In part 1 of my deep dive on Morningstar’s State of Retirement Income – Safe Withdrawal Rate report, the team explained that returns in the future are likely to be lower due to high equity valuations and low bonds yields.
The starting withdrawal rate that we use to estimate our retirement income needs will need to reduce. This means that we may need to accumulate more wealth.
Is there a way to optimize our retirement income plan better (i.e. have retirement income with a smaller portfolio)?
The Morningstar team thinks that if we are able to rationalize our income expectations and be more flexible with our spending, we could have a good outcome.
But how much better?
How flexible withdrawal strategies can help optimize how much you need
Based on the previous article, if we need a constant, inflation-adjusted income stream that lasts 30 years, with a high degree of success, the initial withdrawal rate will be rather low.
Morningstar’s paper states that we should be looking at a withdrawal rate closer to 3.3%. The lower the withdrawal rate, the more money you will need to accumulate for your retirement.
Some of you may be thinking: What if I am more flexible with my spending? Could I spend more, as a percentage of my portfolio? Does that mean I need to accumulate less?
Morningstar explored the more-flexible strategies and suggested that they can indeed be effective because flexible strategies ensure that retirees don’t overspend in periods of portfolio/market weakness while giving the retirees a raise in strong portfolio/market environments.
Adjusting withdrawal rates based on portfolio performance can also help ensure that retirees consume their portfolios efficiently: For retirees with no interest in leaving a legacy, they can plan to consume their entire portfolios during their own lifetimes.
But the Morningstar team pointed out a very important point on applying flexible spending: Flexible spending strategies work mainly if your portfolio spending composes only a portion of your household spending needs.
There are a few different flexible withdrawal strategies, with different characteristics.
I feel that many advisers or people pursuing financial independence will say: “At most I can be flexible in my spending!”
However, that statement doesn’t solve the main problem: Even if you are flexible with your spending, what is the minimum amount you need in your portfolio to completely stop work?
How much higher can you bump up your initial safe withdrawal rate with flexible spending?
And this is partly what the Morningstar team tried to address.
Some of you may be wondering how flexible withdrawal strategies differ from the actual withdrawal strategies. They all differ in characteristics but here is a general idea:
- Instead of the income being adjusted every year based on last year or this year’s inflation rate, flexible spending strategies will recommend year by year spending income based on different systematic rules.
- Flexible spending tends to make your money last longer.
- Flexible spending income tends to lag behind the standard withdrawal strategies in inflation adjustment. Your income is less inflation-protected.
- Flexible spending works better when market conditions are volatile but does not change too drastically. If there are big shifts in market conditions, income may drop and it will be years before income returns to its original level (let alone make back the purchasing power)
- Flexible spending gives you the potential to have a higher income.
In the next section, Morningstar goes deeper into some of the flexible withdrawal strategies they examined.
How Morningstar Measures the Usefulness of the Different Flexible Withdrawal Strategies
The team identify 4 different metrics to measure how successful the withdrawal strategies are.
Monte Carlo analysis was applied to these flexible withdrawal strategies on a 50% equity/50% bond portfolio, and sometimes other equity/bond allocation mix.
Here are the metrics:
The higher the safe withdrawal rate the better. It means that you need less money in your portfolio for your retirement needs.
Given that each strategy has the potential to provide higher and lower-income, the team measures the total income that can be drawn out from the portfolio during the lifetime.
How big will the income variation be?
How much money is left at the end? A larger amount gives greater room for error.
4 Different Flexible Withdrawal Strategies
Morningstar profiled 4 different strategies with different characteristics:
Strategy 1: Forgoing inflation adjustments
The first strategy is easier to understand. There are years where the market is down. When the markets are down, do not adjust for inflation for the spending.
For example, suppose you are in year 7 and the previous year you were recommended to spend $37,350 a year and inflation runs at 6%. If last years return is -15%, then this year you will spend $37,350 instead of adjusting $37,350 by the 6% inflation.
Doing this will reduce the acceleration in spending. Usually, when markets are down, market inflation is low but if there is stagflation, it will hurt.
This is very easy to implement, but you may wonder how much it would improve your situation.
Strategy 2: Required minimum distributions
Required minimum distributions (RMD) is a form of spending that US folks are forced to take at a certain age. This flexible spending scheme does something similar.
Basically, this is equivalent to taking your current portfolio value divided by your life expectancy.
So your portfolio value and income will be like this:
Your income starts off conservative, but as your age reduces, the income that you can take increases.
Because RMD computes based on your CURRENT portfolio value, every year’s income recommendation is adjusted. So if you plan for 30 years, you would not run out of money. (You can always plan as if you will live to 120 or 130 years old so that the income is lower and last longer)
But your income will be very variable depending on your age. You would likely have lower income at the start and more income later.
Actuaries really like this method.
Strategy 3: Guardrails method
This guardrails method is the first strategy that got me excited that I may reach financial independence in 2014.
Guyton and Klinger introduce a few rules to adjust your spending within a certain band, depending on how the market and inflation go.
It can be illustrated in this diagram from Early Retirement Now:
In this strategy, you try to do the normal safe withdrawal rate but if the portfolio value falls too much (it hits the upper guardrail in the diagram), you will reduce recommended income by 10%. Similarly, if the portfolio values grow too much (it hits the lower guardrail in the diagram), you will increase the recommended income by 10%.
This is done for the first 15 years because if you can manage the first few years well, most likely your money will last.
There are a few more rules that Guyton and Klinger have to fine-tune your spending but I shall not go deeper into it. I will link to some resources at the end.
Strategy 4: 10% reductions following losses
This strategy is a variation of strategy 1. Instead of not adjusting for inflation, you reduce your spending by 10% in down years.
This is a more drastic strategy.
Now let us take a look at how these strategies compare in terms of the 4 different metrics.
RMD and Guardrails give the highest starting safe withdrawal rate
The vertical axis shows the starting safe withdrawal rate and the horizontal axis shows portfolios of different equity allocations.
Fixed real refers to the traditional constant inflation-adjusting safe withdrawal rate.
Regardless of the equity allocation, the RMD strategy gives a uniform 4.76% withdrawal rate.
So if your annual spending needs is $25,000, you will need a portfolio worth 25000/0.0476 = $525k versus 25000/0.033 = $757k. Big difference.
In second place is the Guyton Klinger guardrails strategy. It is interesting that having a very high equity allocation may not mean that we can have the highest starting safe withdrawal rate. The balanced portfolio gives the highest starting rate.
Forgo inflation and 10% reduction improve the starting rate but only minor. Instead of 3.33% for a balanced portfolio, they improve to 3.76% and 3.57% respectively.
The strategy with the greater variability (guardrails and RMD) is able to give the highest starting rate.
My personal opinion is that the starting withdrawal rate of flexible strategies can be quite fake.
It works when the market returns and inflation are rather stable. But if they are very volatile, oh boy, you would not like your spending.
Blogger Early Retirement Now explains the worst-case scenario.
Suppose you need $25,000 a year in inflation-adjusted income for your essential expenses. Your essential expenses are rather rigid and difficult to be flexible.
In the worst-case scenario, the Guyton and Klinger guardrail rules will cust your income to an inflation-adjusted income of $12,500 a year or half of what you actually plan for.
How do you live with half of the income you plan for??
RMD and Guardrails give potentially the highest lifetime portfolio withdrawal rate
What you will notice is that between high equity and a low equity portfolio, if you have low equity, there is lesser potential for higher income withdrawal during your retirement lifetime.
With a higher equity allocation, the RMD and guardrails strategy allows you to potentially have greater income.
Not so much for the other methods.
RMD and Guardrails strategy has the greatest income volatility
The vertical axis shows the level of year-to-year volatility in cash flow. The higher the percentage, the greater the volatility.
A high equity allocation and guardrails or RMD strategy implemented can result in your income being very volatile.
How much money is left at the end of 30 years?
The traditional safe withdrawal rate, forgoing inflation and 10% reduction allows higher equity portfolios to leave a larger bequest.
We can also view that income is not adjusted properly.
For this, we can see the appeal of the guardrails strategy.
The RMD is almost zero because that is how the strategy works. You are supposed to spend finish everything.
Morningstar’s Summary and Strategy Evaluations
Here are some summary data of the 5 strategies against the 4 metrics:
Morningstar’s team feels that something that resembles the guardrails type strategy does the best job of enlarging the income potential in a safe and livable way.
The forgoing inflation after a losing year strategy does a decent job of enlarging the lifetime income versus the traditional constant-inflation adjusting strategy without a lot of cash flow volatility on a year to year basis.
The team also explain that there is no best solution.
The flexible withdrawal strategies have the potential to increase income but the downside is that the income volatility can be undesirable such that they might not be very livable.
When to Implement a More Flexible Withdrawal Strategy and When to Implement a Less Flexible Strategy
So given what we understand about fixed real withdrawal and flexible withdrawal strategy, how could we optimize our retirement income plan better?
The Morningstar team believes that you may be able to break up your income need into a few different segments.
In this example, the retiree needed $48,000 in income:
The easy way is to compute how much he requires to retire based on $48,000 a year. But if you try planning how much you need with the entire spending need, you would feel a lot of conflicts:
- He can be flexible but not all his income. Some of his income needs to be there.
- He would need to ensure that some part of his income is more perpetual. Although he may need it for 40 years, he prefers to plan just in case, to have it last 50 years.
- Some part of his income is good to have, if he chooses to spend only 20% of the normal income, he is ok with it.
Given this, he should break his income needs into segments. For each of these segments, a different starting withdrawal rate can be used. In this example, a lower safe withdrawal rate is used for the essential expenses because he needs it to last 50 years. A lower amount is more conservative, more pessimistic returns sequence is factored in.
For another spending different sets of guardrails can be chosen. For extravagant living, a higher starting rate can be chosen, and the guardrail can be made more sensitive. For the $16,000 a year, a less sensitive guardrail can be chosen.
Which type of spending strategy is chosen depends on
- market condition,
- your stage of life,
- your income preference and need
Here are some considerations.
The sequence of return risk is the risk that a poor market sequence happens at the earlier part of your retirement just as you are spending down. A poor early market sequence can kill your retirement.
Hence if you require your wealth to last for a long time, a more flexible withdrawal strategy may be appropriate.
I think you have to be more flexible because if your time horizon is longer, the surprises in your spending needs, market, inflation is greatly magnified.
Equity valuations and bond yields have a strong correlation to what is considered a safe withdrawal rate.
If equity valuations and bond yields point to low future returns, then we should be more conservative in our planning. Perhaps we can over buffer how much money we accumulate or in this case, we are more flexible.
This is a weird one.
I don’t quite agree that if your level of wealth is more you can be more flexible and if your wealth is less you should be less flexible. If your wealth is more, you can implement a less flexible withdrawal strategy. It just means that your wealth can last for a long time.
In most planning, flexible strategies are meant more for spending that is less important. The most essential spending is taken care of by government pension or income solutions where the issuer has a contractual obligation to pay.
If you have a lot of these nonportfolio income sources, you can be more flexible with your portfolio. But if you have less, you would have to greatly rely on your portfolio for income, and thus, you cannot be too flexible.
Each of us has a different income preference. Some of us may get adjusted to income shortfall during our career while a teacher may not be adjusted to it. This influences which spending strategy we will prefer in the future.
If you are someone who wishes to die with zero, yet want to ensure that your income lasts long enough, a more flexible withdrawal strategy may be better.
It will allow you to capture more income systematically to spend while not dying with too big of an estate.
If you would like to leave more inheritance to your heir, then a less flexible withdrawal system may be preferred. This is the opposite of the previous point.
If you have this fear about running out of money, a more flexible strategy such as a guardrail will be preferred.
The downside of the fixed real withdrawal strategy is that it places a huge trust in the research work. However, if you encounter a poor sequence, you would not adjust the plan but trust the strategy.
No matter how we look at things this is rather dangerous.
A more flexible strategy requires you to be sophisticated enough to compute and decide how much to spend so that you do not run out of money.
For some especially, those whose spouses do not like to manage money, this is something that you need to think about.
Kyith’s Closing Thoughts on Flexible Spending Strategies
Morningstar must really like flexible strategies for them to spend a large portion of the report explaining the various strategies.
Flexibility is something that many felt would make their retirement numbers work but they did not thoroughly think through whether flexible spending strategies are suitable for them.
The Morningstar team looked at different flexible strategies and assess them with different metrics.
Flexible spending strategies increases the probability that your portfolio will last long. The strategy also allows you the potential to spend more systematically if the portfolio does well. However, the income does not keep up with inflation that well (this is the cost of income longevity).
What will be new to readers is the Morningstar team’s framework for deciding which is a more suitable income strategy.
The team listed 9 considerations and you should consider them when planning out which is a more suitable retirement income strategy.
Personally, I think flexible spending is great if you are carving out a portfolio where spending is very optional. If the market does well, you spend more and if it doesn’t you spend little or perhaps do not spend.
But if you need your income stream to be very predictable and inflation-adjusting, then the traditional constant-inflation adjusting strategy would be better.
A good test would be the following case: You have limited financial resources and you need an inflation-adjusted income of $2,400 a month to pay for the food and rent of your family. If markets are not good and your flexible income strategy recommends that you cut your portfolio to $1,200 a month, can you live with that recommendation?
This strategy would work for some spending needs but for some, it is not realistic.
This is not the first time I wrote about flexible withdrawal strategies. 7 years ago, I wanted to see if the money that I have accumulated allows me to be financially independent.
While I could not be by the official definition, my research into flexible withdrawal strategies led me to determine that if I am flexible with my spending, I could make it work.
I covered that and the pros and cons of a few different flexible spending styles. You can read the article here. I have also framed what kind of lifestyles and conditions is most suitable to adopt a more flexible spending strategy.
Suffice to say, I feel many have a deep preference towards flexible withdrawal strategy and the dividend strategy or something as a mesh between them.
But often, they did not or could not grasp the weakness of the strategies. Those weaknesses can surprise you. There is only so much that you can be flexible. Your income is going to be variable.
I know cause I explored both and see their great appeal but if we model them, they have flaws. At times, you need to plan for some part of your income to be conservative and stable, which requires modification in both the flexible and dividend strategy.
This ends part 2 of the Morningstar State of Retirement Income paper.
The team still went through some adjustments that may improve your retirement income plan. I will see if I can cover it soon in Part 3 of this Morningstar Retirement Income Deep Dive.
What do you guys think of the strategies that Morningstar proposed?
Were any of you thinking about implementing some of these strategies? How do you feel about these strategies now?
For those interested in the nuts and bolts of retirement income planning, you can take a look at Retirement Planning, Financial Independence and Spend down money section below.
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