Unless clients annuitize most of their retirement savings, they need a framework to guide their withdrawal decisions or risk running out of money.
Most research on “safe” withdrawal rates has focused on the retirement portfolio in isolation, modelling distributions with little heed to other sources of guaranteed income.
But incorporating guaranteed income directly into the equation – particularly for clients who can be flexible in their retirement spending – can alter that safe withdrawal rate significantly, states a paper from David Blanchett, head of retirement research, investment management, with Chicago-based Morningstar Inc.
According to Blanchett’s The Impact of Guaranteed Income and Dynamic Withdrawals on Safe Initial Withdrawal Rates, recently published in the Journal of Financial Planning, the first step is to determine the impact of different factors on retirement withdrawal rates and the probabilities of failure of the retirement plan regarding the adequacy of funds throughout the client’s retirement.
Chronicling the impact of five factors – the amount of guaranteed income; the extent to which the household can adjust spending; the investment portfolio’s risk; the return assumptions used for projections; and the degree of desired income stability – on potential distributions, Blanchett found that the level of guaranteed retirement income is, by far, the most important factor in determining optimal withdrawal rates from investments.
Withdrawal rates are linked to probabilities of success of the retirement plan, which vary based on individual circumstances.
Longer retirement periods, higher probabilities of success and more conservative portfolios tend to yield lower sustainable withdrawal rates.
If you use such success-based metrics, then employing a lower success level (i.e., a 75% success rate vs 95%) is likely to be the preferred route, although the optimal percentage depends on client characteristics, Blanchett’s paper notes.
The good news is that more guaranteed income from outside the portfolio supports the client’s increased ability to accept lower portfolio returns. For example, a sharp 20% cut in distributions from the portfolio represents only a 10% overall change if retirement savings support only half of the retirement expenses to begin with.
According to Blanchett’s analysis, optimal safe withdrawal rates varied by more than four percentage points for different levels of guaranteed income – from approximately 6% annually when 95% of wealth was in guaranteed income to approximately 2% when only 5% was guaranteed.
Blanchett also found that withdrawal rates should be lowered for clients with decreased spending flexibility – and increased when portfolios have higher stock allocations and higher return assumptions.
For clients with a healthy level of guaranteed retirement income and some income flexibility, Blanchett determined that withdrawal rates of 5% could prove quite reasonable when using historical returns in calculations.
Although recent research using forward-looking returns has suggested 3% as a more appropriate withdrawal rate for retirees today, Blanchett believes 4% could be sustainable.
That’s so even using more modest assumptions about future returns – with the support of predictable income.
The takeaway: as a client’s base of guaranteed income rises, so does the safe withdrawal rate for the related portfolio.
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