## Five Ways to Draw Retirement Income

Figuring out how to turn your portfolio into retirement income is a tricky thing because there are two unknowns: 1) you don’t know how the investments will perform, and 2) you don’t know how long you need to draw income.  A recent article from the Wall Street Journal discussed how to optimally tap a nest egg.  It references a study by Morningstar (a link to the Morningstar paper is included in the WSJ article) that compares five different methods.

The authors also propose a metric to determine how “efficient” the retirement income distribution method is.  Some of the methods are fairly heavy on math and count on the investor to use a mortality table and to determine portfolio failure rates using Monte Carlo simulation.  Others, like the 4% rule, are pretty basic.

The math-heavy methods work well, but in practice it might be a little more difficult to get a client to specify if they would prefer the calculation be made for a 50% chance of outliving their money or a 10% chance of outliving their money!  In my experience, clients are much more interested in methods that offer a 0% chance of outliving their money. Actuarial methods are somewhat dependent on the Monte Carlo simulation having a return distribution similar to what has been experienced in the past.  These methods might struggle in the case of a paradigm shift.

As far as simple methods go, the RMD (1/life expectancy or distribution horizon) method and the endowment method are both preferable to the 4% rule.  The RMD (required minimum distribution) method is easy to calculate and simple to adapt to whatever time horizon you choose.  The endowment method (taking a constant % of the portfolio) has the advantage of being relatively efficient over a wide range of asset allocations—not to mention that it has been tested in practice for decades.  Of course, both of these methods take into account the changes in the portfolio’s value, so your distribution may not rise every year.  In practice, endowments often smooth the portfolio value to reduce the income volatility.

The traditional 4% rule (withdraw 4% of the portfolio each year and adjust for inflation) is the worst of the rules tested.  It’s pretty easy for capital to be depleted if a difficult market occurs early in the retirement period because the withdrawals keep accelerating as the market value declines.

The robust methods (RMD and endowment) significantly reduce your chances of ever running out of money, but you have less certainty about year-to-year income as a result.  It’s what I would opt for, but every client’s situation is different.

With thousands of baby boomers hitting age 65 every day now, the Morningstar study deserves a close reading and a lot of thought.

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### One Response to Five Ways to Draw Retirement Income

1. [...] support a 4% withdrawal rate as easily as occurred in the past.  (There may be a couple of more efficient ways to withdraw retirement income than the 4% rule, but the basic problem will [...]