October 17, 2012
--- Using the
Internal Revenue Service’s (IRS’s) required minimum distributions (RMD) as a withdrawal
strategy does almost as well as traditional options and outperforms the 4%
rule. ---
The Center for Retirement Research (CRR) at Boston College
analyzed the traditional rules of thumb for withdrawal—including spending
interest only, basing withdrawals on life expectancy or adopting the 4%
rule—and compared them with the IRS’ RMD strategy (or a percent of assets that
individuals are required to withdraw each year starting at age 70.5). In
comparing the RMD with the 4% rule, the RMD strategy performed better. In
dollar terms, a 65-year-old couple would need about $25,000 more (or 10%) of
their $250,000 savings to be persuaded to use the 4% rule instead of the RMD
strategy.
A spending interest only strategy can work for wealthy
individuals, but has drawbacks for those who lack substantial retirement
savings. One disadvantage is that when an individual dies, he will leave behind
all of his initial wealth plus capital gains. In some cases, this unnecessarily
restricts retirement consumption. Another drawback is that a retiree’s income
and consumption are dictated by his asset allocation, running the risk of a
portfolio allocation that does not minimize the risk for any given level of
expected return on the portfolio. In other words, the retiree may overinvest in
dividend-yielding stocks, losing the benefits of diversification.
A second strategy is to spend all financial assets over
one’s life expectancy. The equation to calculate this is not simple for most
people, and retirees face a high probability (a 50% chance) they will outlive
their savings and be forced to rely solely on Social Security.
Spending a fixed percentage of one’s initial retirement
savings is another popular strategy, commonly known as the 4% rule. The
advantage is that the retiree has a low probability of running out of money;
the drawback is that the rule does not permit retirees to periodically adjust
consumption in response to investment returns. For instance, if returns are
less than expected in a given year, the retiree should respond by reducing
consumption to preserve the assets—a fixed 4% withdrawal does not allow this
flexibility.