, consumption responds to fluctuations in the market value of the financial assets, because the dollar amount of the drawdown is based on the portfolio’s current market value.”
One drawback is that the approach yields smaller withdrawals earlier in retirement when a retiree is more likely to be more active and have a greater demand for spending. One variant to produce more income during those early years would be to draw out an amount equal to what would be a required withdrawal, plus interest and dividends. The report said that statistically, that variant produces the best results of all the alternatives.