Creating a Dynamic Withdrawal Strategy

Have you ever heard of the 4% rule of thumb regarding retirement withdrawals?  Financial advisor William Bengen conducted an extensive study of historical returns in 1994, and concluded that if a new retiree withdraws the equivalent of 4% of his or her retirement portfolio for living expenses in the first year and then increases the dollar amount of withdrawals every year for inflation, he or she should be able to do so for 33 years without running out of money.

Sounds pretty good, right? 

Unfortunately, it’s an oversimplification that can lead retirees down the wrong path.

What happens if there is a large unexpected expense that increases the withdrawal requirement more than the 4% (+ inflation)?  Or if the person had the misfortune of retiring in the first of several down-market years?  These scenarios can materially reduce the principal balance which, in turn, would impact the dividends and interest that can be earned. The end result? A more limited lifestyle for the retiree.

While 4% may be a good place to start, it should not be relied upon solely for the success of your financial plan.  Instead, we often recommend a dynamic withdrawal strategy.  This strategy recognizes the distinction between a retiree’s essential and discretionary expenses and allows for higher withdrawals when the markets outperform the retiree’s required rate of return.  

Using a bucket approach, the total investment portfolio is broken out between cash/cash equivalents, income-producing investments, and growth-oriented investments.  Because we don’t want to be forced to sell investments in a down market, this approach is designed to keep approximately two years’ worth of essential expenses in cash or cash equivalents.  The retiree would receive distributions from this bucket to meet his or her monthly living expenses.  The next bucket would contain dividend-paying stocks or interest-bearing bonds, the income from which would be swept automatically into the aforementioned cash bucket, thereby backfilling the monthly distributions that have already been taken.  Finally, the third bucket would contain growth-oriented investments with a focus not on income – which has been taken care of by the second bucket – but on capital appreciation.  

Implementing this dynamic withdrawal strategy serves multiple purposes.  It creates a solid plan for generating consistent income that should make the retiree feel more confident about meeting his or her needs.  It also reduces the likelihood that the retiree will need to liquidate investments during down market years, thereby allowing the portfolio time to recover and grow.  In addition, in years when the portfolio sees higher returns from capital appreciation, the retiree can lock in some of those gains and sell higher performing investments. This opens up exciting opportunities to supplement discretionary expenses for items like extra vacations, gifting to family, or making larger charitable donations. 

While we love discretionary spending, we also regularly remind clients that just because they can afford to do something, it doesn’t mean they should.  A prudent approach to implementing this dynamic withdrawal strategy would be to strike a balance between peeling off market gains to enjoy life now and refilling the coffers in preparation for the next market downturn.  While higher-than-expected returns are a great surprise, we know that what goes up must come down. Being flexible is what ultimately allows for a confident retirement.

As an independent fiduciary advisor, the Allegiant Private Advisors team is prepared to help you - and your portfolio - navigate the transition to retirement. Contact our office to learn more about our approach to customized wealth management and discuss how a Dynamic Withdrawal Strategy could apply to your personal situation.