You have saved diligently for retirement, and now you are going to be dependent on your retirement savings for income. How do you make sure you don't run out of money? How do you figure out what you can safely withdraw each month? Is one retirement withdrawal strategy better than another? This post will help you identify common risks associated with taking money out of your retirement account and the pros and cons of two common retirement withdrawal strategies.
Sequence of Returns Risk
Retirement withdrawal strategies, also known as drawdown strategies, are trying to address a serious risk that can jeopardize your investments: sequence of returns risk. A crash at the beginning of your retirement can derail your retirement plans.
If the market crashes when you are starting to withdraw money, it will reduce the number of shares available to participate in a market recovery because you will be forced to sell more shares to have the same amount of income. This reduction early in retirement may limit your portfolio growth enough that you may run out of money.
It is called sequence of returns risk because the order of the returns matters. In other words, a crash will have a greater impact at the beginning of your retirement than if you experience the same downturn later in retirement. So how can you prepare for sequence of returns risk? Let's take a look at two retirement withdrawal strategies that address this risk: the safe withdrawal rate strategy and the bucket strategy.
Safe Withdrawal Rate Strategy
The first strategy is covered in our free investment course: determining a safe withdrawal rate (also known as the 4% rule of thumb). This strategy involves determining a safe percentage of your portfolio to withdraw annually. The percentage is called "safe" because it is the percentage plus inflation that you can withdraw each year without running out of money in retirement. The safe withdrawal rate is often between 3-4% depending on your asset allocation and how long your retirement will be.
Rebalancing is essential when managing your portfolio with a safe withdrawal rate strategy. Some people may choose to rebalance by strategically withdrawing money from bonds when stocks are down or overweight securities when the market is up to create a more balanced portfolio. Whether you do it through strategic withdrawals or traditional rebalancing periodically, the point is to stay close to your desired allocation, which should align with your risk tolerance and timeline.
If you are using the safe withdrawal rate strategy, you really don't need to worry about depleting your account during a downturn because the calculation has taken crashes into account. However, human nature tends to want reassurances, so here are some modifications you might consider to prepare for sequence of returns risk.
Reduce Your Rate
During a crash, you can adjust your withdrawal rate. Perhaps you have planned to withdraw 4% plus inflation based on the 4% rule. If the market crashes during the first 5-10 years of retirement you could opt to forgo the inflation bonus or even reduce your withdrawal rate to 3% temporarily.
Rising Equity Glide Path
A glide path is a term for how your asset allocation changes over time. Common investment advice is to create a glide path that becomes more conservative in retirement because you want to preserve your principle. Most target date funds follow this pattern. Conversely, a rising equity glide path is when you start with a more conservative portfolio at the beginning of retirement and increase your equities percentage as you get further into retirement.
While a rising equity glide path is counterintuitive to most traditional retirement advice, it is based on research by well-respected retirement experts Wade Pfau and Michael Kitces. They found that by having a conservative portfolio at the beginning of retirement, you reduce sequence of returns risk by reducing exposure to equities.
If the market crashes, you essentially dollar-cost average back into equities as the market recovers and you increase your equities percentage.
If the market does well at the beginning of retirement, your balance is preserved during the initial period when sequence of returns risk is most impactful. As you increase your equities, you still participate in growth as the risk is less impactful. Your portfolio may not grow as much as it would have during the early years of retirement, but you will successfully preserve your already sufficient retirement funds.
The challenge with this strategy is that you are increasing your volatility as you age, which may be psychologically challenging for some investors.
Bucket Strategy
The bucket strategy consists of creating three buckets of investments based on when you need the investments.
The first bucket is for cash reserves for the next 1-2 years of retirement. This bucket keeps you from having to withdraw money during a market decline. The risk associated with this cash reserve is loss of value due to inflation. However, I would view this the same way as an emergency fund. You may not be optimizing this particular bucket of money for growth, but its job is to be there when you need it.
The second bucket is for the next 3-7 years of retirement. This bucket consists of short-term investments such as bonds and stable dividend-paying stocks. You can use the dividends and interest to refill the first bucket. During a market crash, these investments may be slightly more stable, so you could sell these investments to avoid depleting the third long-term bucket.
The third bucket is made up of long-term investments such as growth stocks, which tend to be more volatile. These are the stocks you don't want to touch during a market downturn.
If you are using the bucket strategy, you will need to create rules about how you refill your buckets in different market scenarios. You can adjust how you refill bucket #1, your cash bucket, based on how the market is doing. The goal is to avoid selling equities when they are doing poorly, preserving your principle and reducing sequence of returns risk.
Supplemental Strategies
It's worth noting that there are a few additional ways to deal with sequence of returns risk. If you haven't retired already, you may opt to continue working a little longer. If you have already retired, you could find a part-time job to supplement your income during the crash. You might also consider diversifying your income through real estate investments or another form of passive income that is independent of the market.
Bucket Strategy vs. Safe Withdrawal Rate
So which strategy is best? There has been a lot of discussion and friendly rivalry over which strategy is best. The bucket strategy actually provides worse outcomes than the safe withdrawal strategy when used alone. However, when you pair it with annual rebalancing, the results are nearly identical. So if you choose to use the bucket strategy, it is essential that you incorporate annual rebalancing into your retirement withdrawal strategy.
It has been suggested that when paired with rebalancing, the bucket and safe withdrawal strategies aren't really different strategies, just different forms of mental accounting. By creating time-based buckets, you create a different way of thinking about asset allocation.
Let's look at the example of someone who has saved $1.5 million for retirement, which gives you about $60,000 per year to spend based on the 4% rule.
Using a safe withdrawal rate strategy, the asset allocation of 70% equities/30% fixed-income (with 10% of fixed income in cash), the portfolio would be about $150,000 in cash and $300,000 in bonds, and $1.05 million in equities.
Using the bucket strategy, bucket #1 (cash, years 1-2) would be $120,000 in cash. Bucket #2 (short-term, years 3-7) would be 5 years of income equaling $300,000 in bonds. Bucket #3 (long-term equities) would be the remaining balance of $1.08 million.
As you can see, the resulting allocation is similar. Adjusting the years or the allocation to a more conservative portfolio still results in similar numbers.
60% equities/40% fixed income with 10% of fixed income in cash results in $150,000 in cash, $450,000 in bonds, and $900,000 in equities.
A more conservative bucket strategy would be $180,000 in bucket #1 (3 years, cash), $420,000 in bucket #2 (7 years, bonds), and $900,000 in bucket #3 (long-term equities).
Psychological Benefits and Risks
For some, the bucket strategy may have a psychological benefit over the safe withdrawal rate strategy. Investors may be more willing to spend the money they are allowed to spend if they have a cash reserve bucket. They may also be less concerned about market volatility if they know they have 2 years of cash reserves.
A risk of the bucket strategy is that it is more complex. Investors must develop rules for refilling the buckets and still rebalance their portfolio periodically. If the market is volatile, they may be tempted to change their plan for refilling the buckets. And you still need to figure out a safe withdrawal rate to determine your annual income if you don't want your portfolio to run out.
The extra steps and rules open the bucket strategy investor up to multiple opportunities to question and change the rules during market volatility. This behavioral risk may in fact be the greatest risk to an investor's portfolio.
Which Retirement Withdrawal Strategy Is Best For You?
I prefer the safe withdrawal rate strategy. Maintaining a specific asset allocation and rebalancing periodically allows me to continue managing my portfolio in the same manner that I did during the growth phase. I feel that the rules are simpler, and I am more likely to stick to this simple plan. However, I might choose a cash allocation percentage that matches 2 years of income suggested by the bucket strategy.
Which strategy is best for you? Decide if you can sleep better by calculating a safe withdrawal number or creating buckets to visualize your portfolio. Will you be disciplined enough to follow your rules if the market is doing especially well or poorly? Do you want to consider a rising equities glide path to address sequence of returns risk?
Take some time to research and determine which option works best for you. Changing your strategy frequently often does more harm than good. So whatever you decide on, make sure you are confident that it is the best strategy for you, and stick with it. That way you can forget about your finances and focus on enjoying your retirement.
Resources
Choose FI Podcast: Episode 427 Drawdown Strategies: Karsten vs. Fritz available at: https://www.choosefi.com/drawdown-strategies-karsten-vs-fritz-ep-427/
Bucket Strategy by Fritz Gilber: https://www.theretirementmanifesto.com/
Safe Withdrawal Rates by Karsten Jeske: https://earlyretirementnow.com/
Pfau, Wade D. and Kitces, Michael, Reducing Retirement Risk with a Rising Equity Glide-Path (September 12, 2013). Available at SSRN: https://ssrn.com/abstract=2324930.
Managing Sequence Of Return Risk With Bucket Strategies Vs A Total Return Rebalancing Approach by Michael Kitces. Available at https://www.kitces.com/blog/managing-sequence-of-return-risk-with-bucket-strategies-vs-a-total-return-rebalancing-approach/
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